PROTECTING
YOUR TENANT CLIENT WHEN ITS LANDLORD
GOES BANKRUPT -- DON'T FALL ASLEEP AT THE SWITCH
by James R. Schroll*
Your client holds valuable rights as a tenant in commercial or industrial property. He calls to tell you that his landlord has just filed a Chapter 11 bankruptcy. You are a real estate lawyer, not a bankruptcy expert. But your client has heard rumors that the Debtor's landlord might sell its property and wants to know whether his possessory interest in the premises is protected. Your client has just received some papers from the debtor and wants you to tell him what, if anything, he needs to do.
SECTION 365(h) OF THE BANKRUPTCY CODE
Section 365 of the Bankruptcy Code (the "Code") generally provides the bankrupt entity the opportunity to reject unexpired leases. Usually the issue arises when the tenant, not the landlord, goes bankrupt. The classic example is the company that is leasing twenty thousand square feet of office space from a landlord for $30.00 per square foot. The lease was entered into when the market and the lessees' business was at its peak. If the tenant is the debtor, it can use Section 365 to reject the lease, thus giving it the opportunity to reduce overhead by moving into a new ten thousand square foot space at only $25 per square foot. 1
However, what are the rights of the tenant when the landlord files for bankruptcy? What if the tenant has a below market lease and has made valuable improvements to the leased premises? The answer lies in Section 365(h), which allows the bankrupt landlord to reject the lease but provides that the tenant may elect to retain its possessory interest in the leased premises notwithstanding the landlord's exercise of its rejection rights. Section 365(h)(l)(A) of the Code provides:
(I) if the rejection by the trustee amounts to such a breach as would entitle the lessee to treat such lease as terminated by virtue of its terms, applicable nonbankruptcy law, or any agreement made by the lessee, then the lessee under such lease may treat such lease as terminated by the rejection; or
(ii) if the term of such lease has commenced, the lessee may retain its rights under such lease (including rights such as those relating to the amount and timing of payment of rent and other amounts payable by the lessee and any right of use, possession, quiet enjoyment, subletting, assignment, or hypothecation that are in or appurtenant to the real property for the balance of the term of such lease and for any renewal or extension of such rights to the extent that such rights are enforceable under applicable nonbankruptcy law.
Thus, section 365 gives
the tenant important protection against the repercussions of the economic demise
of its landlord, including the right to occupy the premises at the same lease
rate and to renew and extend those rights if provided for in the lease and permitted
by state law.
Section 365(h)(l)(B) provides additional protections to the tenant by allowing
the tenant to offset any rent deposit against any damage caused by the landlord's
non-performance after the date of the rejection. However, the tenant cannot
assert a claim for damages above the amount of any setoff amount. Section 365(h)(l)(C)
applies to shopping center leases. It provides that the rejection of a shopping
center lease does not affect the enforceability under state law of any provision
in the lease pertaining to "radius, location, use, exclusivity, or tenant
mix or balance." Thus, key non-monetary provisions of shopping center leases
are left undisturbed. Finally, section 365(h)(l)(D) states that the protections
awarded to the "lessee" apply equally to any "successor, assign
or mortgagee" permitted by the lease.
SECTION 363 OF THE BANKRUPTCY CODE
The protections provided by section 365 to tenants are significant. But what happens if the bankrupt landlord sells its fee interest in the leased remises? The Bankruptcy Code contains significant provisions intended to facilitate the debtor's sale of its assets to generate money to pay creditors. Section 363 of the Code sets out the rules which apply when a bankrupt entity wants to sell its assets outside the ordinary course of its business. This might involve the sale of certain assets no longer needed by the reorganizing debtor, or it could entail the sale of all assets of the debtor. Section 363 tries to strike a balance between the rights of the debtor and the rights of both secured and unsecured creditors. On the one hand, section 363 encourages the sale of assets by allowing assets to be sold "free and clear of liens." This facilitates the sale of assets by allowing a purchaser to acquire good title to assets which could not have been sold outside of bankruptcy because of liens encumbering the property. However, section 363 protects the rights of secured creditors and others holding an interest in the debtor's property by permitting the sale of assets only if certain conditions are met. 2 In general, if an entity with an interest in the assets objects to the sale, the assets cannot be sold unless the holder of that interest is given adequate protection. 3
PRECISION INDUSTRIES, INC. V. QUALITECH STEEL SBQ, LLC
In May 2003, in Precision Industries, Inc. v. Qualitech Steel SBQ, LLC,
327 F. 3d 537 (7th Cir. 2003), reh'g denied, 2003 U.S. App. LEXIS 10626 (7th
Cir., May 7, 2003), the United States Court of Appeals for the Seventh Circuit
grappled with an apparent conflict between the right of a lessee to retain its
possessory interest in leased premises under section 365 of the Code and the
right of a debtor who is a lessor to sell its assets free and clear of the rights
of the lessee under section 363 of the Bankruptcy Code. The debtor, Qualitech,
operated a steel mill on 138 acres. In 1998, Precision entered into two agreements
with Qualitech. Under a supply agreement, Precision would build a supply warehouse
on Qualitech's property and would operate the warehouse for ten years so as
to provide on-site integrated supply services for Qualitech. Under a separate
land lease agreement, Qualitech would lease the warehouse to Precision for $1.00
per year for ten years. Precision would have the right to exclusive possession
and use of the warehouse and any other improvements or fixtures on the premises.
If the lease or supply agreement were terminated early, Precision could remove
all improvements and fixtures. At the end of the ten-year term, Qualitech had
the right to purchase the building and all improvements and fixtures for $1.00.
In 1999, Qualitech filed a Chapter 11 bankruptcy. Shortly thereafter, after providing notice to all creditors and parties in interest, including Precision, Qualitech sold all of its assets for $180 million to a third party pursuant to section 363 of the Code. Precision did not object to the sale. The notice to creditors and the order approving the sale provided that the sale of assets was "free and clear of all liens, claims, encumbrances, and interests" pursuant to section 363(f) and other provisions of the Code. All persons holding interests other than certain interests expressly reserved in the sale order were barred from asserting those interests against the purchaser.
The Order also reserved to the purchaser the debtor's right to assume and assign executory contracts pursuant to section 365 of the Code. However, after negotiations between Precision and the purchaser proved unsuccessful, the lease with Precision was considered to be de facto rejected. The new owner changed the locks on the warehouse, and Precision was dispossessed of the premises.
Thus, the issue was framed. Did Precision retain its possessory rights in the premises under section 365(h), under which lessees are supposed to retain possession of property in the event a debtor rejects the lease? Or did the sale of the debtor's property under 363(f) divest Precision of its rights in the leased premises notwithstanding the protections accorded to lessees under section 365(h)? The Bankruptcy Court ruled that the section 363 sale extinguished Precision's lease rights. On appeal, the District Court reversed, holding that Precision's possessory rights to the leased premises survived the asset sale. However, the Seventh Circuit had the last word, reversing the District Court and holding that the sale of assets under section 363 wiped out the rights of Precision.
Although at first blush the Seventh Circuit's ruling appeared to many to be a landmark ruling and to represent a significant setback for the rights of tenants, in reality Qualitech primarily reinforced the fundamental rule that "equity (and the law) rewards the vigilant." The most notable fact in Qualitech was that, for reasons unknown, counsel for Precision did not object to the order allowing the sale of Qualitech's assets free and clear of all liens and interests. Thus, the Court noted that "[a]lthough the statute conditions such a sale on the satisfaction of one of five conditions, the parties before us do not dispute that at least one of these conditions was satisfied." Qualitech, 327 F.3d at 546. While the Court did not specify which of the five elements was satisfied, it would appear that Precision's failure to object to the sale was treated as consent under section 363(f)(2). 4 If Precision had objected, the Court could not have approved the sale without dealing with the rights of Precision.
So Qualitech tells us that when papers arrive from your tenant client
consisting of a notice of the sale of assets by its landlord under section 363,
you cannot sit back and rely on section 365 to protect your client's interest.
Rather, its time to roll up your sleeves, file an objection and prepare to take
whatever steps are necessary to protect the interests of your client.
The Qualitech court noted that the remedy available to Precision was to seek "adequate protection" for its interest under section 363(e) of the Code. Of course, "adequate protection" can come in many forms and will depend on the facts and circumstances of each case. Section 361 of the Code describes "adequate protection" as follows:
When adequate protection is required under section 362, 363, or 364 of this title of any interest of an entity in property, such adequate protection may be provided by --
(1) requiring the trustee to make a cash payment or periodic cash payments to such entity, to the extent that the stay under section 362 of this title, use, sale, or lease under section 363 of this title, or any grant of a lien under section 364 of this title results in a decrease in the value of such entity's interest in such property;
(2) providing to such entity an additional or replacement lien to the extent that such stay, use, sale, lease, or grant results in a decrease in the value of such entity's interest in such property; or
(3) granting such other relief, other than entitling such entity to compensation allowable under section 503(b)(1) of this title as an administrative expense, as will result in the realization by such entity of the indubitable equivalent of such entity's interest in such property.
In the case of leased premises, perhaps the most straightforward way of ensuring adequate protection is to require that the order approving any sale under section 363 expressly provide that the sale is subject to any leasehold rights in the transferred property. This would guaranty that the lessee would obtain the same rights it would have enjoyed had the debtor retained ownership of the property. 5
If the retention of leasehold rights by the lessee would be incompatible with
the purchase transaction, the task for the parties would be to fashion through
negotiation (or resolve through litigation) some other form of protection (presumably
cash) which would be adequate to protect the interest of the lessee while enabling
the property to be sold free and clear of that interest. That poses interesting
challenges, such as whether and to what extent to place a value on leasehold
improvements made by the lessee; the method by which to value the leasehold
rights, i.e. by comparison to current market rates or by some other method;
and whether and how to take into account damages and lost profits to be sustained
by the lessee if forced to relocate to new premises. 6 The
potential difficulty in negotiating or litigating these issues places a premium
on putting language in the lease at the time of its negotiation to clearly allocate
the risk of an early termination by the landlord. For example, language could
be included that states that the lessee is entitled to recoup the cost of its
investment in leasehold improvements as well as the cost of relocating to other
premises.
The issue of protecting the rights of a lessee in a landlord's bankruptcy obviously has important implications for any holder of a mortgage secured by leasehold rights where the fee interest of the lessor has not been subordinated to the leasehold mortgage. Counsel representing the interest of a lender secured by a leasehold mortgage will want to take care to include provisions in its documents to ensure that its rights in the leasehold interest are not wiped out by the failure of the lessee to take appropriate steps to protect the leasehold interest in the event of a proposed sale of assets under section 363. 7 These protections could provide, among other things, that the leasehold mortgagee be immediately notified in the event of a bankruptcy and that the mortgagee is authorized to file pleadings in the bankruptcy case on behalf of the lessee.
CONCLUSION
The lesson of Qualitech, then, is not that the holder of a leasehold interest has fewer rights than previously thought. To the contrary, Qualitech reminds us that a lessee has important rights and, by withholding its consent to any proposed sale, is in a position of leverage from which it can and should demand adequate protection of its leasehold rights as a condition of any sale of the debtor's assets. What will ultimately be considered adequate protection will be a function of the particular facts of each case and the vigilance and creativity of the tenant (or leasehold mortgagee's) counsel in each particular instance.
* John R. Schroll is the senior shareholder in the creditors' rights section of the law firm of Bean, Kinney & Korman, P.C., in Arlington, Virginia and a member of the Board of Governors of the bankruptcy section of the Virginia State Bar. He obtained valuable assistance in preparing the article from law student Alison Reynolds, the firm's law clerk.
1 Of course, the debtor is liable to the landlord for defaulting under the lease, but the landlord's claim is merely an unsecured claim, and the amount of damages is capped under section 502(a)(6)(A) of the Code.
2 Section 363(f) provides that the trustee may sell property free and clear of any interest in such property held by an entity other than the debtor, only if:
(1) applicable nonbankruptcy law permits sale of such property free and clear of such interest; (2) such entity consents; (3) such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property; (4) such interest is in bona fide dispute; or (5) such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.
3 Section 363(e) provides, in pertinent part:
Notwithstanding any other provision of this section, at any time, on request of an entity that has an interest in property used, sold, or leased, or proposed to be used, sold or leased, by the trustee, the court, with or without a hearing, shall prohibit or condition such use, sale, or lease as is necessary to provide adequate protection of such interest.
4 Literally
read, section 363(f)(2) would appear to require actual consent, not a mere failure
to object. Therefore, the absence of an affirmative expression of consent would
seem to be sufficient to prevent the sale. See In re Takeout Taxi Holdings,
Inc., 307 B.R. 525 (Bankr. E.D. Va.) (Mar. 2, 2004) ("Generally, silence
is not consent sufficient to permit a sale under Section 363(f)(2)"). See
also In re Thomas A. Roberts, 249 B.R. 152 (Bankr. W.D. Mich.) (May 22,
2000). However, other courts have construed the failure to object as the equivalent
of consent under section 363(f)(2). See, e.g., In re Michael Kevin James,
203 B.R. 449 (Bankr. W. D. Mo. 1997); In re Tabone, Inc., 175 B.R. 855
(Bankr. N.J. 1994); In re Mark Shary, 152 B.R. 724 (Bankr. N.D. Ohio
1993); In re George Sherman Elliot, 93 B.R. 343 (Bankr. E.D. Pa. 1988);
In re Donald Gabel, 61 BR 661 (Bankr. W.D. La. 1985).
5 As
previously noted, the order approving the section 363 sale in Qualitech
reserved for the purchaser the debtor's right to assume and assign executory
contracts pursuant to section 365. Precision might have presumed that this meant
that its lease rights were to survive the section 363 sale. Indeed, in ruling
in favor of Precision, the District Court cited this reservation of lease assumption
rights to the purchaser as evidence that the lessee's leasehold rights had not
been extinguished. Qualitech, 327 F.3d at 542. However, the Circuit Court
did not find this factor persuasive. Obviously, it would be prudent to make
sure that the reservation of rights for the lessee is explicitly stated in the
order approving the section 363 asset sale.
6 It
is at least arguable whether the holder of a leasehold interest could be compelled
to accept cash or some other consideration as adequate protection if the parties
fail to negotiate a resolution of their competing interests. What if the tenant
claims that its interest in the property is unique and that no amount of money
can substitute for its right to continue to occupy the premises? The better
argument seems to be that the tenant can be forced to take a monetary award
as adequate protection. The holder of an interest in real property can be compelled
to accept a money satisfaction of its interest (e.g., through condemnation proceedings),
thus satisfying section 363(f)(5) of the Code. The Qualitech court seemed
to take this for granted, noting that "adequate protection does not necessarily
guarantee a lessee's continued possession of the property, but it does demand,
in the alternative, that the lessee be compensated for the value of its leasehold
-- typically from the proceeds of the sale." Qualitech, 327 F.3d
at 548 (citations omitted).
7 For a more detailed discussion of protecting the rights of lenders holding leasehold mortgages, see John C. Murray, Bankruptcy Sale of Debtor's Property "Free and Clear" Terminates Lease (First American Corporation, 2003), available at www.firstam.com/faf/html/cust/jm-freeclear.html.