On February 16, 2022, the United States Court of Appeals for the Fifth Circuit in the case of In re Royal Street Bistro, L.L.C., 2022 WL 499938 (5th Cir. Feb. 16, 2022), in reaching an outcome in line with two other circuit courts, the Seventh Circuit and the Ninth Circuit, permitted a Chapter 11 trustee to sell a debtor’s real property free and clear of the leasehold estates held by certain non-debtor tenants.
This decision follows the Seventh Circuit and the Ninth Circuit in holding that, in certain circumstances, real property can be sold free and clear of all liens, claims and interests, including leasehold possessory interests, under Section 363(f) of the United States Bankruptcy Code (as amended, the “Bankruptcy Code”), despite such non-debtor tenant’s possessory rights in the lease pursuant to Section 365(h) of the Bankruptcy Code.
Background
Royal Alice Properties, LLC (the “Debtor”) owned three separate parcels of real estate located in the famed French Quarter of New Orleans, Louisiana. The Debtor filed for Chapter 11 protection in the United States Bankruptcy Court for the Eastern District of Louisiana (the “Bankruptcy Court”) to prevent the secured lender from foreclosing on the Debtor’s properties. Prior to filing, however, the Debtor, as landlord, entered into leases at below market rates for all three properties with insiders (related parties), as tenants (collectively, the “Insider Leases”).
About a year after the commencement of the Chapter 11 case, the Bankruptcy Court appointed a Chapter 11 trustee (the “Trustee”) over the Debtor’s estate, and the Trustee then sought to sell all three properties free and clear all liens, claims and interests, including those of the tenants to the Insider Leases. The tenants objected, arguing that the properties could not be sold free of their possessory rights to the properties under Section 365(h) of the Bankruptcy Code.
Bankruptcy Law
Section 363(f)(1) of the Bankruptcy Code allows a trustee or debtor-in-possession to sell property of the bankruptcy estate free and clear of all liens, claims and interests, including third-party interests, when applicable nonbankruptcy law permits a sale of the property free and clear of such interests. 11 U.S.C. § 363(f)(1).
Section 365(h) on the other hand, generally recognizes a tenant’s right of possession to leasehold property even after a trustee or debtor-in-possession rejects the lease.
Simply put, there are circumstances where Sections 363(f) and 365(h) can be incompatible with each other, like the circumstances in this case.
Lower Court Decisions
The Bankruptcy Court, following the Seventh Circuit’s 2003 opinion in Precision Industries, Inc. v Qualitech Steel, SBQ, LLC (In re Qualitech Steel Corporation), 327 F.3d 537 (7th Cir. 2003), and the Ninth Circuit’s 2017 decision in Matter of Spanish Peaks Holdings II, LLC, 872 F.3d 892 (9th Cir. 2017), held that, notwithstanding Section 365(h), the Debtor’s properties could be sold free and clear of all liens, claims, encumbrances and interests under Section 363(f). The Bankruptcy Court reasoned that because the Insider Leases would be wiped out in a foreclosure sale, the Bankruptcy Code should not provide tenants with any greater rights.
The tenants then sought a stay of the sale on appeal before the U.S. District Court for the Eastern District of Louisiana (the “District Court”). The District Court declined to issue a stay, holding that the tenants did not demonstrate a likelihood of success on the merits to prevail on appeal in order to stop the sale. In re Royal Street Bistro, LLC, 2022 WL 326636, *5-6 (E.D. La. Feb. 3, 2022).
Fifth Circuit Decision
On appeal from the District Court, the Fifth Circuit, while stating that the Seventh Circuit’s decision in Qualitech was too broad, followed both the Seventh and Ninth Circuits in holding that in this case, where the tenants’ rights and possessory interests in the Insider Leases would be wiped out in a foreclosure sale, the Debtor’s properties could be sold free and clear of all liens, claims and interests under Section 363(f), notwithstanding Section 365(h).
Conclusion
There are now three Circuit Courts (the Fifth, Seventh and Ninth) that have rejected the proposition (once largely accepted by lower courts) that a non-debtor tenant’s leasehold rights under Section 365(h) should control over those of Bankruptcy Code Section 363(f).
Taking all of the above, it seems that a non-debtor tenant confronted by a proposed “free and clear” sale of real property will not be able to successfully demand that its possessory rights in the real property be preserved under Bankruptcy Code Section 365(h) unless either: (i) the tenant’s lease is senior to the mortgage such that lease would not be wiped-out in foreclosure; or (ii) the tenant and the secured lender have a pre-petition subordination and non-disturbance agreement that protects the tenant’s leasehold estate from being wiped-out in foreclosure by the secured lender.
