Colder than a Landlord's Heart? Reconciling a Debtor's Authority to Sell Property Free and Clear of a Lease Under Bankruptcy Code Section 363(f) with the Tenant's Right to Remain in Possession on a Lease Rejection Under Bankruptcy Code Section 365(h)

The question examined in this paper is a simple one: can a tenant with a right to possession under section 365(h) of the Bankruptcy Code be ousted from possession by a free and clear sale of the real property by the debtor-landlord pursuant to section 363(f) of the Bankruptcy Code? The Seventh Circuit, the only court of appeals to have considered the issue, said “yes” in Precision Industries, Inc. v. Qualitech Steel SBQ, LLC and authorized a sale free and clear of the lease and the tenant’s right to remain in possession. Subsequent decisions from the district and bankruptcy courts are split, and most say “no.”This paper concludes that the answer lies in affording the tenant the same protection and priority against the property sold and the sale proceeds that the tenant has under state law. The answer has nothing to do with whether one of sections 365(h) or 363(f) trumps the other, and the Code does not show that either does. Rather, on a free and clear sale the tenants, mortgagees and other holders of interests against the property should be treated in accordance with the priorities of their respective bargained-for prepetition state law property interests against the property. Thus, if the lease has first priority, the sale should be subject to the lease and the tenant’s possessory rights under section 365(h), or if the tenant whose lease has priority consents to the sale it should be paid the first proceeds of the sale in an amount up to the value of the lease. If instead the lease is subordinate to a monetary lien or other encumbrance, the sale should be free and clear of the subordinate lease and of the tenant’s possessory rights, provided that the tenant is paid the value of its lease after payment to the holders of liens and encumbrances which are prior to the lease. Admittedly, the tenant under a subordinate lease will receive nothing if the lease is out-of-the-money and there are no sale proceeds remaining after payment of the prior liens and encumbrances. But that outcome, as cold as it may appear, represents the value of the tenant’s interest in the property sold.This result is compelled: (1) by the Supreme Court’s decisions in Butner and Nobleman, under which the property rights of parties in a bankruptcy case are determined by state law; (2) by 130 years of unequivocal pre-Code law and practice that characterized free and clear bankruptcy sales as hypothetical foreclosure sales under which the parties were treated in accordance the state law priorities of their interests in the property in sold, which Congress has never indicated it changed by enacting the Code; and (3) by the Code’s text regarding sales free and clear, adequate protection of interests in property that is sold in a bankruptcy case, and lease rejections, by the Code’s purposes of uniform and equitable distribution to creditors and maximization of the value of the debtor’s estate, and by the Code’s legislative history. This conclusion preserves to the tenant in each case the value of its interest in the property sold. In the case of a first priority lease this may be the full value of the lease and in the case of a subordinate lease this may be zero. But in each case, this rule vindicates the state law rights that the parties bargained for prior to the commencement of the bankruptcy case.