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Tenants Beware: Bankruptcy Sale May Terminate Your Lease

A recent ruling by the Ninth Circuit Court of Appeals that a lessee’s possessory right did not survive a “free and clear” sale under section 363 of the Bankruptcy Code is a warning to tenants of a bankrupt landlord to be diligent. The case, In the Matter of Spanish Peaks Holdings II, LLC (No. 15-35572), involved the Chapter 7 bankruptcy of a resort in Montana. The debtor had entered into two leases with insiders, one for 99 years for $1,000 per year in rent, and the other for 60 years for $1,285 per year in rent. The Chapter 7 trustee and the debtor’s secured lender agreed to a plan for liquidating the debtor’s real and personal property via sale “free and clear of any and all liens, claims, encumbrances and interests.” The sale excepted specified encumbrances, but the two leases were not among them. The leases were not rejected before the sale, and the tenants had not requested adequate protection for their leasehold interests under Bankruptcy Code section 363(e) before the sale. The tenants objected to the sale, asserting that section 365(h) gave them the right to retain possession of the leased property notwithstanding the sale. The Bankruptcy Court authorized the sale without ruling on the tenants’ objection, deferring their claimed right to possession to the hearing on the motion to approve the sale. The winning bidder testified at the sale hearing that its bid was contingent on the property being free and clear of the leases. The Bankruptcy Court approved the sale free and clear of the tenants’ interests and approved the sale. The District Court affirmed. The Ninth Circuit affirmed, acknowledging that it was adopting the “minority approach” to reconciling sections 363 and 365. The majority approach protects the lessee, holding that section 365 trumps section 363 under the canon of statutory construction that “the specific prevails over the general.” And, because section 365(h) gives lessees the right to retain possession of leased real property notwithstanding rejection of the lease, lessees may also retain possession following a sale under section 363 when the lease has not been rejected. The court rejected this line of cases and instead held that the two statutory provisions — 363 and 365 — did not conflict here because the trustee had not rejected the leases. “A sale of property free and clear of a lease may be an effective rejection of the lease in some everyday sense, but it is not the same thing as ‘rejection’ contemplated by section 365.” In this case, there was a sale but no rejection. Therefore, the lessees’ possessory interest in the property was extinguished by section 363. Importantly, the court noted that lessees have recourse in situations like this — by seek adequate protection of their leasehold interest under section 363(e). The tenants in this case had not done so.

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