Fracas in the French Quarter: Fifth Circuit weighs in on ongoing controversy over the intersection of Bankruptcy Code Sections 363(f) and 365(h)

Reaching an outcome in line with two other circuit courts, on February 16, 2022 the Fifth Circuit Court of Appeals permitted a Chapter 11 trustee to sell a debtor’s real property free and clear of the leasehold estates held by certain non-debtor lessees. See In re Royal Street Bistro, L.L.C., 2022 WL 499938 (5th Cir. February 16, 2022)(the “Ruling”)

The dispute before the Fifth Circuit arose out of the bankruptcy proceedings of Royal Alice Properties, LLC (the “Debtor”), a single-member limited liability company that filed for Chapter 11 in the United States Bankruptcy Court for the Eastern District of Louisiana (the "Bankruptcy Court”). 

At the time of its bankruptcy filing, the Debtor held title to three parcels of real property in New Orleans’ famed French Quarter. Before the Chapter 11 filing, the Debtor entered into a series of leases with insiders at below-market rates (collectively, the "Insider Lessees"). The Debtor admitted it filed bankruptcy to prevent a secured lender from foreclosing upon a senior mortgage encumbering all three parcels. 

After the Debtor lingered in Chapter 11 for over a year without confirming a Chapter 11 plan, the Bankruptcy Court appointed a Chapter 11 trustee. Following his appointment, the Chapter 11 trustee sought approval to sell all three parcels free and clear of any liens and interests, including the interests of the non-debtor lessees. The Chapter 11 trustee relied on Bankruptcy Code Section 363(f)(1), which allows a bankruptcy trustee or debtor-in-possession to sell property of the bankruptcy estate free and clear of third-party “interests” when “applicable nonbankruptcy law permits a sale of such property free and clear of such interests.” 11 U.S.C. §363(f)(1). 

Background

Historically, most lower courts did not allow Chapter 11 debtors and trustees to use Bankruptcy Code Section 363(f) to sell real property free and clear of leasehold interests over the objections of the non-debtor lessees. These courts reasoned that a sale free and clear of leasehold interests was incompatible with Section 365(h), which generally recognizes a lessee's continued right of possession even after a bankrupt landlord (or its trustee) "rejects" the lease. To these courts, Bankruptcy Code Sections 363(f) and 365(h)(1) were incompatible with one another, and, since Bankruptcy Code Section 365(h)(1) was more specific, it should control. 

Then, in 2003, the Seventh Circuit Court of Appeals issued its groundbreaking opinion in Precision Industries, Inc. v. Qualitech Steel, SBQ, LLC (In re Qualitech Steel Corporation), 327 F.3d 537 (7th Cir. 2003)(“Qualitech"). Dismissing the incompatibility argument, the Seventh Circuit held that a Chapter 11 debtor-in-possession or trustee may use Bankruptcy Code Section 363(f) to sell real property free and clear of possessory rights that a non-debtor lessee might otherwise hold under Bankruptcy Code Section 365(h). 

Fourteen years later, the Ninth Circuit followed suit in Matter of Spanish Peaks Holdings II, LLC, 872 F.3d 892 (9th Cir. 2017)(“Spanish Peaks"). The Ninth Circuit held that notwithstanding Bankruptcy Code Section 365(h), a purchaser of real property from a Chapter 7 trustee under Bankruptcy Code Section 363(f) took free and clear of the leasehold interests held by certain non-debtor lessees. The Ninth Circuit noted that the property would have been wiped out in a hypothetical foreclosure sale outside of bankruptcy and that the Bankruptcy Code should not provide the lessees with any greater rights. 872 F.3d at 896.

Many practitioners and legal observers have regarded the outcomes in Qualitech and Spanish Peaks as not being inevitable even under the reasoning employed by the appellate courts in each case. Instead, the elimination of the lessees’ possessory rights in Qualitech and Spanish Peaks has often been attributed to the lessees’ purported failure to invoke other available relief and protections. For instance, in challenging the "free and clear" sales at issue in Qualitech and Spanish Peaks, none of the lessees timely invoked the provisions of Bankruptcy Code Section 363(e), which require that non-debtor parties receive some form of “adequate protection” if a Chapter 11 debtor or trustee sells an asset in which such parties hold an interest. 

Similarly, none of the underlying leases at issue in Qualitech and Spanish Peaks had been formally rejected at the time the “free and clear” asset sales at issue were approved in each case. The fact that the leases had not been rejected before the sales were approved in each case arguably undercut the lessees’ ability to contend that the provisions of Bankruptcy Code Section 365(h) were operative and should be considered controlling.

The Royal Street Bistro case

In the Royal Street Bistro case, however, the Insider Lessees timely responded to the Chapter 11 Trustee’s sale motion by filing their own motion seeking both adequate protection under Bankruptcy Code Section 363(e) and requesting the Bankruptcy Court to compel the Chapter 11 trustee to assume or reject the parties’ underlying lease agreements before the sale of the real estate. With respect to their demand for adequate protection, the Insider Lessees insisted that they should be permitted to maintain their possessory rights under Bankruptcy Code Section 365(h) after the sale — a contention for which the Insider Lessees drew support from Dishi & Sons v. Bay Condos LLC, 510 B.R. 696, 711-2 (S.D.N.Y. 2014)(recognizing a non-debtor lessee’s ongoing possessory rights under Bankruptcy Code Section 365(h) as an appropriate form of “adequate protection” in the face of a bankrupt lessor’s proposed “free and clear” sale of the underlying real property). 

Notwithstanding the Insider Lessees’ careful efforts to evade the fate of the non-debtor lessee parties in Qualitech and Spanish Peaks, the Bankruptcy Court denied their requests for adequate protection and to compel a presale assumption or rejection of their lease agreements. See In re Royal Alice Properties, LLC, 2021 WL 5711988, 9-12 (Bankr. E. D. La. November 30, 2021). Instead, the Bankruptcy Court authorized the Chapter 11 trustee to sell the real property free and clear of the Insider Lessees' leasehold estates under Bankruptcy Code Section 363(f)(1). Id. 

The Insider Lessees appealed to the U.S. District Court for the Eastern District of Louisiana (the “District Court”), asking the District Court to stay the Bankruptcy Court's ruling to prevent the appeal from being rendered statutorily moot under the provisions of Bankruptcy Code Section 363(m). See 11 U.S.C. §363(m)(providing that the reversal on appeal of an order authorizing a sale of property of the bankruptcy estate does not affect the validity of the sale unless the order authorizing the sale is stayed pending appeal). 

The District Court, however, refused to grant such a stay, finding (among other things) that the Insider Lessees had failed to demonstrate a likelihood of success on the merits. See In re Royal Street Bistro, LLC, 2022 WL 326636, 5-6 (E.D. La. February 3, 2022). 

The Insider Lessees then petitioned the Fifth Circuit to issue a writ of mandamus compelling the District Court to stay the effectiveness of the bankruptcy court’s sale order pending the Insider Lessees’ appeal. 

The appellate decision 

In what it acknowledged was a less than fully comprehensive discussion of the issues, a three-member panel of the Fifth Circuit (the “Panel”)  — which included legendary bankruptcy jurist Judge Edith H. Jones — denied the Insider Lessees’ request for a writ of mandamus in a four-page opinion. See Ruling, at 4. In doing so, the Panel voiced approval with respect to the bulk of the reasoning employed by the Bankruptcy Court. 

Thus, the Panel agreed with the Bankruptcy Court that the senior mortgagee’s ability to wipe out the Insider Lessees’ leaseholds in a state law foreclosure action not only provided a sufficient basis under Bankruptcy Code Sections 363(f)(1) to allow the real property to be sold free and clear of the Insider Lessees’ leases but it also prevented the Insider Lessees from insisting that their possessory rights be preserved as a form of adequate protection. Id. at 2, n.2 (noting that none of the Insider Lessees’ “leases contained nondisturbance clauses that would have protected the lessees from [a foreclosure by the senior mortgage holder].”). 

Likewise, the Panel agreed with the Bankruptcy Court's conclusion that because the underlying property possessed no residual beyond that necessary to satisfy the senior mortgage, the Insider Lessees were not entitled to any other form of “adequate protection.” Id. at 2, n. 3.  

Notwithstanding its holding, the Panel chastised both the Bankruptcy Court and the District Court for their alleged over-reliance upon the Qualitech opinion. The Panel criticized Qualitech as standing for the "excessively broad proposition that sales free and clear under Section 363 override, and essentially render nugatory, the critical lessee protections against a debtor-lessor under Section 365(h).” Id. at 3. To reinforce the point, the Panel concluded by admonishing “[c]ourts . . . against blithely accepting Qualitech’s reasoning and textual exegesis.” Id. at 4. 

Conclusions

Similar to Qualitech and Spanish Peaks, Royal Street Bistro involved below-market leases whose legitimacy as true leases certainly seemed subject to challenge. Notwithstanding these “bad facts,” the Fifth Circuit’s ruling in Royal Street Bistro represents another Circuit-level decision rejecting the proposition (once widely embraced) that the provisions of Bankruptcy Code Section 365(h) should control over those of Bankruptcy Code Section 363(f). 

Admittedly, even after the 2003 decision in Qualitech, some courts continued to support the notion that the provisions of Bankruptcy Code Section 365(h) cannot be overcome through a “free and clear” sale under Bankruptcy Code Section 363(f) See, e.g., In re Revel, AC, Inc., 802 F.3d 558, 575 (3rd Cir. 2015)(wherein the Honorable Thomas L. Ambro, writing for a divided panel of the Third Circuit, stayed a free and clear sale of the debtor’s real property assets so as to allow a non-debtor lessee to pursue on appeal the contention that its rights under Bankruptcy Code Section 365(h) could not be wiped out under Bankruptcy Code Section 363(f)); Dishi & Sons v. Bay Condos LLC, 510 B.R. 696, 708-710 (S.D.N.Y. 2014)(holding that Bankruptcy Code Section 363(f)(1) only pertains to voluntary sales of property by a debtor under applicable state law and, thus, does not authorize a Chapter 11 debtor to sell real property free and clear of a non-debtor lessee’s possessory rights under Bankruptcy Code Section 365(h) on the premise that the lessee’s interests would be wiped-out in a state law foreclosure action). 

With three Circuit courts now squarely holding to contrary, it remains to be seen whether courts such as the Third Circuit in Revel and the Southern District of New York in Dishi will continue to adhere to the above-referenced positions. 

As noted, the Fifth Circuit pushed back rather harshly against what it perceived as Qualitech’s overly broad and facile conclusion that the provisions of Bankruptcy Code Section 363(f) necessarily override those of Bankruptcy Code 365(h). Nevertheless, the decision in Royal Street Bistro seems to delineate a narrow set of circumstances under which the foregoing outcome will not hold. 

Indeed, carried to its logical conclusion, the Fifth Circuit’s reasoning in Royal Street Bistro suggests that in those instances in which a debtor’s real property is encumbered by a mortgage (which is almost always the case), a non-debtor lessee confronted by a proposed “free and clear” sale of such real property will not be able to successfully demand that its possessory rights in the property be preserved under Bankruptcy Code Section 365(h) unless either: (a) the lessee’s lease is senior to the mortgage such that the mortgagee would not wipe-out the lessee's leasehold estate in a state law mortgage foreclosure action; or (b) the lessee and the mortgagee are parties to a pre-petition subordination and non-disturbance agreement that protects the lessee’s leasehold estate from being wiped-out by the mortgagee. 

By recognizing the foregoing limitations on when a non-debtor lessee’s possessory rights under Bankruptcy Code Section 365(h) will prevail in the face of a "free and clear" sale, the Royal Street Bistro opinion seems to dispel the popular perception that the only reason that the lessees lost in Qualitech and Spanish Peaks was because they did not timely invoke other available remedies and protections, such as demanding “adequate protection” under Bankruptcy Code Section 363(e). 

David Farrell represents secured lenders, securitization participants, unsecured trade creditors, creditors’ committees, and buyers and sellers of distressed businesses.