by Gavin Mackie*

The balancing act that is the United States Bankruptcy Code sometimes leads to a tension between sections of the Code that grant rights to debtors and those that provide protections for parties with an interest in the debtor’s property. In this Contribution, Gavin Mackie (’19) explores the conflict between Sections 363(f) and 363(h) and how courts have approached situations where this conflict arises. Ultimately, this Contribution will argue that the possessory rights guaranteed by section 365(h) should be protected in any sale, and that a sale under 363(f) cannot eliminate the lessee’s interest.

The United States Bankruptcy Code is a delicate balancing act, pitting the needs of debtors against the rights of creditors and others who have some stake in the debtor’s property. This balancing act sometimes leads to a tension between sections of the Code that grant rights to debtors and those that provide protections for parties with an interest in the debtor’s property. The story of sections 363(f) and 365(h) is one such example.

Section 363(f) allows a debtor to sell property of the estate in bankruptcy “free and clear of any interest in such property of an entity other than the estate, only if” at least one of five conditions is met.2 There is a general consensus that a lease is an “interest in such property” for purposes of this section.3 Section 365 provides for protections of lessees in cases where the estate in bankruptcy is burdened by an unexpired lease.4 Under that section, a trustee may assume or reject a lease.5 If a lease is rejected, section 365(h) allows a lessee to either pursue damages for breach6 or “retain its rights under such lease that are in or appurtenant to the real property for the balance of the term of such lease.”7 This means that a lessee can maintain its possessory interest for the remainder of the term, but that the estate is free of any lease terms not appurtenant to the real property.

Though each scheme on its own is straightforward, an unavoidable conflict arises in a situation where a 363(f) sale functions to terminate rights that are protected under 365(h). In one case, for example, a debtor who owned an apartment building wanted to sell that building free and clear of a lease for the operation of washer/dryer machines in the building under the terms of section 363(f).8 The leaseholder, who had invested in the property by purchasing and installing laundry machines, opted to maintain their possessory interest in the property as provided by section 365(h).9 In such an instance, “each provision seems to provide an exclusive right that when invoked would override the interest of the other.”10 Since these provisions both appear to grant a right that application of the other would destroy, courts are tasked with determining which right must prevail.

This Contribution will argue that the possessory rights guaranteed by section 365(h) should be protected in any sale, and that a sale under 363(f) cannot eliminate the lessee’s interest.

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Courts have divided on which right should prevail when this statutory conflict arises. Most courts have determined that the rights of a lessee protected by 365 prevail over the right of a debtor/trustee to sell free and clear under 363(f) (the “majority position”).11 A minority of courts, and the only circuit courts to have considered the issue, have concluded the opposite, though always with a condition that the rights of the leaseholder be adequately protected (the “minority position”).12

The majority position that has emerged among bankruptcy courts has its roots in some of the earliest cases that have addressed the conflict at issue. One of these cases was In re Taylor.13 There, the debtor proposed to sell a number of nursing homes under 363(f), and various lessees objected, arguing that 365 is the only method through which a lessor can terminate its lease obligations.14 The court determined that the specific rights of a tenant to retain possession when a lease is rejected must be protected.15 In making this determination, the court focused on the “great particularity” of “the rights and duties of the lessor and lessee” enumerated in section 365, contrasting it with the absence of any language about the specific situation of unexpired leases in section 363(f).16 The court also assessed academic research and legislative history which it found overwhelmingly supported the proposition that the 365 rights must be protected.17 Similarly, in Churchill Properties, the court rejected an attempt by a debtor to sell an apartment building free and clear of a washing machine lease.18 This court went further, pointing out that if a sale were allowed to proceed free and clear under 363(f), the protections for lessees under 365(h) “would be nugatory.”19

Relying on these seminal cases, most lower courts have adopted the position that rights protected in 365(h) must prevail, though this position has yet to be adopted by any circuit courts.20

The minority position was first articulated by the Seventh Circuit in Precision Industries v. Qualitech Steel.21 In that case, the Seventh Circuit explicitly rejected the majority position in reversing the lower court, arguing that the two statutes can and should be read to entirely avoid conflict.22 The court argued that a sale of property does not qualify as a “rejection” of the lease, and so section 365(h) simply does not apply when a landlord chooses to sell property rather than reject the lease.23 Additionally, the court noted that because section 363 contains its own provision by which parties affected by a sale can seek “adequate protection,” the protections afforded by section 365 do not apply.24 This position has also been adopted by the Ninth Circuit, which followed the reasoning of the Seventh Circuit.25

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The majority position is the stronger argument and should be adopted by the circuits who have not yet had the opportunity to consider the issue. Both the plain language of the two statutes, as well as the clear history of legislative intent compel a reading that preserves the interests protected by 365(h). The specific protections for leaseholders in 365(h) should prevail over the limited, general provisions allowing a debtor/trustee to sell property free and clear in section 363(f). Further, 363(f) should not be read so as to completely destroy rights specifically granted in 365(h). The legislative history clearly supports this interpretation, and the majority of courts have accepted this interpretation.

The plain language of the two statutes indicates that the protections for leaseholders granted in 365(h) should prevail over the right of debtors to sell property free and clear under 363(f). Since “it is a commonplace of statutory construction that the specific governs the general”26 the general allowance for a sale in 363(f) must be read in the context of the specific protections for lessees afforded in 365(h). As the Taylor court noted, “§ 365(h) specifically references the situation where the debtor is the lessor and with great particularity sets forth the rights and duties of the lessor and lessee while § 363 does not.”27

Additionally, the language of section 363 is quite narrow, contrary to the assertion of the Seventh Circuit that that section creates a “broad right.”28 Michael St. Patrick Baxter, a bankruptcy partner at Covington & Burling who authored a leading article on this issue, argues that the right is clearly constrained by the language of 363 itself.29 He argues that the sale under 363(f) is allowed only under the conditions of 363(b) and (c), and is limited further because it is allowed only in five “carefully described conditions.”30 He further argues that the various other provisions of section 363 that limit sales under section 363(b) and (c) are also limitations on sales under 363(f), since a 363(f) sale is a sale “under [363] (b) or (c)”.31 Since 363(l) contains language specifically stating that sales under 363(b) and (c) are subject to the entirety of 365, sales under 363(f) should be read to incorporate those protections.32 His assertions as to Congress’ intent are brought into question in a personal anecdote recounted by Professor Robert Zinman, former President and Chairman of the American Bankruptcy Institute, in his seminal article reviewing the Qualitech decision. There, Professor Zinman claims that the provisio Baxter focuses on was an afterthought added in an amendment, and Congress could not have had the general intent that Baxter claims.33  Nevertheless, Baxter’s textual arguments are sound.

In addition to the arguments advanced by Baxter, the extent of 363(f)’s application is limited by the language of the very first sentence. It states that a debtor “may” sell property free and clear “only if” at least one of the five statutory conditions are satisfied.34 There is nothing in that sentence to suggest that it creates an absolute right to a free and clear sale as long as one of the statutory conditions are satisfied. It says that a sale cannot be free and clear if one of the conditions is not satisfied. That does not mean that the satisfaction of a statutory condition is sufficient to guarantee a sale, merely that it is necessary.35 Since the language clearly indicates that the enumerated conditions are necessary for a free and clear sale but not sufficient, a bankruptcy court must consider whether there are other provisions, such as section 365(h), that would prohibit such a sale.

Finally, it is a common rule of statutory interpretation that all words be given effect, and that language in one section of a code should not be read in a way that would render another section ineffective or null.36 Allowing a sale free and clear of leasehold interest would create a clear opportunity for the debtor to “[do] indirectly what it could not do directly, namely dispossess” the tenant.37 Giving such an opportunity to debtors effectively renders the protections of 365(h) entirely useless, as debtors faced with a tenant who opts to maintain possession of a lease could simply move to sell the property free and clear of that lease.

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In addition to the plain meaning of the text, the legislative history strongly supports the protection of leaseholder rights. In interpreting the language of both sections 363 and 365, it is essential to place the statutes in the context in which they were adopted and to consider the substantive reasons that Congress put them in place.

Since section 365 was adopted, there was widespread understanding and agreement as to Congress’ intent. As one early court noted,

In enacting §365(h), Congress sought to codify a delicate balance between the rights of a debtor-lessor and the rights of its tenants, by preserving certain expectations of parties to real estate transactions. Specifically, Congress concluded that rejection of a lease by a debtor-lessor should not deprive a tenant of his estate for the term for which he bargained.38

This history indicates that Congress thoughtfully considered what should happen in the event of a bankruptcy of a lessor and concluded that a lessee should be able to retain possessory rights in the event of a landlord’s bankruptcy.

In his authoritative article reviewing the Qualitech decision, Professor Zinman came to the same conclusion, saying that

Congress, again and again, from the drafting of the Code to the amendments that followed over the years, expressed in concrete statutory provisions its intention to protect the tenant’s estate and the rights of those with interests in that estate when the lease is disaffirmed in the landlord’s bankruptcy. On its face, this view is inconsistent with the notion that Congress intended that the landlord could easily avoid these protections by employing § 363 in lieu of § 365. 39

Professor Zinman goes on to recount personal conversations with a drafter of the original Bankruptcy Code as well as his own experiences working with Congress in drafting amendments to support his assertion that there was a clear intent to protect the possessory rights of lessees.40 While his account is anecdotal, his first hand experience over a period of over four decades provides valuable insight into the motivations and intent of the legislatures that enacted both sections.

Even while adopting the minority approach, the Ninth Circuit noted that “section 365 embodies a congressional intent to protect lessees.”41 They nonetheless felt compelled by the text of 363 to endorse an approach that balanced that intent with other possible purposes.42 As shown above, however, the plain text of the statute can and should be read in concert with this legislative intent.

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In resolving the apparent tension between sections 363(f) and 365(h) of the Bankruptcy Code, the protection of possessory rights granted to lessees must prevail over the limited right to sell property free and clear of any interests that burden the property. The plain language of the two statutes, read in accordance with the traditional tools of statutory construction, indicate that 365(h) should control over 363(f). The weight of authority from bankruptcy courts and the legislative history surrounding the adoption of 365(h) support this conclusion. Future circuit courts who are faced with this issue should follow that reasoning and adopt the majority position.

* Gavin Mackie is a 3L at New York University School of Law. This piece is a commentary on the problem presented at the 2018 Duberstein Bankruptcy Moot Court Competition at St. John’s University School of Law. The question presented asked whether a bankruptcy court can approve a sale of real property “free and clear” of a leasehold interest under section 363(f) of the Bankruptcy Code notwithstanding the protections for leasehold interests in section 365(h) of the code. This article presents a distillation of the side of the argument assigned to the author in the Duberstein competition, and the views expressed herein do not necessarily reflect the views of the author.

2. 11 U.S.C. 363(f).

3. See Precision Industries v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp.), 327 F.3d 537, 545 (7th Cir. 2003); see also Michael St. Patrick Baxter, Section 363 Sales Free and Clear of Interests: Why the Seventh Circuit Erred in Precision Industries v. Qualitech Steel, 59 Bus. Law. 475, 475 n.3 (2004) (explaining the history of interpretation of the term “interest” and concluding that modern courts adopt an expansive reading of the term that includes leaseholds).

4. 11 U.S.C. 365.

5. Id.

6. 11 U.S.C. 365(h).

7. 11 U.S.C. §365(h)(1).

8. In re Churchill Properties, III, Ltd. Partnership, 197 B.R. 283, 286 (Bankr. N.D. Ill. 1996).

9. Id.

10. Id.

11. See, e.g., In re Taylor, 198 B.R. 142 (Bankr. D.S.C. 1996); In re Churchill Properties, III, Ltd. Partnership, 197 B.R. 283 (Bankr. N.D. Ill. 1996); In re Haskell, L.P., 321 B.R. 1 (Bankr. D. Mass. 2005); In re Zota Petroleums, LLC, 482 B.R. 154 (Bankr. E.D. Va. 2012).

12. See, e.g., Precision Industries v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp.), 327 F.3d 537 (7th Cir. 2003); Pinnacle Rest. at Big Sky, LLC v. CH SP Acquisitions (In re Spanish Peaks Holdings II, LLC), 872 F.3d 892 (9th Cir. 2017).

13. Taylor, 198 B.R. at 142.

14. Id. at 144.

15. Id. at 167.

16. Id. at 165.

17. Id. at 165-66.

18. Churchill Properties, 197 B.R. at 288.

19. Id.

20. See, e.g., IDEA Boardwalk, LLC v. Revel Entm’t Grp. (In re Revel AC, Inc.), 532 B.R. 216, 227 (Bankr. D.N.J. 2015) (holding that tenants retain possessory rights under 365(h) notwithstanding a 363 sale); In re Samaritan Alliance, LLC, 2007 Bankr. LEXIS 3896, 9-10 (Bankr. E.D. Ky. 2007) (holding that a lessee retains 365(h) rights following a 363 sale); In re MMH Auto. Group, LLC, 385 B.R. 347, 363 (Bankr. S.D. Fla. 2008) (“the vast majority of lower court decisions have held that a debtor cannot use the provisions of section 363(f) to circumvent the rights of tenants expressly preserved by Congress in section 365(h)”).

21. Qualitech, 327 F.3d at 540.

22. Id. at 546-47.

23. Id. at 547.

24. Id. at 547-48.

25. See Spanish Peaks Holdings II, 872 F.3d at 894 (“We base our interpretation principally on the reasons given by the Seventh Circuit”).

26. Morales v. Trans World Airlines, Inc., 504 U.S. 374, 384 (1992).

27. Taylor, 198 B.R. at 165 (emphasis in original).

28. See Qualitech, 327 F.3d at 546-47.

29. Baxter, supra note 3, 59 Bus. Law. at 481-83.

30. Id.

31. Id. at 483-84.

32. Id. at 484 (“If the provisio . . . were intended to be applicable only with respect to ipso facto or bankruptcy clauses, the provisio would have referred specifically to § 365(e)(2) rather than to § 365 generally”).

33. See Robert M. Zinman, Precision in Statutory Drafting: The Qualitech Quagmire and the Sad History of § 365(h) of the Bankruptcy Code, 38 J. Marshall L. Rev. 97, 125-26 (2004).

34. 11 U.S.C § 363(f).

35. The term “only if” is used in formal logic to refer to necessary conditions. The term “if” sets out sufficient conditions, and “if and only if” sets out a condition that is both necessary and sufficient. Use of the term “only if” in this case indicates a specific choice to make the various conditions necessary to effectuate a sale, but not sufficient.

36. See Pottsburge & Lake Erie R.R. Co. v. Railway Labor Executives’ Ass’n, 491 U.S. 490, 510 (1989) (“when two statutes are capable of co-existence, it is the duty of the courts, absent a clearly expressed congressional intention to the contrary, to regard each as effective.”).

37. Haskell, 321 B.R. at 9.

38. In re Lee Road Partners, Ltd., 155 B.R. 55, 60 (Bankr. E.D.N.Y. 1993) (quoting H.R. Rep. No. 595, 95th Cong., 1st Sess. 349-350 (1977); S. Rep. No. 989, 95th Cong., 2d Sess. 60 (1978), U.S. Code Cong. & Admin. News 1978, p. 5787).

39. Zinman, supra note 31, at 118.

40. See Id. at 106-118.

41. Spanish Peaks Holdings II, 872 F.3d at 900.

42. Id.