In the latest chapter of the Qualitech Steel Corp. bankruptcy saga, Precision Indus. Inc. v. Qualitech Steel SBQ LLC, 327 F.3d 537 (7th Cir. 2003), the Seventh Circuit was faced with an issue of first impression at the circuit level: "Can a sale free and clear of interests pursuant to 11 U.S.C. §363(f)¹ extinguish a lessee's possessory interest in the debtor's property, or is the possessory interest preserved by 11 U.S.C. §365(h)?"² The Circuit Court's opinion raises some interesting issues for the debtor and creditor bars as well as attorneys representing lessees of debtors.

The Background

Precision Industries Inc. and Circo Leasing Co. LLC (collectively, "Precision") entered into a supply agreement and lease (unrecorded) with Qualitech. Precision leased property from Qualitech on which it built a warehouse to supply its product. Qualitech's venture failed, and in its subsequent bankruptcy substantially all of its assets were sold at a §363 auction sale to a group of senior pre-petition lenders, who in turn formed a new venture, Qualitech Steel SBQ LLC (collectively, "New Qualitech"). At the conclusion of the sale hearing, the bankruptcy court entered an order conveying Qualitech's assets free and clear of liens, claims, interests and encumbrances, other than certain enumerated liens, to New Qualitech pursuant to §363(f) (sale order). The sale order also provided that all entities holding interests in the assets other than those expressly preserved in the sale order would be barred from asserting such interests against New Qualitech. Furthermore, the sale order preserved Qualitech's right to assume and assign any unexpired leases. Precision, despite proper notice, did not file an objection to the sale, appear at the sale hearing or appeal the sale order.

Precision and Qualitech entered negotiations regarding the assumption and assignment of the lease and supply agreement. These negotiations proved fruitless, resulting in the de facto rejection of the lease and supply agreement.

Precision vacated the warehouse and padlocked the doors. However, New Qualitech hired a locksmith, removed the padlocks and changed the locks. This prompted Precision to file a diversity action against New Qualitech in federal district court for trespass, conversion, wrongful eviction, breach of implied contract and estoppel. New Qualitech requested that the district court refer Precision's action to the bankruptcy court and that the bankruptcy court clarify that the sale order extinguished Precision's possessory interest. The district court granted New Qualitech's request.

The History Below

The bankruptcy court held that Precision's possessory interest was extinguished when the sale order conveyed Qualitech's assets free and clear of interests to New Qualitech. The bankruptcy court also found that the sale order was unambiguous. Therefore, Precision was barred from asserting any interest in the warehouse because the sale order was no longer subject to attack. This ruling did not specifically discuss Precision's rights under §365(h).

The district court reversed, finding a conflict between §§363(f) and 365(h) of the Bankruptcy Code. A review of the legislative history of these sections led the district court to hold that §365(h), as the more specific section, prevailed over §363(f) as applied to the rights of lessees of debtors. The district court also found that the sale order was ambiguous, given that it (1) said the sale was pursuant to both §§363 and 365, (2) did not plainly eviscerate Precision's possessory interest and (3) preserved the right of Qualitech to assume and assign unexpired leases. Precision's appeal therefore was not untimely or barred by res judicata.

The Decision

The Seventh Circuit first considered the applicability of res judicata. Sale orders are final and appealable, the circuit court noted, and once that appeal period has passed, no party can attack the sale order with a new suit. Id. at 543. Noting that Precision, in effect, was doing just that, the appeals court found that res judicata did not apply in this case because of the referral of Precision's suit to the bankruptcy court, which entered the sale order and New Qualitech's request for clarification of the sale order. Id. Furthermore, the Seventh Circuit reasoned that res judicata would not bar a review of whether the bankruptcy court had authority to sell assets free and clear of a lessee's possessory interest. Id.

Turning to the substantive issue, the Seventh Circuit analyzed the language of §§363(f) and 365(h) and whether the two statutes could be construed to avoid direct conflict. Id. at 543-44. Section 363, the court began, generally provides for the sale of the debtor's property both in and outside the ordinary course. Id. at 544. Subsection (f) allows the debtor to sell such property free and clear of any interest in certain circumstances, and subsection (e) affords the interest-holder the opportunity to request that such a sale be prohibited or conditioned on adequate protection of that interest. Id. at 545.

The phrase "any interest" is not defined in the Bankruptcy Code. However, the appeals court noted that the use of the term "any" favors a broad interpretation. Id. (citing United States v. Gonzales, 520 U.S. 1 (1997)). The Seventh Circuit also drew upon the Supreme Court's expansive definition of "interest" in the context of the federal RICO statue³ to include "all forms of real and personal property, including profits and proceeds." Id. (citing Russello v. United States, 464 U.S. 16, 21 (1983)). Finally, the panel looked at the definition of "interest" in Black's Law Dictionary, 816 (7th ed. 1999), which it defined as "[a] legal share in something; all or part of a legal or equitable claim or right in property." Precision Indus. Inc., 327 F.3d at 545. Given that Precision's possessory interest as a tenant was not simply a right connected to or arising from the property but rather was a right to the property itself, the Seventh Circuit found that Precision's possessory interest was an interest under §365(f). Id.

The language of §363(f), standing alone, clearly empowered the bankruptcy court to enter the sale order providing for the sale of Qualitech's assets free and clear of Precision's interest, provided that the criteria of §363(f) were met. Id. at 546. Precision did not quarrel with this proposition, arguing instead that §365(h) overrides the provisions of §363(f).

Looking again at the general purpose of the section at issue, the Seventh Circuit reasoned that the general purpose of §365 was to provide debtors with the ability to reject unexpired leases and allow debtors to jettison leases that are unduly burdensome. Id. This ability is limited by §365(h)(1), which prevents debtors from evicting lessees. Id. This balances the interests of the debtor (escaping the burdensome obligations of the lease) with those of the lessee (retaining right to possession for bargained-for term). Id.

The Seventh Circuit held that §365(h) does not conflict with or override §363(f) and reversed the district court's decision. Id. at 547. In reaching its conclusion, the appeals court noted that §§363(d) and 365(a) contain cross-references indicating that they are subject to other statutory mandates. Id. Sections 363(f) and 365(h) do not contain cross-references, leading the panel to find that Congress did not intend §365(h) to limit §363(f). Id. The Seventh Circuit next reasoned that §365(h)(1)(A) had a limited scope, applying only when the debtor rejects an unexpired lease of real property. Id. Section 365(h) therefore does not apply to all events that threaten a lessee's possessory interest. Id. As §365(h) is silent as to sales of estate property, the Seventh Circuit opined that the statutes do not conflict. Id.

Finally, the panel reasoned that §363(e) provides a mechanism for the protection of those interest-holders affected by the sale of estate property.⁴ Id. As a lessee's possessory interest qualifies as an interest under §363(f), a lessee would have the right to insist on protection for that interest. Id. at 548. This protection does not necessarily guarantee a lessee's continued possession of the property; however, it does require that at a minimum the "lessee be compensated for the value of its leasehold...." Id. Precision was therefore not without recourse when Qualitech attempted to sell its property free and clear of interests pursuant to §363(f). Id.

In conclusion, the Seventh Circuit found that §363(f) allowed property to be sold free and clear of a lessee's possessory interest, provided that the lessee, upon request, is granted adequate protection for this possessory interest. Id. (Emphasis added.) When the debtor's property is not sold and instead the debtor remains in possession and chooses to reject its lease with a tenant, §365(h) applies and provides the lessee with continued possession. Id. So read, the rights of lessees are protected, conflict between the two provisions is avoided, and §363(f) remains free of any limitations not intended by Congress. Id.

Applying its holding to the case at bar, the Seventh Circuit held that the bankruptcy court had authority to transfer Qualitech's assets free and clear of Precision's possessory interest, and that Precision's interest was extinguished because Precision did not object to or appeal the Sale Order or avail itself of the protections of §363(e).

Analysis

The simple moral of this story is that attorneys representing lessees of debtors must object to §363(f) sales and/or request adequate protection for the lessee's interests pursuant to §363(e). Precision, either by neglect or choice, did neither and lost its possessory interest.

What is adequate protection of a lessee's possessory interest? At one end of the spectrum, there is the argument that all real estate is unique and there is no way to compensate a lessee for the loss of possession other than to provide for continued possession. In such a case, the Seventh Circuit's opinion seems to indicate that §365(h) would make continued possession inviolate.

This result creates a serious problem for debtors. If the prospective purchaser of the debtor's assets was interested in allowing the lessee to continue in possession, the debtor would likely seek to assume and assign the lease as part of the sale. Therefore, §365(h) will usually apply in the context of an asset sale when the debtor is attempting to sell assets to a buyer who is adverse to allowing the lessee to continue in possession of the leasehold. Is the debtor powerless to divest the lessee's possessory interest and therefore unable to sell its property? The use of the word "prohibits" in §363(e) implies that the answer is yes.

The other end of the spectrum would be that the lessee's possessory interest was of no value and that no adequate protection was necessary. This, however, is unlikely, as the lessee would not have entered into the lease if such possessory interest was valueless.

Adequate protection will not always guarantee continued possession; nor does it seem likely that adequate protection will provide the lessee with nothing. This leaves most cases somewhere in the middle: The lessee had an interest, the debtor sold the leasehold free and clear of this interest, and as compensation for the sale the bankruptcy court grants the lessee a claim against the debtor for the value of the lost possessory interest. Granting a creditor a monetary claim against the debtor for adequate protection is relatively commonplace under §363. To begin, how do you value the possessory interest? Is it simply the rental rate? Is there a difference between the current rent and rent at a similar location? Is mitigation of damages applicable? In addition, what type of claim is granted in the context of a possessory interest? Is it a pre-petition unsecured claim? Is it an administrative claim? Lease rejection claims are treated as pre-petition claims pursuant to §502(g). However, a lessee's possessory interest survives rejection under §365(h). Therefore, a lessee's §363(e) adequate protection claim must be treated as an administrative expense.

But what if such adequate protection consists of the tenant being granted a secured claim? The Seventh Circuit's opinion opens the door to this interpretation by stating that "the lessee be compensated for the value of its leasehold—typically from the proceeds of the sale." Id. (Emphasis added.) Generally, only secured creditors satisfy their claims directly from sale proceeds. Can divested lessees look to sale proceeds as well? If so, would it be first priority, placing it ahead of the secured lender? What effect would a recorded lease have on a court's analysis?

Conclusion

The Seventh Circuit's decision in Precision Indus. Inc. demonstrates that when it comes to lessees of a debtor, snoozing really means losing. Unfortunately, it leaves unanswered the far more interesting and far-reaching question of what happens when lessees avail themselves of the protections of §363(e) and request adequate protection.

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Footnotes

¹ Section 363(f) provides that "[t]he trustee may sell property free and clear of any interest in such property of an entity other than the estate...." Return to article

² Section 365(h)(1)(A) states, in pertinent part, that "[i]f the trustee rejects an unexpired lease of real property under which the debtor is the lessor and (ii) if the term of such lease has commenced, the lessee may retain its rights under the lease...that are in or appurtenant to the real property for the balance of the term of such lease and for any renewal or extension...." Return to article

³ 18 U.S.C. §1963(a)(1). Return to article

⁴ "Notwithstanding any other provision of this section, at any time, on request of an entity that has an interest in property...sold...or proposed to be sold...the court...shall prohibit or condition such...sale...as is necessary to provide adequate protection of such interest...." 11 U.S.C. §363(e). Return to article