What happens when two sections of the Bankruptcy Code seem to contradict each other? 

That can happen when the owner of rental property files bankruptcy and wants to sell it without the lease, to get a better price.

One section of the Bankruptcy Code says tenants of bankrupt owners can stay in possession for the terms of their leases, so long as they pay rent when due and honor other lease terms. But another section allows a bankrupt owner or trustee to sell property free and clear of all liens and interests, which suggests free and clear of a tenant's leasehold interest. 

That was the situation in a case recently decided by the Ninth Circuit Court of Appeals – the highest federal court for Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon and Washington. 

The court (along with the lower courts) ruled the chapter 7 trustee could sell real property free and clear of leasehold interests over the objections of tenants who wanted to continue leasing part of the property. 

In the case called Matter of Spanish Peak Holdings, the debtor owned a 5,700-acre resort in Big Sky, Montana and had two long term leases for part of the property (one for 99 years, the other for 60 years) at monthly rents below market with entities that were under common ownership.  

When the resort failed, the chapter 7 trustee sought authority to sell the resort free and clear of liens and interests, including the leases. The tenants opposed the sale. But they made a critical mistake by not requesting, per the Bankruptcy Code, "adequate protection" of their leasehold interests.  

The bankruptcy court approved the sale. It didn’t immediately rule on what rights (if any) the two tenants would have after the sale, but after a two-day hearing, the bankruptcy court decided that the leases were not protected from the sale free and clear of their leases.  

It noted that one tenant had not operated a restaurant at the property for over six years; the rent was far below fair market; the leases were signed at a time when the landlord and both tenants were controlled by the same person; the leases were subject to a bona fide dispute; under state law if the bank with a lien on the property foreclosed, it would wipe out the leases; and the trustee could use such state law in bankruptcy to avoid the leases when selling the property. 

Based upon these findings, the bankruptcy court ruled the sale could proceed free and clear of the leases. When that decision was appealed, the district court affirmed the bankruptcy judge's rulings.  

The tenants appealed again, to the Ninth Circuit. The court acknowledged the potential tension between Bankruptcy Code section 363, which authorizes a trustee to sell property free and clear of all liens and interests, and section 365(h), which protects a tenant when a landlord in bankruptcy "rejects" the lease and gives the tenant an option to remain in possession for the balance of the lease term. 

The Ninth Circuit noted that the "majority" of other courts, when handling the apparent conflict between the two code provisions, ruled the section 365 rights of tenants trump the section 363 rights of a trustee to sell property free and clear of leases.  

However, the court agreed with  a different interpretation by the Seventh Circuit, the only other circuit court to have addressed the issue, in reaching a different conclusion: that sections 363 and 365 do not necessarily conflict; and neither section supersedes or limits the other. 

The Ninth Circuit ruled that section 363 offers a way to recognize a tenant’s interests when property is being sold in the bankruptcy case, because it requires a bankruptcy court to provide "adequate protection" of a tenant's rights in connection with a sale – if the tenant requests that protection.  

However, these tenants did not request adequate protection in connection with the sale, so the court was not required to grant it after the fact.

 The Ninth Circuit also noted that under Montana law, if the lender with a lien on the real property had foreclosed it would have terminated the leases and a trustee in bankruptcy can use such state law to assist in a bankruptcy sale and drive up the sale price, since all property buyers will prefer acquiring the property unencumbered by the two long-term (below market) leases.

The court said that, even though section 365(h) is designed to protect tenant rights in the property owner's bankruptcy, it is not designed to enhance those rights beyond what the tenant has under state law. 

The takeaway is that tenants of a bankrupt landlord must aggressively pursue and protect their rights and request "adequate protection" under Bankruptcy Code section 363 in connection with any proposed sale of the underlying real property free and clear of the tenant's lease.

This ruling may embolden more bankrupt companies and trustees to sell rental property free and clear of the leases, and thereby increase the sale proceeds.

Such "sold out" tenants can file a claim for damages, but the recovery can be little and worth far less than the right to continue using the rental property.

By Gary F. Torrell