Fifth Circuit Provides Commercial Lessees Likely Protection in Bankruptcy Court Free and Clear Asset Sales


A bankruptcy court provided “unnecessary and probably incorrect” reasoning in support of its “overly broad proposition that sales are free and fair under [Bankruptcy Code (“Code”)] Section 363 nullifies, and essentially nullifies, critical tenant protections against a debtor-landlord under [Code] 365(h),” the United States Court of Appeals for the Fifth Circuit said on February 16, 2022. In relation to Royal Bistro, LLC, 2022 WL 499938, *1-*2 (5th Cir. Feb. 16, 2022). The court still denied the tenants’ “request for injunction” to “compel the district court to stay the pending appeal” of a bankruptcy court order authorizing the trustee’s sale of “the debtor’s real property. . free and clean” of the tenants. interests. ID. at 1. In essence, the Fifth Circuit stated that it would not approve in later cases a sale of real property by a bankruptcy court that summarily severs the rights of a debtor’s tenants.

The Court of Appeals emphasized that the lower courts “made the mistake of relying on” the heavily criticized Seventh Circuit decision in Precision Indus Inc. v. Qualitech Steel SBQ, 327 F.3d 537, 547 (7th Cir. 2003) (Section 365(h) tenant protections against a debtor-landlord do not replace the free and clear terms of sale of Section 363(f)). On the facts of the limited motion before him, the Fifth Circuit rejected the lower courts’ “exaggeration of their reasoning” based on their “gross misinterpretation of the law or the facts.” 2022 WL 499938, at *2. Because the “essential state law rights of tenants in this case [were] limited by the prior lien of the primary mortgagee on the “property being sold, however, “or [Code] Section 363(e) and 365(h)(A)(ii) Offers [the lessee-appellants] protection.” ID. “[S]state law [was] everything the bankruptcy court needed to decide this case” against the tenants. ID.


The Third Circuit emphasized in another similar case that a bankruptcy trustee or a Chapter 11 debtor in possession may not summarily use a free and clear sale under Code § 363(f) to sell property subject to a free and free lease of the lease and therefore extinguish the possessory interest of the lessee. In relation to Revel AC, Inc., 802 F.3d 558, 564, 573 (3d Cir. 2015) (2-1) (tenant requested stay pending appeal of sale order that would “erase” tenant interest; stay granted because, among other things things, “success was assured to him on the merits”). He emphasized that Code § 365(h) protects the lessee’s interest after the trustee’s rejection of the lease when the interest is not disputed in good faith. ID. Although the Fifth Circuit in royal bistro did not quote Rollicknoted the strong criticism of Qualitech by other courts and commentators. Dishi and sons v. Bay Condos LLC510 BR 696, 704 (SDNY 2014) (criticizing Qualitech); in re samaritan Alliance LLC2007 WL 4162918, *4 (Bankr. ED Ky. 2007 Nov 21); In re Haskell LP, 321 BR 1, 9 (Bankr. D. Mass. 2005); Michael S. Patrick Baxter, “Section 363 Sales Free and Clear of Interests: Why The Seventh Circuit Erred in Qualitech”, Bus 59. Law. 475 (2004) (Qualitech had “the potential to profoundly impact the world of bankruptcy”); Robert M. Zimman, “Accuracy in Statutory Drafting: The Qualitech Quagmire and the Sad History of § 365(h) of the Bankruptcy Code,” 38 John Marshall L. Rev. 97 (2004) (acknowledging the turmoil created by Qualitech).

Followed the Ninth Circuit Qualitechhowever, by holding that a debtor’s real property leased to a third party could be sold free of the lessee’s interest, reasoning that a sale is not a rejection of the debtor’s lease. In re Spanish Peaks Holdings II, LLC, 875 F.3d 892, 899, 900-01 (9th Cir. 2017) (“A sale…is not the same as…’rejection’ under Section 365”). According to the Ninth Circuit, Code § 365(h), which protects a tenant of real property from refusal of the lease by the debtor-landlord, applies only when the debtor refuses the lease and remains in possession of the property. . ID. (“Since the trustee did not reject the leases, section 365 was not implicated.”) A tenant in that situation is entitled to adequate protection under Code § 363(e) if the tenant requests such relief, but did not. so in Spanish spikes. ID., to 900.

The nuanced analysis of the fifth circuit

The Fifth Circuit dictates on royal bistro he focused on the particular facts of the case before him. Two tenants of the debtor’s property had opposed the sale of the property and were alternatively seeking “either adequate protection under Section 363(e) or denial of leases, all of which were denied by the trial court.” bankruptcies”. 2022 WL 499938, at *1. The tenants, “initiated in the debtor company”, have leases “secondary to the rights of the mortgagee” on the property. ID. “If there had been no bankruptcy,” the mortgagee “could have foreclosed under state law and liquidated secondary interest.” ID. The leases also did not have “non-disturbance clauses that would have protected tenants from” foreclosure. ID. For that reason, the bankruptcy court rejected the tenants’ objection to the sale. According to the Court of Appeals, “state law is all the bankruptcy court needed to decide” the case. ID.

Both § § 363(f)(1) and 365(h)(1)(A)(ii) limit the debtor’s options, subject to applicable state law. First, under § 363(f), the debtor may sell freely and clearly if “allowed by applicable nonbankruptcy law,” subject to providing “adequate protection” to the tenant under § 363(e). Because the tenants here had no residual value after the lender’s previous mortgage debt was satisfied, the trustee had no “duty to provide adequate protection.” ID.

Tenants may have had an additional right to remain in the debtor’s property during the term of their leases if the trustee had rejected their leases “to the extent such rights are enforceable under applicable law other than bankruptcy,” under § 365(h)(1)(A)(ii).

Bankruptcy law, in other words, acknowledges and defers to state law in these provisions.” ID., citing Butner v. United States440 US 48, 54-57 (1979) (except where the Code overrides state law, the Code enforces proprietary rights under applicable state law).

State law governed the bankruptcy court’s first reason for denying relief to insider tenants in royal bistro. Aside from the fact that the leases were subject to mortgagee rights, one of the tenants “had not paid any rent for many months…and was…in default.” 2022 WL 499938 at *1. Because state law drove the outcome, there was no reason for lower courts to rely on Qualitech. ID. In the Ninth Circuit Spanish Peaks In the case, too, the leases “were legally subordinated to a principal interest of the mortgagee in the real property.” ID., at 2.

The lower courts exaggerated “their reasoning” in royal bistro but got the correct result. ID. According to the Fifth Circuit, courts “should be cautioned … against cheerfully accepting quality reasoning and textual exegesis”. ID. Therefore, state law remains relevant in federal bankruptcy cases. It should be read in conjunction with the Code, particularly where the Code explicitly refers to it.


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