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We frequently see cases involving bankrupt tenants and their rights to terminate leases. It is less common to see cases that involve the effect of a landlord’s bankruptcy on tenants’ rights. Section 365(h) of the Bankruptcy Code deals with that issue and limits the landlord’s power of rejection of the lease so as to protect the tenant against eviction. That section provides that “the lessee may retain its rights under such lease . . . 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 non-bankruptcy law.” Section 365(h)(1)(A)(ii). This provision attempts to strike a balance between the rights of the debtor-landlord and its tenant. The tenant retains the right to possess the property for the remainder of the term it bargained for, while the rejection frees the debtor-landlord of other burdensome obligations that it assumed in the lease, for example, the duty to provide services to the tenant. FIRST IMPRESSION The recent case of Precision Industries v. Qualitech, 2003 U.S. App. (7th Cir.) (April 23, 2003), dealt with the issue of whether a bankrupt landlord can overcome that tenant protection against lease rejection by selling the landlord’s property free and clear of the tenant’s interest in a lease. Judge Diane P. Rovner, a highly respected judge and Philadelphia native on the 7th U.S. Circuit Court of Appeals, had to decide that issue in what she called a case of first impression at the circuit court level. In reaching her decision she attempted to reconcile the tenant-protection provisions of Section 365(h) of the Bankruptcy Code with another code section that permits the sale of the landlord’s real estate “free and clear” of any “interest.” Section 363(f). The court pointed out that the property may be sold free and clear only if one of the following conditions applies: “(1) Applicable nonbankruptcy law permits the 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.” That section also provides that “on request of an entity that has an interest in property . . . proposed to be . . . sold . . . by the trustee, the court, with or without a hearing shall prohibit or condition such . . . sale . . . as is necessary to provide adequate protection of such interest.” In this case, the debtors owned and operated a steel mill in Indiana. The tenants constructed a supply warehouse at the property for the sole purpose of providing supply services for Qualitech. In 1998 Precision entered into a 10-year supply agreement with Qualitech. If an earlier termination or default occurred under either agreement, Precision had the right to remove all improvements and fixtures. Otherwise Qualitech could buy the improvements and fixtures for $1 at the end of the term. Qualitech filed its Chapter 11 bankruptcy petition on March 22, 1999, and on June 30, 1999, sold substantially all of its assets at auction pursuant to the sale order “free and clear of all liens, claims, encumbrances and interest” under the above-quoted 363(f) of the Bankruptcy Code. The sale order approved the sale to a group of pre-petition, secured lenders for $180 million. Precision, which had proper notice of the sale, did not object. The purchasers then transferred their interests in the property to a new entity that assumed the rights of the purchaser under the sale order and took title to the property. The sale order also provided that the purchaser retained the debtors’ right to assume and assign executory contracts pursuant to 365 of the Bankruptcy Code. Negotiations for assumption of the lease proved to be unsuccessful. The result, according to the 7th Circuit, was that “Precision’s lease and supply agreement were de facto rejected.” By Dec. 3, 1999, Precision had vacated and padlocked the warehouse on the property, and, shortly thereafter, the purchaser changed the locks on the building without Precision’s knowledge or approval. REVERSALS That’s when Precision filed suit, claiming that its possessory interest in the leased property, protected under 365(h), survived the bankruptcy sale. The bankruptcy court disagreed and held that since Precision’s lease was an “interest” under the sale order, the purchaser had obtained title to the property free and clear of the lease under 363(f). The district court reversed, ruling that the terms of 365(h) prevailed over those of 363(f). It reasoned that there was no statutory basis for allowing the debtor-landlord to sell its property and terminate an underlying lease. That would limit the tenant’s post-rejection rights solely to cases where the debtor-landlord retained title and possession of the property. The 7th Circuit reversed the holding of the district court. It stated that Precision never objected to the sale order and that sale orders are final, appealable orders, i.e. once the appeal period has expired, res judicata precludes a subsequent lawsuit contesting that order. The court then examined the meaning of the word “interest” in Section 363(f) and found that even though the term is not defined in the Bankruptcy Code, based on cited case law a tenant’s leasehold estate was an interest under that section. The court also noted that the parties never disputed that the landlord had met one or more of the five statutory conditions (listed previously) in order to sell free and clear of an interest. Therefore the court assumed that a sale of the property free and clear of Precision’s leasehold interest was permissible under 363(f). BANKRUPTCY BOMBSHELL The court’s analyses on these threshold issues is revealing, but the most significant part of the decision is the holding that the sale of the real estate free and clear of the lease is not trumped by 365(h), which protects the rights of a tenant when a landlord rejects a lease. In reaching this conclusion, it reversed the district court and has now confirmed the ability of bankrupt landlords to terminate leases on their properties. This can be viewed as a bankruptcy bombshell that will reverberate in legal circles around the country. Under these circumstances, tenants may now be left with only a claim for damages that may or may not have priority against the sale proceeds and will have the potential of frustrating tenants’ expectations under their leases. Also, while the case did not involve a leasehold lender, the decision will cause anxiety among leasehold lenders who normally rely on the security of leases as collateral for their loans. Rovner began her decision by pointing out that the court was asked to reconcile two distinct provisions of the Bankruptcy Code, which seem to be in conflict. She decided the case in favor of the “free and clear” provision for three reasons. First, the code provides no-cross reference from one section to the other indicating that the broad right to sell real estate free of any interest is subordinate to the protections that 365(h) accords to tenants. “The omission suggests that Congress did not intend for the latter section to limit the former,” Rovner said “Second, the plain language in Section 365(h)(1)(A) suggests that it has limited scope. By its own terms, this subsection applies ‘if the trustee [or debtor-in-possession] rejects an unexpired lease as real property’” [emphasis added]. Rovner pointed out that what occurred in the first instance was a sale of the property that Precision was leasing rather than a “rejection” of its lease. However, she granted that if the sale order operated to extinguish Precision’s right to possess the property, as she concluded it did, then the effect of the sale might be understood as the “equivalent of a repudiation of Precision’s lease.” Despite that, she found that “nothing in the express terms of Section 365(h) suggests that it applies to any and all events that threaten the lessee’s possessory rights. Section 365(h) instead focuses on a specific type of event – the rejection of an executory contract by the trustee or a debtor-in-possession – and spells out the rights of parties affected by that event. It says nothing at all about sales of estate property which are the province of Section 363. The two statutory provisions thus apply to distinct sets of circumstances.” Third, she pointed out that 363 provides for a mechanism to protect the rights of the parties whose interests may be adversely affected by the sale of estate property. Section 363(e)(3) directs the bankruptcy court on the request of an entity which has an interest in the property to be sold, “to prohibit or condition such . . . sale . . . as is necessary to provide adequate protection of such interest.” Therefore, a tenant of a property being sold would have the right to insist that its interest be protected. This does not necessarily guarantee that tenants continue possession of the property, but it does demand in the alternative that the tenant be compensated for the value of its leasehold “typically from the proceeds of the sale.” In summary the court pointed out that the two statutory provisions can be construed in a way that “does not disable Section 363(f) vis a vis leasehold interests.” Where estate property under lease is to be sold, 363 permits the sale to occur free of a tenant’s possessory interest, provided that the tenant “upon request” is granted adequate protection for its interest. Where the property is not sold and the debtor remains in possession, but chooses to reject the lease, 365(h) comes into play and the tenant retains the right to possess the property. PROBLEMS FOR TENANTS One of the problems with the circuit court’s conclusion that the two statutory provisions apply to “distinct sets of circumstances,” is that once you decide that 363(f) applies over 365(h) and the tenant’s lease is terminated, a sale has the same effect on the lease as a rejection. The termination by sale is just not labeled a “rejection,” and therefore the tenant’s remedies will differ. One of the questions raised by the case, but not answered in the decision, is how the tenant will be compensated for the loss of its lease. Liens and claims that are cut off in a 363(f) sale attach to the proceeds of a sale. But it is not clear that the tenant will receive any part of the proceeds because there may be other secured creditors trying to reach the same proceeds. Also, in a multi-parcel sale it will be difficult for the tenant to segregate that portion of the whole purchase price which applies to the parcel it leased. In addition, it will not be easy to calculate damages on a terminated lease. The American Land Title Association has struggled with this problem in trying to define the damages that may be recovered under leasehold title insurance. What are the damages suffered by a tenant that loses a 20-year lease at a “bargain rental” which an expert could testify is now at a dollar a square foot less than a fair market rental rate? Will the lost value of improvements be calculated on a depreciated basis, and will moving and relocation damages be included? How will renewal rights and lease options of various kinds be evaluated and will “good will” be included? How about lost subleases? In addition, the tenant may have to compete for recovery with losses to a leasehold-mortgage holder, which may include claims for future interest and prepayment premiums. Major office buildings and shopping centers throughout the country have been built by tenants on leasehold interests. Think of all of the long-term leases that spawned high-rise buildings developed along Park Avenue and Lexington Avenue in New York over the tracks of the former Penn Central Railroad. The master tenants in these transactions have subleased building space to large companies, which in some cases have sub-subleased space to many other occupants. What will happen to all of these leases and subleases if a bankrupt landowner goes into bankruptcy and sells free and clear of the leases? Many mortgage lenders now demand better protection against borrowers’ bankruptcies by requiring borrowers to set up so-called “bankruptcy-remote” entities. These are entities that will own only the secured property, and by their structure will theoretically be unable to incur outside debt. This is one way to ward off the likelihood of bankruptcy. In light of the Precision decision, perhaps prospective long-term tenants will want to require bankruptcy-remote landlords. LESSONS A couple of lessons emerged from the Precision Industries case on possible ways to avoid these “free and clear” sales under 363(f). First, when a tenant receives notice that “interests” in the property are going to be terminated at the proposed sale, the tenant should not wait to assert its rights to “prohibit or condition” the sale “as is necessary to provide adequate protection” of its interest. The tenant should immediately assert these rights even if the proposed sale order only refers to “liens, claims, encumbrances, and interests” in a general way and does not specifically mention the tenant’s lease. It is possible that Precision didn’t comprehend the full significance of the free-and-clear notice. Also, a tenant should consider challenging whether 363(f) even applies to its lease under any of the five statutory conditions. In Precision Industries the court didn’t have to analyze those conditions because the tenant did not object on those grounds, but based on the facts set forth in the opinion, it is not clear whether any of those conditions would have applied to the Precision lease. For example, if that issue were challenged by Precision, would the court have found that criteria one was met i.e., applicable non-bankruptcy law would have permitted a sale free and clear of the lease? Could the debtors have argued that under state law either a senior lien creditor or a municipality that was owed real estate taxes could have foreclosed against the property and sold it free and clear of the lease? Or would condition five have been met, i.e. the tenant could have been compelled, in a legal or equitable proceeding, to accept a money satisfaction for its lease? Precision Industries stands as an important case on what could happen to a tenant when its landlord goes belly up. Lawyers and bankruptcy experts will probably cite it as a leading precedent in future cases, and undoubtedly its implications will stir debate and commentary in legal periodicals, seminars and workshops.

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