Just last month, the Ninth Circuit issued a ruling in the case of Matter of Spanish Peak Holding II, LLC, that is potentially devastating to a tenant that leases property from a landlord that files for bankruptcy relief.  Based on the Spanish Peaks decision, the leased property can be sold in the landlord’s bankruptcy case, “free and clear” of a tenant’s lease with the landlord, terminating the lease and the tenant’s right to possession of the leased property.

In the Spanish Peaks case, the developer of a 57 acre resort in Montana obtained a $130 million loan secured by a deed of trust  and assignment of rents on the property.  A collection of interrelated entities owned the resort and managed the property, which included a ski club, a golf course and residential and commercial real estate sales and rentals.  The developer defaulted in the loan payments and filed for Chapter 7 bankruptcy protection.  Shortly after the bankruptcy was filed, the Chapter 7 trustee moved the bankruptcy court to approve the sale of substantially all of the debtor’s real and personal property, “free and clear” of all interests under Bankruptcy Code Section 363(f).

At issue in the Spanish Peaks case was the treatment of two commercial real property leases on the real property that was sought to be sold in the trustee’s sale motion.  At the time that the trustee’s sale motion was heard, the two leases at issue had not been assumed or rejected by the Bankruptcy Court. Further, neither lease was mentioned in the trustee’s sale motion as encumbrances that would survive the sale of the real property or on the list of encumbrances that would be provided protection following the sale.  The lessees of both leases objected to the trustee’s sale motion on the ground that the sale wrongfully deprived them of their right to possession of the leased property under Bankruptcy Code Section 365(h).

Bankruptcy Code Section 363(f) authorizes the sale of property “free and clear” of an interest in the property under certain conditions set forth in the code section.  Bankruptcy Code Section 365 deals with the assumption or rejection of executory contracts, such as lease agreements.  Bankruptcy Code Section 365(h) contains protections for a tenant if a landlord for bankruptcy relief.  Specifically,  Section 365(h) provides if a real property lease is rejected in a bankruptcy case filed by the landlord, the non-debtor tenant may continue to remain in possession of the leased real property for the remainder of the lease term, and the tenant’s rights and obligations under the lease agreement will remain unchanged, except that the tenant cannot assert an affirmative claim against the landlord for damages caused by the landlord’s nonperformance under the lease after the date of rejection of the lease.  If a lease agreement is assumed, the tenant remains in possession of the leased property subject to the terms of the lease agreement

As correctly noted in the Spanish Peaks decision, Bankruptcy Code Section 363(f) does not expressly authorize the trustee in a bankruptcy case filed by the landlord  to sell real property without recognizing the rights of a tenant under Bankruptcy Code Section 365(h).  Conversely, Bankruptcy Code Section 365(h) does not expressly state that, in a bankruptcy case filed by the landlord, the rights granted to a non-debtor tenant under Section 365(h) survive a sale of the leased property free and clear of all interests under Bankruptcy Code Section 363(f).  Thus, the Bankruptcy Code is unclear whether the rights of a trustee to sell leased property in a bankruptcy case filed by a landlord free and clear under Bankruptcy Code Section 363(f) eliminate the rights of a tenant if the lease is rejected or whether those rights are subordinate to the protections of a tenant found in Bankruptcy Code Section 365(h).

Although this issue had not previously been decided by the Ninth Circuit, the majority position of other circuits that had faced the issue of the impact of a sale under Bankruptcy Code Section 363(f) on the protections of a tenant under Bankruptcy Code Section 365(h) is that the rights of a non-debtor tenant under Bankruptcy Code Section 365(h), including the tenant’s right to possession even if the lease is rejected, cannot be terminated by a sale under Bankruptcy Code Section 363(f).  In support of this position, many bankruptcy courts cited Congress’ intent, as found in the legislative history of Bankruptcy Code Section 365, to protect the tenant when the landlord files for bankruptcy relief.

Nevertheless, the Ninth Circuit adopted the minority position and ruled that a sale of real property free and clear of all interests under Bankruptcy Code Section 363(f) necessarily vitiates the protections granted to a tenant under Bankruptcy Code Section 365(h), including its rights to possession of the leased property.  In adopting the minority position, the Ninth Circuit in the Spanish Peaks decision noted that the tenants could have sought “adequate protection” of their tenancy interests despite the free and clear sale of the leased property under Bankruptcy Code Section 363(e), but they refused to do so.  The Spanish Peaks court also noted at the conclusion of its decision that the ability of a trustee to terminate a lease agreement without facing the restrictions found in Bankruptcy Code Section 365(h) also enhances the sales price of the property, maximizing recovery for the landlord’s bankruptcy estate and its creditors, which is a “core purpose” of the Bankruptcy Code.

This is complicated stuff.  However, it is easy to see how a landlord may be motivated to file for bankruptcy relief to take advantage of the Spanish Peaks decision and terminate unfavorable leases in order to increase the value of its real property, while ignoring the tenant protections found in Bankruptcy Code Section 365(h).  Perhaps the tenant’s best strategy to challenge a motion filed in the landlord’s bankruptcy case to sell the leased property would be to promptly seek “adequate protection” of its interest in the property, although the Spanish Peaks court provided little guidance as to the nature of such adequate protection or how such adequate protection would be calculated.  Thus, perhaps the critical lesson from the Spanish Peaks case is the need for tenants to obtain experienced counsel as soon as possible if their landlords file for bankruptcy relief.