Fifth Circuit Offers Commercial Tenants Likely Protection in Bankruptcy Court Free and Clear Asset Sales

A bankruptcy court gave “unnecessary and probably incorrect” reasoning to support its “excessively broad proposition that free and clear sales under [Bankruptcy Code (“Code”)] Section 363 nullifies and essentially renders inoperative the lessee’s critical protections against a debtor-lessor under [Code] 365(h),” the United States Court of Appeals for the Fifth Circuit said on February 16, 2022. In re Royal Bistro, LLC, 2022 WL 499938, *1-*2 (5th Cir. 16 February 2022). The court still denied the tenants’ “writ of mandamus motion” to “compel the district court to stand pending appeal” of a bankruptcy court order authorizing the trustee’s sale of the ” real estate of the debtor… frank and clear” of the tenants. interests. Identifier. at 1. Essentially, the Fifth Circuit has signaled that it will not approve in subsequent cases a sale of real estate assets by the bankruptcy court that summarily severes the rights of debtor tenants.

The Court of Appeals pointed out that the lower courts “erred to rely on” the heavily criticized Seventh Circuit decision in Precision Indus Inc. v. Qualitech SBQ Steel, 327 F.3d 537, 547 (7th Cir. 2003) (Section 365(h) lessee’s debtor-lessor protections do not supersede Section 363(f)’s free and clear terms of sale). On the facts of the limited motion before it, the Fifth Circuit rejected the lower courts’ “overstatement of their reasoning” based on their “serious misapprehension of the law or the facts.” 2022 WL 499938, at *2. Because the “essential rights of state law of tenants in this matter [were] limited by the prior lien of the primary mortgagee on the “sold property”, however, “neither [Code] Offers under Sections 363(e) and 365(h)(A)(ii) [the lessee-appellants] protection.” Identifier. “[S]state law [was] everything the commercial court needed to decide this case” against the tenants. Identifier.


The Third Circuit pointed out in another similar case that a trustee in bankruptcy or a debtor in possession of Chapter 11 cannot summarily use a free and clear sale under Code § 363(f) to sell property making the object of a free and quit lease and therefore extinguish the right of possession of a tenant. In re Revel AC, Inc., 802 F.3d 558, 564, 573 (3d Cir. 2015) (2-1) (the lessee requested the suspension pending the call of a sell order which would “annihilate” the interest of the lessee; reprieve granted because, among other things, “success has been assured to him on the merits”). He pointed out that Code § 365(h) protects the tenant’s interest after the trustee rejects the lease when the interest is not disputed in good faith. ID. Although the fifth circuit of royal bistro did not quote revel inhe noted the strong criticism of Qualitech by other courts and commentators. Dishi and son against Bay Condos LLC510 BR 696, 704 (SDNY 2014) (review Qualitech); In re Samaritan Alliance LLC2007 WL 4162918, *4 (Bankr. ED Ky. 21 Nov 2007); In re Haskell LP, 321 BR 1, 9 (Bankr. D. Mass. 2005); Michael S. Patrick Baxter, “Section 363 Free and Interest-Free Sales: Why the Seventh Circuit Got it Wrong in Qualitech», 59 Buses. Law. 475 (2004) (Qualitech had “the potential to have a profound impact on the world of bankruptcy”); Robert M. Zimman, “Precision in Legislative Drafting: The Qualitech Quagmire and the Sad History of § 365(h) of the Bankruptcy Code”, 38 John Marshall L. Rev. 97 (2004) (acknowledging the troubles created by Qualitech).

The Ninth Circuit followed Qualitechhowever, by judging that a debtor’s building leased to a third party could be sold free of the lessee’s interest, considering that a sale is not the termination 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…a ‘discharge’ contemplated by Section 365”). According to the Ninth Circuit, Code § 365(h), which protects a lessee of real property from rejection of its lease by the debtor-lessor, only applies when the debtor rejects 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 this situation is entitled to adequate protection under Section 363(e) of the Code if the tenant requests such repair, but has failed to do so. so in Spanish Peaks. ID., at 900.

The nuanced analysis of the fifth circuit

The Fifth Circuit dictated in royal bistro focused on the particular facts of the case before it. Two tenants of the debtor’s property had objected to the sale of the property and had alternately requested “either adequate protection under Section 363(e) or rejection of the leases, which the bankruptcy court ruled refuse”. 2022 WL 499938, at *1. The tenants, “insiders of the debtor company”, have leases “inferior to the rights of the mortgagee” on the building. ID. “If there had been no bankruptcy,” the mortgagee “could have foreclosed under state law and wiped out the junior interests.” ID. The leases also lacked “non-disturbance clauses that would have protected tenants from” foreclosure. ID. For this reason, the bankruptcy court rejected the opposition of the tenants initiated to the sale. According to the Court of Appeals, “State law is all the bankruptcy court needed to decide” the case. ID.

§§ 363(f)(1) and 365(h)(1)(A)(ii) limit debtor options, subject to applicable state law. First, under section 363(f), the debtor may sell free and clear if “the applicable non-bankruptcy law permits”, subject to providing “adequate protection” to the lessee under section 363(f). 363(e). Since the tenants here had no residual value after paying off the lender’s previous mortgage debt, the trustee had no “duty to provide adequate protection.” ID.

The tenants might have had the right to remain on the debtor’s property during the term of their leases had the trustee rejected their leases “to the extent such rights are enforceable under applicable non-bankruptcy law. “, per § 365(h)(1)(A)(ii).

“Bankruptcy law, in other words, recognizes and defers to state law in these provisions.” ID., citing Butner v. United States440 US 48, 54-57 (1979) (except where the Code prevails over state law, the Code applies to applicable state law proprietary rights).

State law governed the first reason given by the bankruptcy court for denying assistance to tenants initiated into royal bistro. In addition to the leases subject to mortgagee rights, one of the tenants had “many months of unpaid rent…and was…in default”. 2022 WL 499938 to *1. Since state law determined the outcome, there was therefore no reason for lower courts to rely on Qualitech. ID. In the ninth circuit Spanish peaks Also in this case, the leases “were legally subordinated to a principal mortgage interest in the property”. ID., at 2 o’clock.

The lower courts overstated “their reasoning” in royal bistro but achieved the right result. ID. According to the Fifth Circuit, courts “must be cautioned…against blithely accepting Qualitech reasoning and textual exegesis. ID. State law therefore remains relevant in federal bankruptcy cases. It should be read in conjunction with the Code, particularly when the Code explicitly refers to it.

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