Daily Development for Wednesday, March 9, 2005
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
Another excellent and important Jack Murray item:
BANKRUPTCY; LEASES; FREE AND CLEAR SALE: Bankruptcy court holds that 363 “fee and clear sale”of bankrupt landlord’s assets cannot terminate tenant’s 364 rights where tenant objects. Qualitech limited and distinguished.
In re Haskell L.P., 2005 Bankr. LEXIS 251 (Bankr. D. Mass. Jan. 11, 2005)
In a case of first impression by a bankruptcy court in the First Circuit, the court, departing from and distinguishing Precision Indus. v. Qualitech Steel SBQ, LLC, 327 F.3d 737 (7th Cir. 2003), (the DIRT DD for 4/29/03) ruled that the landlord-debtor could not compel a sale free and clear of the tenant's leasehold interest under sec. 363(f)(5) of the Bankruptcy Code because: (1) the tenant could not be compelled to accept a monetary satisfaction of its claim where the amount of its damages could not be quantified, and (2) adequate protection of the tenant's interest could only be achieved through the tenant's continued possession of the leased premises.
The tenant, NEBH, was in possession of a portion of the landlord-debtor's property, which the landlord operated as a 76-bed assisted living facility. The leased space consisted of a "short-term stay facility" and 60 parking spaces, pursuant to a 99-year lease under which NEBH paid no fixed rent but only certain operating expenses and real estate taxes. The lease, which was recorded, also granted NEBH a first right of refusal to purchase the property. NEBH also executed a subordination, attornment and nondisturbance agreement with the landlord-debtor and its mortgage lender (and HUD, which insured the loan). The SNDA provided that the lease was subordinated to the mortgage but that it would not be terminated or disturbed as the result of any subsequent foreclosure of the mortgage, or by "any judicial sale or execution or other sale of the premises." To secure the performance of NEBH's purchase-option right, the landlord-debtor granted NEBH a second (subordinate) mortgage on t!
The landlord-debtor filed a Chapter 11 liquidating reorganization plan with the bankruptcy court, wherein it sought to sell the property at public auction under sec. 363 of the Bankruptcy Code free and clear of all liens, claims and "interests" (including the lease), and filed a motion to reject the NEBH lease. NEBH objected to the landlord-debtor's motion to sell the property free of its leasehold interest, but (for whatever reason) did not dispute the landlord-debtor's right to sell the property free and clear of its right of first refusal. An appraisal of the property (obtained by the successor in interest to the landlord-debtor's mortgage lender, and apparently uncontested) indicated that the market value of the property at the time of the landlord-debtor's bankruptcy filing was $6.5 million, and that the landlord-debtor owed its mortgage lender approximately $13 million as of the filing date.
The landlord-debtor argued that it was entitled to sell the property free and clear of the NEBH lease because NEBH could be compelled to accept a money satisfaction in exchange for its leasehold interest in the property under sec. 363(f)(5) of the Bankruptcy Code. (The landlord-debtor did not argue that any of the other subsections of sec. 363(f) authorized it to sell the property free and clear NEBH's leasehold interest. The landlord-debtor contended that sec. 363(f)(5) was applicable because (citing a law review article), it was "hypothetically possible" to compel NEBH to accept monetary compensation for its interest, "such as through an eminent domain taking by the government." The debtor also cited the notorious Seventh Circuit Precision Industries decision for the proposition that sec. 365(h), which permits a tenant under a rejected lease to remain in possession of the leased premises, did not supersede the provisions of sec. 363 with respect to sales free and clear of!
interests. NEBH argued vigorously that it could not be compelled to accept a money judgment in lieu of continued possession because it was impossible to quantify the value of its leasehold interest, and the SNDA that it executed prevented it from being dispossessed.
The bankruptcy court, after examining the relationship between Secs. 363 and 365 (and finding that a lease constitutes an "interest" for purposes of sec. 363), and after reviewing the existing case law (including the Precision Industries case), stated that the landlord-debtor "has failed to cite to any controlling or persuasive legal authority in support of its argument that sec. 363(f)(5) provides a hypothetical [e.g., a taking by eminent domain], not an actual test." According to the court, Sec. 363(f)(5) requires that "the trustee or the debtor be the party able to compel monetary satisfaction for the interest which is the subject of the sale," and not a third party such a governmental condemning authority. The court ruled that, in this case, NEBH was entitled to remain in possession of the leased premises and could not be compelled to accept monetary satisfaction of its claim because: (1) NEBH's claim could not (as supported by uncontradicted testimony) be quantified a!
incapable of calculation, and (2) where, as here, the landlord-debtor specifically sought to reject the lease as part of its liquidating plan and NEBH objected to the landlord-debtor's request to sell the property free and clear of its lease, NEBH retained the option under Sec. 365(h) to remain in possession of the leased premises. The court also noted that the landlord-debtor had not offered any adequate protection for NEBH's interest in its leasehold estate, as required by Sec. 363(e), and that a lien on the proceeds of the sale (as opposed to continued possession) would be insufficient because the amount due on the prior first mortgage was almost double the value of the property.
Finally, the court stated that it did not need to consider the issue of the relevance or sufficiency of the SNDA, because it had ruled for NEBH based on its analysis of the interplay between Secs. 363(f) and 365(h).
Reorter’s Comment 1: This decision was well-reasoned and (in the Reporter's opinion) correctly decided. This case is clearly distinguishable from Precision Industries, for a number of reasons. In Precision Industries, the Seventh Circuit made much (perhaps too much) of the fact that, in its opinion, Sec. 365(h) applies to a specific event - the rejection of an executory contract by the trustee or debtor in possession - and not to a sale of the debtor's property where the lease has not been affirmatively rejected, which is supposedly governed by sec. 363 (which provision, according to the Seventh Circuit, is to be broadly construed and provides that property may be sold free and clear of any interest, whether that interest is a lien or a lease). In the In re Haskell case, the landlord-debtor brought a motion to reject the lease as part of its liquidating plan, and NEBH (unlike the tenant in Precision Industries) specifically objected to the landlord-debtor's motion to sell t!
perty free and clear of its leasehold interest, arguing (also unlike the tenant in Precision Industries) that the landlord-debtor could not satisfy the requirements under sec. 363(f)(5) because it could not compel NEBH to accept a money satisfaction for its leasehold interest, and in any event its leasehold interest could not be adequately protected under sec. 365(h) unless it was permitted to retain possession of its leased space. The court's decision in In re Haskell clearly illustrates the importance of the tenant objecting "early and often" to any proposed bankruptcy sale of the landlord-debtor's property free and clear of the leasehold interest, and affirmatively requesting the court to provide it with adequate protection for its leasehold interest (neither of which occurred in the Precision Industries case.) (The tenant could even file its own motion to compel the landlord's assumption or rejection of the lease; although such motions historically rarely have succeeded!
a motion may be justified -- and constitute "cause" -- given the post- Precision Industries uncertainty in this area and force the landlord-debtor to commit to treating the lease under sec. 365, which would then entitle the tenant to the protections of that section of the Bankruptcy Code.)
Reporter’s Comment 2: The concept of adequate protection under sec. 363(e) is designed to protect property interests, and generally is compensatory. Therefore, the tenant conceivably could be able to assert a claim for the value of the leasehold estate and its interest could attach to the proceeds from the sale. (According to the court in Precision Industries, "the lessee is to be compensated for the value of the leasehold - typically from the proceeds of the sale." 327 F.3d at 546; the court in In re Haskell noted that, "adequate protection may consist of compensation for [the tenant's] loss, secured by some other interest, or continued possession.") However, generally only creditors with secured claims (such as the secured first-mortgage lender in the In re Haskell case) can "credit bid" or receive the amounts owing on their claims directly from the sales proceeds. If there are secured claims against the property (e.g., a fee or leasehold mortgage or a judgment lien), wha!
d be the priority of the tenant's claim against the sale proceeds with respect to such competing interests? Should it make any difference whether or not the lease was recorded (as occurred in the In re Haskell case) for purposes of determining relative priorities? Should marshalling principles be applied? Also, as noted by the bankruptcy case in In re Haskell, where the amount of the secured first mortgage claim vastly exceeds the value of the leased property, and there is uncontradicted testimony that the amount of monetary compensation to be paid to the tenant is incapable of calculation (the court in In re Haskell stated that, "[the landlord-debtor} did not submit any rebuttal evidence, including the amount of any losses NEBH would sustain by virtue of the need for a replacement tenancy"), the tenant cannot be dispossessed from the leased premises.
Reporter’s Comment 3: Section 363(e) does not require that the lessee receive the benefit of its bargain in "kind" when the property is sold so long as the tenant's interest is adequately protected "in value." In contrast, without the protection afforded by § 365(h)(1) (permitting the tenant to remain in possession of the property), if the lease were rejected by the landlord-debtor - as opposed to a sale of the landlord-debtor's property under § 363(f) - the tenant would lose its leasehold interest in the property and have only a prepetition unsecured claim for damages, upon which it may ultimately recover little or nothing at the conclusion of the bankruptcy proceeding. See Steven R. Haydon and Nancy J. March, Sale of Estate Property Free and Clear of Real Property Leasehold Interests Pursuant to §363(f): An Unwritten Limitation?, 19 ABI J. 20 (2000). As evidenced by the court's holding in In re Haskell, adequate protection for leasehold interests may extremely difficult to!
ify. If the lease rental is at or close to the market rate, the strictly monetary value of the lease may be negligible. But if the tenant has a unique location or long-established good will at a particular site, or has spent significant funds on tenant improvements or build-out, "adequate protection" under sec. 363(e) may be a poor substitute for continued possession of the leased space. See In re Port Angeles Waterfront Associates, 134 B.R. 377, 381 (9th Cir. BAP 1991) (dissenting opinion noted that debtor, which had not defaulted under the lease, would lose $3.5 million of improvements it had made on the leased property); In re Taylor, 198 B.R. 142, 166 (Bankr. D. S.C. 1996) ("To allow a sale free and clear of a leasehold pursuant to § 363 even if the lessee received the value of its interest from the proceeds would effectively provide a debtor-lessor with means of dispossessing the lessee, a result that would appear to be in contravention of Congressional intent"). Shoul!
tenant be entitled, under certain circumstances, to claim that continued possession is the only form of "adequate protection" that will protect the tenant's interest? Tenants' attorneys will, most likely, be faced with the question, How is the tenant's possessory interest to be valued (for purposes of monetary compensation) for purposes of adequate protection? Is the value determined by the lease rental rate? Is the value determined by reference to the rental rate of other leases in the same building (assuming a multi-tenant property)? Is the value determined by similar leases at properties in the same geographical area? Must mitigation of damages, or special tenant-improvement allowances or rent (or other) concessions be taken into account? Furthermore, must the tenant's adequate protection claim for its possessory interest be treated as an administrative expense because it survives rejection (as opposed to being treated as a prepetition unsecured claim)? See In re Taylor, !
198 B.R. at 160 n.18 ("While the court declines to set a value at this time in as much as it's unnecessary in this ruling the Court believes the lease interests to have considerable value and will ascribe a value when necessary in this case"); Jerald I. Ancel, Marlene Reich, and Jeffrey J. Graham, Can a § 363 Sale Dispossess a Tenant Notwithstanding § 365(h)? 22 ABI J. 18 (2003); Peter N. Tamposi, Tenants Beware - Your Lease Rights May Be Subject to Termination by the Bankruptcy Court, 22 ABI J. 30 (2003).
Reporter’s Comment 4: A debtor in a Chapter 11 bankruptcy ordinarily must obtain confirmation of a reorganization plan before selling all or substantially all of its assets. (See generally §§ 1121-29 of the Bankruptcy Code.) But under § 363(b)(1), a debtor in possession, "after notice and a hearing, may use, sell or lease, other than in the ordinary course of business, property of the estate." Further, under § 363(f), a § 363 sale can be made "free and clear of any interest" in the property of an entity other than the estate if:
(1) applicable nonbankruptcy law permits sale of such property free and clear of such interest;
(2) such entity consents;
(3) such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property;
(4) such interest is in bona fide dispute; or
(5) such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.
In the In re Haskell decision, that bankruptcy court correctly noted that, "[t]he debtor did not contend that any of the other subsections of sec. 363(f)(1)-(4) authorize it to sell the Property free and clear of its leasehold interest." This is unlike the situation in the Precision Industries case, where the Seventh Circuit noted that there was no dispute as to whether the landlord-debtor had complied with any one (or more) of the five (disjunctive) conditions of sec. 363(f) set forth above because the court assumed - from the tenant's failure to raise the issue - that one or more of the statutory criteria had been met.
The landlord-debtor in In re Haskell argued that subsection (5) of sec. 363(f) applied (which provides that a sale free and clear of an interest can occur if an entity other than the bankruptcy estate could be compelled to accept a money satisfaction of the interest), on the theory that the tenant could be forced in a condemnation proceeding to accept a money satisfaction (although, as the court in In re Haskell correctly noted, it is incorrect to assume that this subsection can - or should - be interpreted to apply to a highly hypothetical and improbable situation where there exists an ability to get money for one's leasehold interest, let alone entitle the debtor or trustee to sell the property free and clear of such interest).
Under state law, a tenant generally can't be forced to surrender the leased premises for a payment of money, absent a provision in the lease permitting such payment. See, e.g., In re Independence Village, Inc., 52 B.R. 715, 734 (Bankr. E.D. Mich. 1983) (ruling that sale of life care facility under § 363(f) did not permit avoidance of interests of life-care residents and noting that if the interests held by residents were leases, then a sale would include either an assumption of leases or the leases could be rejected but trigger the lessees' rights under § 365(h); the court stated that "we know of no authority permitting a remainderman to force a life tenant to cash out his interest"); In re Lee Road Partners, Ltd., 155 B.R. 55, 60 (Bankr. E.D. N.Y. 1993) ("the lessee's leasehold estate cannot be diminished, changed or modified due to bankruptcy's intervention"); In re Taylor, 198 B.R. 142, 167 (Bankr. D. Md. 1996) ("courts have held that a sale of a property interest by a d!
-lessor to which an unexpired lease is related necessarily implies that the lease be assumed by the debtor" (citations omitted)). Cf. In re Rose, 113 B.R. 534, 539 ( Bankr. W.D. Mo. 1990) (permitting sale of real property free and clear of life estate interest under § 363(f)(1) and (4) with value of life estate to attach to proceeds). (An interesting question: As a result of the holding in Precision Industries, and related cases such as In re Haskell, should attorneys for tenants consider adding language to future leases, or amendments to existing leases -- especially ground leases -- stating that if the landlord brings any action to terminate or reject the lease when the tenant is not in default, monetary damages will not adequately compensate the tenant for its loss and the tenant is entitled, at its option, to specific performance of its right to continued possession of the leased premises?)
Reporter’s Comment 5: Although the court in In re Haskell reasoned that it did not need to address the issue of the language in the SNDA providing for non-disturbance of the tenant's possession if the first-mortgage lender foreclosed on the property (given the court's resolution of the issues on the basis of the facts and statutory construction), this certainly could have been a factor in the tenant's favor (no SNDA existed in the Precision Industries case). The SNDA was well-drafted, because it did not limit the tenant's right to continued possession solely to the situation involving a "foreclosure sale" (which might not benefit the tenant if the property were sold pursuant to a sec. 363 "free and clear" sale in a bankruptcy proceeding); rather, the SNDA stated that the tenant's rights under the lease would not be "terminated, disturbed, affected or impaired by . . . the foreclosure of the mortgage" or "by any sale or execution or other sale of the Premises, or by deed in l!
foreclosure . . ." Furthermore, the SNDA stated that the parties agreed that "the Lease shall remain in full force and effect, regardless of who has title to the Premises . . ."
Editor’s Comment: The threat isn’t over. As the editor noted in his recent discussion of the procedural limitations of challenging decisions by bankruptcy courts in this area, a tenant faced with a free and clear sale order may have great difficulty staying that order in order to appeal the court’s rejection of its protest. See Weingarten Nostate v. Service Merchandise, 2005 U.S. App. LEXIS 1131 (1/ 24/05), the DIRT DD for 1/ 28/05). (Under the "mootness" doctrine contained in Bankruptcy Code Section 363, the courts' decision to deny a stay pending landlord's appeal of a bankruptcy judge's order authorizing an assumption and assignment of a lease concludes the landlord's ability to appeal whether such authorization provided "adequate protection" to the landlord as required by Code Section 365.) This case was a landlord’s challenge, not a tenant’s but the issues regarding mootness are the same.
Once the sale is made, even to a party fully aware of the objecting tenant’s appeal, the sale is valid and the appeal is moot.
Here, of course, the bankruptcy court ruled in favor of the tenant, so the problem didn’t arise. We can have no certainty, until there is resolution from a higher authority, that other bankruptcy courts, or even the First Circuit, will concur in this court’s reading of Section 363.
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