The Ninth Circuit recently determined, in Pinnacle Rest. at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holdings II, LLC), 862 F.3d 1148 (9th Cir. 2017), that a sale of real property free and clear of liens and interests under Section 363(f) of the United States Bankruptcy Code, 11 U.S.C. § 363(f) (“Section 363(f)”), can terminate a leasehold in the underlying property notwithstanding the provisions of Section 365(h) favoring non-debtor lessees. In so holding, the Ninth Circuit joins the minority of courts allowing such property to be sold in bankruptcy free and clear of these leasehold rights.

At issue in Spanish Peaks is the interplay between Sections 363 and 365 of the Bankruptcy Code. When a lessor/debtor or trustee in a bankruptcy case rejects a real estate lease, the lessee is afforded certain statutory protections under Section 365(h) of the Bankruptcy Code. In such instances, the non-debtor lessee can treat the lease as terminated and assert a damages claim. Alternatively, the lessee can waive any claim against the bankruptcy estate, retain possession of the leasehold property for the remaining lease term, and continue to pay rent (offset by any actual costs incurred based on non-performance by the debtor/lessor).

Section 363 of the Bankruptcy Code gives a debtor or trustee the ability to sell property of the bankruptcy estate free and clear of liens and interests if certain requirements are met. Under the usual scenario, liens held by secured creditors are stripped off and attached to the sale proceeds in the order of priority.

Under the Ninth Circuit’s ruling in Spanish Peaks, a tenant of a bankrupt landlord could find itself with no interest in the property following the sale.

Facts and History. The debtor was one of the multiple entities involved with Timothy Blixseth and the resort he and others had planned in Big Sky, Montana. The resort project was funded by a $130 million loan secured by a mortgage on the resort property and an assignment of rent. After the loan, the debtor entered into two leases at the resort with two related entities. One, a restaurant lease for a term of 99 years for $1,000 per year in rent. And a second lease for a parcel of property with a term of 60 years at an annual rent amount of $1,285.

The debtor defaulted on its loan payments for the resort and filed for relief under Chapter 7 of the United States Bankruptcy Code. The Chapter 7 trustee and the lender agreed that the trustee would sell the resort property “free and clear of any and all liens, claims, encumbrances, and interest” pursuant to Section 363(f). The bankruptcy court, after some procedural hurdles, entered an order approving the sale of the resort property to the lender for $26.1 million under Section 363(f). At the conclusion of the sale to the lender, the two lessees argued that, under 11 U.S.C. § 365(h), the lender took the property subject to the two long-term leases.

After a two-day hearing on the matter, the bankruptcy court authorized the sale free and clear, on the grounds that the trustee had met the applicable requirements under Section 363(f). The bankruptcy court noted that the tenants failed to request adequate protection of their leasehold interests under 11 U.S.C. § 363(e). The district court affirmed.

On appeal to the Ninth Circuit, the tenants asserted that Section 365(h) should govern their leasehold rights in the real estate, as opposed to Section 363(f). The tenants also argued that there was no basis under Section 363(f) to sell the real property free and clear of liens. The trustee maintained that Section 365(h) did not apply because the trustee was seeking to sell the real property, rather than to reject the lease. Furthermore, the trustee argued that Section 363(f)(1) authorized a free and clear sale. Section 363(f)(1) allows such a sale if “applicable nonbankruptcy law permits the sale of such property free and clear of such interest.” The trustee pointed out that under Montana state law if the bank had foreclosed on the real estate, the leases would have been extinguished.

Ninth Circuit Reasoning. The Ninth Circuit acknowledged that, when Sections 363 and 365 collide, the majority of courts have held that Section 365 trumps Section 363 under the canon of statutory construction that the specific prevails over the general. The specific protections afforded to lessees under Section 365(h) would be rendered meaningless if the real property could be sold free and clear of the leasehold under the more general provisions of Section 363(f).

The Ninth Circuit also acknowledged that the only court to reach a different conclusion as the Seventh Circuit in Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537 (7th Cir. 2003). In Qualitech Steel, the Seventh Circuit concluded that there was no conflict between Sections 363 and 365 because Section 363(f) confers a right to sell property free and clear of “any interest,” without excepting from that authority leases entitled to the protections of Section 365(h). By contrast, Section 365(h) has a more limited scope – defining the rights of a lessee affected by the rejection of a lease by the debtor or trustee. The Seventh Circuit also noted that in the contract of a free and clear sale, the lessee is not left without a remedy. The lessee has the right to seek protection under Section 363(e), and upon request, the bankruptcy court must ensure that the lessee’s interests are adequately protected.

The Spanish Peaks court adopted the “minority” approach as set forth in Qualitech Steel. The court noted that no party was seeking to reject the lease, and therefore Section 365 did not apply. The court also agreed that foreclosure law could be relied upon to meet the Section 363(f)(1) free and clear sale requirement. In addition, the court pointed out that Section 363(e) provides a “powerful check on potential abuses of free-and-clear sales” and that, depending on the circumstances, adequate protection could include permitting the tenant to remain in the premises. Spanish Peaks, 862 F.3d at 1156. Unfortunately, in this case, the tenants did not raise the issue of adequate protection until the appeal. Takeaway. With this decision, the Ninth Circuit has formally joined the minority when it comes to the question of whether a property in bankruptcy may be sold free and clear of leaseholds. Had the tenants properly raised the issue of adequate protection under Section 363(e) at the bankruptcy court level, they likely would have received something on account of their interest, including possibly remaining in possession (leases, unlike lien interests, are more difficult to satisfy by proceeds from the sale). Bankruptcy sales can move very quickly and, no doubt, debtors/trustees will take full advantage of the Spanish Peaks decision. Tenants must be vigilant and timely assert appropriate arguments to protect valuable leasehold interests.

For more information regarding the Spanish Peaks decision specifically, or bankruptcy law generally, please contact Donald H. Cram, III at or 415-677-5536.