The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), analyzing a recent decision of interest:
In a published order denying a petition for writ of mandamus to compel a district court to grant a stay pending appeal of a bankruptcy sale order, the Fifth Circuit Court of Appeals (the Court) ruled that a chapter 11 trustee could sell real property free and clear of leasehold interests which were junior to the rights of a mortgagee which could have foreclosed out those interests in a state court proceeding, but for the bankruptcy. In doing so, the Court rejected alternative arguments relied upon by the bankruptcy court and the district court. In re Royal Street Bistro, LLC, ___ F. 4th ___., 2022 WL 499938 (5th Cir. 2/16/22).
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Debtor Royal Street Bistro filed a Chapter 11 bankruptcy case to, among other things, resolve a dispute with its mortgagee AMAG and prevent a foreclosure on Bourbon Street property (the “Property”.). The appointed chapter 11 Trustee sought to settle the AMAG claim and to sell the Property free and clear of interests under Bankruptcy Code § 363(f)(1). Two lessees of the property, who were insiders of the debtor company, objected to the sale free and clear of their interests, asserting their rights to remain in possession were protected by Code § 365(h)(1)(A)(ii). The Bankruptcy Court rejected that argument for several reasons, the first of which was based on a textual analysis of the two pertinent statutory subsections. The District Court affirmed, using similar reasoning. When the lessees appealed that order to the Court, they sought a stay of the sale pending appeal from the District Court. The denial of that stay resulted in the writ of mandamus to the Court, which was denied in this ruling.
The Debtor filed a voluntary Chapter 11 petition on November 1, 2021, identifying itself as a small business debtor and electing to proceed under Subchapter V. The reported opinion addresses two motions: first, the motion of the Debtor seeking to extend the time to file its Subchapter V plan of reorganization (the “Extension Motion”) by 90 days. The second is the motion of Security Benefit for a determination that the automatic stay does not apply to litigation it wanted to file or in the alternative, for relief from the automatic stay to pursue such litigation. This report addresses only the Extension Motion that the Court granted.
The Court did not need to look past the first reason the lower courts had given to overrule the lessees’ objections. It looked at the wording of § 365(f), which provides the means to sell free and clear: “The trustee may sell property…free and clear of any interest in such property of an entity other than the estate, only if – (1) applicable nonbankruptcy law permits sale of such property free and clear of such interest.” It found that since under the applicable nonbankruptcy (state) law, with no bankruptcy case pending, AMAG would have been entitled to foreclose and wipe out the junior interests of the lessees, the statute allowed the Trustee to sell free and clear of those interests. The objectors had no valid defense.
The Court then turned to the argument raised under § 365(h)(1)(a)(ii), which can preserve a tenant’s right to remain in possession through its lease term if the debtor is the lessor and rejects the lease under § 365. However, this protection is also limited by the words in the subsection which apply when the lease is rejected: “(ii)…. the lessee may retain its rights under such lease…for the balance of the term…to the extent that such rights are enforceable under applicable nonbankruptcy law.” Again, the Court reasoned that since AMAG could foreclose out those junior interests (and the leases did not contain nondisturbance clauses that would have protected the lessees upon such foreclosure), their rights to remain in possession were not enforceable under applicable nonbankruptcy law. For these two straightforward reasons, the order for sale would stand and no stay pending appeal should issue.
The Court was not quite done, however. Both lower courts had also relied on a Seventh Circuit decision, Precision Indus., Inc. v. Qualitech Steel SBQ, LLC, 327 F. 3d 537 (7th Cir. 2003), a reliance the Court found was misplaced. The Court found that Qualitech had posed an “excessively broad proposition that sale free and clear under Section 363 override[s], and essentially render[s] nugatory, the critical lessee protections against a debtor-lessor under Section 365(h).” It noted that Qualitech, which had been followed by the Ninth Circuit in In re Spanish Peaks Holdings II, LLC, 872 F. 3d 892, 899-900 (9th Cir. 2017),had been widely criticized for “the potential of profoundly impact[ing] the bankruptcy world.” The Court specifically did not endorse the Qualitech approach in the Fifth Circuit, particularly because this case could be simply resolved by its textual analysis.
This case is appealing for its simplicity. First, if adopted by the Ninth Circuit, it would take the “taint” out of the BAP’s Clear Channel Outdoor, Inc. v. Knupfer (In re PW, LLC),391 B.R. 25 (9th Cir. BAP 2008), a much-criticized case which held that a trustee could not rely on § 363(f)(5) to sell free and clear of junior interests, a practice which had been widely adopted in that circuit. Using § 363(f)(1) would solve that problem. Second, it stifles the impact of Qualitech, particularly if applied to facts similar to these. Both impacts should be welcomed by trustees and debtors in possession. I expect to see the arguments made in this case asserted frequently for sales free and clear of junior interests in the future.
This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.