Under Section 365(h) of the Bankruptcy Code, where a debtor, as lessor, rejects a lease, the debtor’s contractual obligations under the lease generally disappear. However, the non-debtor tenant may elect to remain in possession of the premises as long as it continues to perform its obligations under the lease. In apparent contradiction to the possessory rights of a non-debtor tenant under Section 365(h), Section 363(f) of the code allows a debtor to sell its assets, including real estate, subject to a lease, “free and clear” of “liens, claims and encumbrances.”

On October 1, 2012, in In re Zota Petroleums, No. 11-35079-DOT, 482 B.R. 154 (E.D. Va. 2012), the U.S. Bankruptcy Court for the Eastern District of Virginia, Richmond Division, considered whether the assignment of an assumed lease could extinguish a sublessee’s statutory rights under Section 365(h) of the code. In Zota, the assignment was made as part of a sale of the debtor’s assets free and clear of all interests pursuant to Section 363 of the code. In its opinion, the bankruptcy court added its voice to the ongoing debate concerning the interplay of Sections 365(h) and 363(f) of the code, an issue most notably discussed by the U.S. Court of Appeals for the Seventh Circuit in Precision Industries v. Qualitech Steel SBQ (In re Qualitech Steel), 327 F.3d 537 (7th Cir. 2003). Concluding that the Section 365(h) rights of the sublessee survived the Section 363 sale, the bankruptcy court in Zota distinguished the Seventh Circuit’s interpretation of the scope and effect of Section 363, particularly where the lease interest at issue was rejected before or alongside the Section 363 sale.

The Facts

Before its bankruptcy, Zota Petroleums LLC was the lessee of certain real property, which it in turn subleased to D&MRE LLC for the purpose of operating a gas station and convenience store. After the commencement of the debtor’s bankruptcy case, the Chapter 11 trustee filed a sale and assumption motion seeking, inter alia, entry of orders authorizing the sale of substantially all of the debtor’s assets, as well as authorizing the assumption and assignment of certain leases and executory contracts, including the debtor’s original lease of the gas station property. The trustee also filed a notice of assumption and assignment of the identified leases, which set forth the proposed cure amounts for the affected contracts and leases. Shortly thereafter, the trustee filed a motion to reject certain other leases and executory contracts, including the debtor’s sublease of the gas station property to D&MRE.

While the trustee’s rejection motion was pending, an auction of the debtor’s assets was held, and LAP Petroleum LLC was determined to be the successful bidder at that auction. The resulting asset transaction, styled as both a sale of assets and an assignment of executory contracts and leases, was approved by court order November 30, 2011. Importantly, the order approving the transaction provided that “to the extent of applicable law, the sale of the assets shall vest LAP with good title to the assets, and the assets shall be free and clear of any and all liens encumbrances and all ‘claims’ as defined in § 101(5) of the Bankruptcy Code.” The order separately authorized the trustee to assume and assign the identified leases – including the debtor’s original lease of the gas station property – to LAP Petroleum at the closing of the asset sale.

On the same day that the asset sale to LAP Petroleum was approved, the bankruptcy court, by separate order, granted the trustee’s rejection motion. Upon the rejection of its sublease of the gas station property, D&MRE filed a motion seeking a determination that it was entitled, pursuant to Section 365(h)(1)(A) of the code, to retain its rights under the rejected sublease agreement, including its right to retain possession of the gas station property. LAP Petroleum objected to D&MRE’s motion on the grounds that the sale order approved the sale of assets free and clear of all interests pursuant to Section 363(f), including any interests under Section 365(h). In short, D&MRE sought to stay in possession of the gas station property as a subtenant, while LAP Petroleum expressed its intention to oust D&MRE from the property.

The Court’s Analysis

The bankruptcy court found in favor of D&MRE, explaining that “the provisions of § 365(h), which give the sublessee the right to retain its rights under the lease, apply,” and thus D&MRE was entitled to quiet enjoyment of the gas station property. In reaching this conclusion, the bankruptcy court distinguished the Seventh Circuit’s holding in Qualitech, which favored a robust reading of the general language of Section 363 to support an extinguishment of the tenant’s rights. The bankruptcy court instead relied upon the more specific language of Section 365(h) to hold that D&MRE’s rights as sublessee survived despite the “free and clear” language of the asset transaction. In reaching this determination, the bankruptcy court carefully analyzed the asset transaction and lease assignment to LAP Petroleum in order to distinguish the transaction from the facts presented by Qualitech and its supporting cases. (See, e.g., In re Downtown Athletic Club of New York City, 2000 U.S. Dist. LEXIS 7917 (S.D.N.Y. June 9, 2000), (holding that when a debtor-lessor sells property subject to a lease free and clear of the lease pursuant to Section 363(f), the court will not apply Section 365(h), but not addressing the same question in a scenario where the underlying lease was rejected pursuant to Section 365(h)); In re R.J. Dooley Realty, 2010 Bankr. LEXIS 1761 (S.D.N.Y. Bankr. May 21, 2010) (allowing sale of property “free and clear” of pre-existing leases pursuant to Section 363(f), but noting Section 365(h) only implicated upon rejection of lease).)

Dual Nature of the Asset Transaction

The bankruptcy court’s holding was largely driven by its conclusion that, notwithstanding the unitary nature of the asset transfer to LAP Petroleum, the operative documents were “all quite specific that certain assets were to be sold and certain leases and executory contracts were to be assumed and assigned.” In support of this determination, the bankruptcy court noted that the order approving the asset transfer attached a schedule listing the cure amounts for the various leases to be assumed and assigned, including the debtor’s lease of the gas station property. Because the transaction operated as a “free and clear” sale under Section 363 and an assumption and assignment under Section 365, the bankruptcy court concluded that the provisions of Section 365 were necessarily implicated.

Qualitech Case Distinguished

In Qualitech, the Seventh Circuit reached a different conclusion where a “free and clear” sale of substantially all of a debtor’s assets included property subject to an unexpired ground lease. At the time of the sale, no assumption or assignment of the ground lease had occurred and the lessee had failed to object to the sale. Following the sale, the lessee sought to retain possession of the leased property, despite the objection of the asset purchaser. The bankruptcy court ruled in favor of the asset purchaser and the Seventh Circuit subsequently affirmed. Relying on the plain language of Section 363(f), the Seventh Circuit concluded that “the provisions of § 365(h) were inapplicable if a lease were sold as part of a § 363(f) sale.”

Distinguishing the Qualitech holding, the bankruptcy court in Zota relied upon the principle of statutory construction that “the more specific provision should prevail over the general.” Citing a line of cases diverging from Qualitech, the bankruptcy court noted that “Section 365(h) is clear and specific in providing for certain rights and remedies available to the lessee after rejection of its lease. … Since Congress decided that lessees have the option to remain in possession, it would make little sense to permit a general provision, such as Section 363(f), to override its purpose.” In language likely to be relied upon by future lessees finding themselves in similar circumstances, the bankruptcy court explicitly held that “the rights of a tenant may not be extinguished by a § 363 sale; to hold to the contrary would give open license to debtors to dispossess tenants by utilizing the § 363 sale mechanism,” a result the Zota court could not countenance.

Going Forward

Given the increasing prevalence of Section 363 sales as a means for debtors to dispose of assets “free and clear” of liens and other interests, the issues highlighted in Zota are likely to continue to cause conflict among debtors, purchasers and lessees seeking to clarify and confirm their rights under unexpired leases. While this decision does not settle the debate over the proper interaction of Sections 365(h) and 363(f), Zota is instructive: it suggests that, particularly where an unexpired lease is explicitly rejected in connection with a Section 363 sale, the specific language and protections of Section 365(h) survive to protect the interest of the lessee, even in the face of the more general “free and clear” language of Section 363(f). •

Rudolph J. Di Massa Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights.

Jarret P. Hitchings is an associate in the firm’s Wilmington, Del., office and practices in the area of business reorganization and financial restructuring.