Do a lessee’s possessory interests in real property survive a “free and clear” sale of the property under section 363 of the Bankruptcy Code? In a recent decision, the Ninth Circuit Court of Appeals said “no,” holding that section 365(h) did not protect the interest of the lessee in the context of a section 363 sale when there had been no prior formal rejection of the lease under section 365. In so holding, the Ninth Circuit joined the Seventh Circuit Court of Appeals in rejecting the majority view that a sale of real property under 363(f) does not extinguish leasehold interests in that property. The Ninth Circuit’s decision undermines the notion that lessees enjoy special protections under the Bankruptcy Code and underscores the need for lessees to be proactive in protecting their interests when their lessors file bankruptcy.

The case, In the Matter of Spanish Peaks Holdings II, LLC, was a Chapter 7 case filed in 2011 by the owners and operators of Spanish Peaks, a resort in Big Sky, Montana. The Chapter 7 trustee sought authority from the bankruptcy court to auction substantially all of the debtors’ real and personal property “free and clear” of all encumbrances, except for certain encumbrances as specified in the sale motion. Two separate commercial leases, held by The Pinnacle Restaurant at Big Sky, LLC (“Pinnacle”) and Montana Opticom, LLC (“Opticom”), were not included in the schedule of encumbrances to receive special treatment in the sale, and the trustee had not moved to reject the leases under section 365. Both Pinnacle and Opticom objected to the sale motion, arguing that section 365(h) gave them the right to retain possession of the leased real property notwithstanding the sale. The bankruptcy court approved the sale motion and authorized the trustee to conduct an auction of the debtors’ assets under section 363, but deferred the Pinnacle and Opticom objections to the hearing to approve the sale following the auction.

The winning bidder agreed to pay over $26 million for the debtors’ assets, but made its bid contingent on the property being free and clear of the Pinnacle and Opticom leases. The bankruptcy court approved the sale free and clear of any interests, including Pinnacle’s and Opticom’s interests, and the district court affirmed.

In its decision, the Ninth Circuit noted that sections 363 and 365 often operate in isolation; in many cases, a debtor-in-possession or trustee either will sell real property that is not subject to an unexpired lease under section 363(f) or will seek to assume or reject an unexpired lease of real property that is not being sold. However, both sections come into play when a debtor-in-possession or trustee seeks to sell real property free and clear of all encumbrances, and one of the encumbrances is an unexpired lease.

The majority of courts has found that section 365 trumps section 363 under the canon of statutory construction that “the specific prevails over the general.” According to this majority view, because section 365(h) gives lessees the right to retain possession of leased real property notwithstanding rejection of the lease, lessees may retain possession following a sale under section 363(f) when the property lease has not been rejected. These courts find support in the legislative history of section 365, which evinces Congress’s clear intent to (a) protect a lessee when a lessor files bankruptcy, and (b) prevent a debtor-lessor from using a section 363 sale as a means of evicting a lessee from property.

The Ninth Circuit rejected this line of cases and held instead that where there had been no rejection, section 365(h) was not triggered and that therefore section 363(f) extinguishes the lessee’s possessory interest in the property. The court reasoned that while Congress may have sought to protect lessees by enacting section 365(h), that intent is not absolute and must exist alongside the other purposes of the Bankruptcy Code. Further, Congress protected lessees by providing for adequate protection under section 363(e), which requires bankruptcy courts to award adequate protection to such lessees, but only upon application to the court.

The Ninth Circuit declined to say whether a sale under section 363 would extinguish the interest of a lessee whose lease had been rejected under section 365 prior to the sale. Nevertheless, Spanish Peaks casts doubt on the scope of protection that lessees may have when their leased real property is sold under section 363. The Ninth Circuit’s decision may influence the timing of section 363 sales, especially when the buyer wants to shed below-market leases. In these cases, the debtor will tee-up its sale motion before filing a motion to reject, thereby depriving the lessees of their rights to stay in the leased property under 365(h). The court’s decision puts a premium on strategic planning on the part of lessees that are threatened by a “free and clear” sale. For now, their primary solace is that the Ninth Circuit’s decision is still in the minority.