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Striking a Balance: Resolving the Conflicts Between Sections 363 and 365 of the Bankruptcy Code

by Gavin Mack­ie1

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.

* * * * *

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

* * * * *

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 ©, 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 © are also lim­i­ta­tions on sales under 363(f), since a 363(f) sale is a sale “under [363] (b) or ©”.31 Since 363(l) con­tains lan­guage specif­i­cal­ly stat­ing that sales under 363(b) and © 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.

* * * * *

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.

* * * * *

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.

 

Notes:

1. 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.