Pub. 8 2017 Issue 4

Winter 2017 9 West Virginia Banker There Goes the Neighborhood? By Julia A. Chincheck and Daniel J. Cohn , Bowles Rice LLP. T he United States Court of Appeals for the Ninth Circuit recently waded into an esoteric question of law, but one that has sig- nificant implications—in particular for commercial tenants whose landlords file for bankruptcy, as well as the banks that lend to the tenants. The issue is the interplay between two differ- ent sections of the Bankruptcy Code affecting the rights of lessees. This issue has the potential to affect both banking institutions and their clients. Banks often make loans to commer- cial customers that become tenants and build structures on a landlord’s real property. The bank often se- cures the loan with a leasehold deed of trust. What happens to the lessee and bank client, and what happens to the bank, when the debtor-land- lord attempts to reject the lease or sell free and clear, or both? The Bankruptcy Code has two poten- tially-conflicting provisions. Section 365 permits a debtor-landlord to “reject” an unexpired lease. Upon rejection, the debtor-landlord has no further obligations under the lease. However, in this scenario, a non-debtor tenant may remain in possession of the property even though the debtor-land- lord has rejected the lease. Section 363(f) permits a debtor to sell assets, including real property, free and clear of encumbrances and interests. Courts are split as to how to treat tenants whose debtor landlords are at- tempting to sell the property free and clear of the tenants’ interests pursuant to the lease. The Ninth Circuit just held that a debtor-landlord may sell property that is otherwise subject to a lease free and clear of that leasehold interest pursuant to section 363(f), notwithstanding the language in 365(h) that permits a non-debtor ten- ant to retain possession of the prop- erty even after the debtor-landlord’s rejection of the lease. In In re Spanish Peaks Holdings II, LLC, ___ F.3d ___, 2017 WL 4156370 (9th Cir. Sep. 12, 2017), the Ninth Circuit followed the Seventh Circuit’s holding that a debt- or-landlord may sell property free and clear of a lessee’s leasehold interest pursuant to another provision of the Bankruptcy Code. The Ninth Circuit noted that it was not addressing a situation where a lease had been rejected before the debtor-landlord attempted to sell the property free and clear of the lease- hold interest. However, it did note that, where a lease is not assumed or rejected, the Bankruptcy Code sec- tion permitting the lessee’s continued possession is not implicated at all, and property subject to such a lease may be sold free and clear of the leasehold interest if state law would permit such a transaction outside of bankruptcy. In addition, the Ninth Circuit found it important that a foreclosure sale by the mortgage holder would have extinguished the subsequent lease- hold interest of the lessee. Because the lender’s foreclosure would have wiped out that subsequent leasehold interest, the Ninth Circuit reasoned, there should be no reason why a debt- or could not sell free and clear of the leasehold interest as well. In engaging in its analysis, the Ninth Circuit observed first that “sections 363 and 365 do not conflict.” This is because, at least in part, section 363 mandates that a bankruptcy court provide adequate protection upon request to a party with a leasehold interest that would be extinguished in a sale, which, according to the Ninth Circuit, could even be in the form of continued possession of the property. Additionally, the court noted that a traditional foreclosure sale by the prior mortgage holder would have extin- guished the leasehold interest under state law anyway, and section 365 is designed only “to protect lessees’ rights . . . , not . . . to enhance them.” But what happens when a debtor-land- lord rejects an unexpired lease under section 365 and then attempts to sell the property free and clear of the leasehold interest under section 363? Only a few lower courts seem to have addressed the issue, and there is a split of authority on whether the lessee can The Effect on Banks (and their Customers) of Sale in Bankruptcy