Planning and Vigilance is Necessary in Bankruptcy Matters
by Raymond J. Werner
(Originally published in Vol. 16 No.. 9 of Commercial Leasing Law and Strategy February 2004)
Two recent decisions of the bankruptcy courts have attracted a bit of attention. Both of those cases were decided by the 7th Circuit Court of Appeals, the Federal Appellate court that sits in Chicago and whose decisions are give considerable weight by other courts.
The first decision that created quite a stir involved a landlord's bankruptcy. While at first light the facts and outcome of the case seem devastating to tenants, upon further analysis, the true lessen of the case may be simply put that the tenant must be vigilant in the protection of its rights if its landlord is in bankruptcy.
In Precision Industries, Inc. v. Qualitech Steel SBQ, LLC, 327 F3d 537 (7th Cir. 2003) the court held that the sale of the debtor's assets, including property that was subject to a ground lease to the late objecting tenant, was a sale free and clear of the tenant's interest, thereby extinguishing that leasehold interest. Qualitech Steel, the debtor, ground leased land at the debtor's steel mill facility to Precision which in turn constructed a warehouse on that land. The warehouse was part of an integrated, on-site, supply services agreement which Precision and Qualitech had entered onto. The lease had a term of ten years and called for the payment by Precision to Qualitech of an annual rent of $1.00. Precision constructed and stocked the warehouse and the supply arrangement was begun.
Not even a year after these contracts were executed, Qualitech filed a Chapter 11 petition, and shortly thereafter, all or Qualitech's assets were sold to the debtor's senior pre-petition lenders who held the mortgage on the facility. The sale order provided that the debtor was to convey its assets to the lenders "free and clear of all liens, claims, encumbrances and interests, except for certain enumerated liens. This was all done pursuant to Section 363(f) of the Bankruptcy Code. The lenders in turn assigned their rights to a newly created entity and that entity and Precision disputed who was entitle to the possession of the warehouse facility and leased premises.
The court first held that the tenant's interest under a lease is an interest in the property of the debtor and the sale under Section 363 can be made free of that interest. For such a result to follow, however, one of several requirements must be satisfied. Applicable nonbankruptcy law must permit the sale of such property free and clear of such interest; the party whose interest is extinguished must consent; the interest must be a lien and the price at which such property is to be sold must be greater than the aggregate value of all liens on such property; the interest is in dispute; or the holder of the interest must be able to be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest. Since Precision did not assert that none of the requirements were satisfied, the court expressly assumed that "one or more of the statutory criteria were met and that a sale of the property free and clear of Precision's interest as a lessee was permissible."
If we only knew what would have happened if Precision had objected in a timely manner and asserted that the requirements for a sale free and clear of its leasehold interest was not permitted. As the case stands, Precision's interest has been extinguished. Is that reason for all tenants to fear that their interest could be extinguished if their landlord went into bankruptcy and sold the demised premises free and clear of the leasehold interest? Probably not, but tenants must be careful to protect their interests and not sleep on their rights, they should not be subject to the loss of their interest.
It must be noted that if the debtor had proceeded to reject the Precision lease rather than selling its assets free and clear, Section 365(h) allows a tenant in possession under a rejected lease to retain its rights under the lease that are in or appurtenant to the real estate for the balance of the term, including renewals. That provision is not found in Section 363, and the court held that the tenant protective provisions of Section 365 cannot be read into Section 363. How can the tenant obtain the equivalent of those protections. There may be at least two ways.
First, the diligent tenant will assert that the requirements for the sale free and clear of the leasehold interest are not met. If it is assumed that the interest is not in dispute and the tenant does not consent to the sale free and clear so those requirements are not satisfied. The lease is not a lien by its very nature, and there is no legal basis to require that the tenant accept a money satisfaction of its interest. That leaves the argument that applicable nonbankruptcy law permits the sale of the property free and clear of the tenant's interest. While there may be law, such as that which is applicable in the context of the foreclosure of a mortgage that is prior to the lease, or the execution sale on a judgment that is prior to the lease, or the sale of real estate taxes and resultant tax deed, or the condemnation of the property, that will allow the property to be sold free and clear of the tenant's interest, how is that law "applicable" to the sale of the property in bankruptcy free and clear of the lease. In the case at hand, the lenders did not foreclose their mortgage, that may have been prior to the lease, and the reported decision does not indicate that the tenant obtained a nondisturbance agreement, the bankruptcy court used its statutory power to sell the assets free of all interests. These other laws that may be applicable in some circumstances may not be applicable to the bankruptcy sale of the debtor's property.
Second, the court itself readily points out that there is a mechanism in the Bankruptcy Code to protect the tenant's interest by petitioning the court to prohibit or condition the sale as may be necessary to adequately protect such interest. Section 363(e). Precision did not seek such protections.
While it is facile to say that bad cases make bad law and that this is merely a case that presents a bad result because the tenant did not take timely steps to protect its interest, that may well be the case. Tenants must be vigilant to protect their interests and prevent the leasehold estate from being terminated as a result of a sale free and clear in bankruptcy.
It should also be pointed that not all under market leases are in jeopardy of being extinguished on the whim of the landlord. Resort to bankruptcy is not available to all landlords. They must be in financial difficulties and otherwise make a good faith bankruptcy filing. Even those landlords who may qualify may not wish to enter the bankruptcy arena and loose control over their destiny, being subject to the scrutiny of the court.
The other Seventh Circuit case involves a bankrupt tenant and an oversized or at least disproportionate result. Ha-Lo Industries, Inc. v. Center Point Properties Trust, ____ F.3d ____ (7th Cir. 2003) is a case of bad timing. Ha-Lo, the debtor, had a new custom designed headquarters building constructed for it. The monthly rent for this high tech and highly styled building was $660,342.17. Ha-Lo exercised its right to reject this lease and vacated the building on or about November 3, 2001. On November 1, 2001, the debtor paid rent in the amount of $60,031.17, or rent for three of the thirty days of November, claiming that its obligation was only to pay the prorated rent for November. The landlord demanded the balance of the November rent and filed an administrative claim for that rent.
Section 365(d)(3) of the Code requires the timely performance of all obligations of the debtor under an unexpired lease until the lease is assumed or rejected. The Ha-Lo lease requires that rent be paid on the first day of each month. As a result, the debtor was required to pay the entire amount of the rental payment on November 1 and could not prorate that rent for the time in which the tenant was in occupancy before the effective date of the lease rejection. While the lease had various provisions that allowed the proration of rent under certain specific circumstances, such as the termination of the lease upon the destruction of the premises as a result of a casualty, or the beginning or ending of the term on other than the first or last day of a month, those provisions were not applicable in this instance before the court. Ha-Lo was obligated to pay the whole month's rent, even though it had occupancy for a shorter period until the lease was effectively rejected.
Both of these cases provide the lesson that the parties must be careful and protect their rights. If possible the debtor in the Ha-Lo case could have planned to vacate the premises before or at the end of the prior month and save a large amount of rent. Precision could have been more active in protecting its rights and shaping the result when the landlord's assets were sold free and clear. Both good lessons to learn.
