Is Your Leasehold Interest in Danger if Your Landlord Files Bankruptcy and Sells the Property?

Posted by Attorney David J. Espin in Bankruptcy / Comments

As the ubiquitous maxim goes, “hard cases make bad law." Although this is oftentimes accurate, in some instances hard cases prompt courts to undertake a detailed and thorough analysis of the law which can lead to well-reasoned decisions that create thoughtful and practically useful precedent. Such is the case in a pair of court of appeals opinions regarding the interplay between two important bankruptcy code provisions that appear to be in conflict: § 363(f), which governs bankruptcy sales free and clear of certain liens, claims, encumbrances, and interests, and § 365(h), which governs a tenant's rights after a rejection of its lease when the debtor is the lessor.

In Spanish Peaks Holdings II, LLC, the Ninth Circuit recently agreed with the Seventh Circuit's reasoning in its Precision Industries decision by holding that in some circumstances, the sale of real estate pursuant to § 363(f) can be free and clear of all liens, claims, encumbrances, and interests, including the leasehold interest of a tenant on the property. While at first blush this appears to be a harsh and even inequitable result, upon deeper examination these two decisions harmonize these seemingly conflicting bankruptcy code provisions, and create a road map for tenants to protect their interests.

It is helpful to first understand the facts and procedural posture of these cases. Both cases concerned bankruptcy filings whereby the trustee attempted to sell substantially all of the estate's assets free and clear of all liens, claims, encumbrances, and interests in order to maximize the value of the assets. Maximizing the bankruptcy estate's value is of course the trustee's primary responsibility in a bankruptcy proceeding. In many instances, assets will fetch a higher value if they can be sold “free and clear," since the buyer can then use the property for any purpose it chooses. In addition, both cases also had the following factual similarities:

• The leases in each case were well below fair market value. In Spanish Peaks, rent was $1,000 per year, and the lessee and lessor were related parties. In Precision, it was $1 per year.

• Neither of the leases was recorded.

• In both cases, the lender on the property was in a senior position to the tenant.

• The trustees in both cases never formally rejected the leases under § 365(h).

• Neither tenant asserted it had a non-disturbance agreement clause in its lease.

• Neither tenant timely objected to the sale and requested “adequate protection" for their leasehold interest.

By delving into the reasoning set out in each opinion, it quickly becomes apparent how important these shared facts were to the holdings in both cases. As a threshold matter, 363(f) allows a trustee to sell property free and clear of “any interest in such property" if “applicable non-bankruptcy law permits sale of such property free and clear of such interest." Since the leases were both junior to the primary lender's mortgage on the property, were both unrecorded, and did not contain non-disturbance clauses, they could and presumably would have been terminated if the lenders had simply foreclosed on the properties in state court. As the Spanish Peaks court expressly stated, the intent of these code provisions is to protect tenant's rights, not enhance them.

In Wisconsin, according to Wis. Stat. 708.02, the default rule is that if property is leased after it has already been secured by a mortgage, the lease is subordinate to the mortgage interest and thus at risk of being extinguished in a foreclosure sale. Accordingly, in a bankruptcy sale of a Wisconsin property with facts similar to those set forth above, the analysis would likely be the same.

In addition, upon the request of a lessee, the bankruptcy court must provide “adequate protection" for an interest that is being terminated by the sale. Neither lessee made such a request, so the issue of what would entail such “adequate protection" was never decided in these cases. However, one can infer from these decisions that in the case of a lease that is 1) properly recorded, 2) contains a properly drafted non-disturbance clause, and 3) is the result of an arms-length agreement between the landlord and tenant (in order to avoid an accusation of self-dealing), “adequate protection" would likely mean continued possession of the property for the length of the lease term. This is the same protection a lessee would have if the lease was rejected under § 365(h), or if the property were foreclosed upon in state court.

In short, the lesson for tenants and their attorneys from these decisions is that it is important to be proactive on the front end when negotiating and drafting the lease, as well as on the back end after a bankruptcy has been filed. Bankruptcy sales often move quickly, so tenants and their lawyers must be diligent and appear in the case right away, monitor the bankruptcy docket, and properly assert these rights in a timely manner to protect their leasehold interests.