A tenant's possessory interest in property leased from a bankrupt debtor, protected after rejection of a lease by §365(h) of the Bankruptcy Code, may not survive a sale of the underlying property under §363, the U.S. Court of Appeals for the Seventh Circuit held on April 23, 2003, in the matter of Precision Industries Inc. v. Qualitech Steel SBQ LLC (In re Qualitech Steel Corp.), 7 Cir., No. 01-2753 (4/23/03). In a somewhat surprising ruling, the court held that the protections afforded to a tenant under §365(h) are overruled by the provisions of §363(f), which allow for the sale of the debtor's property free and clear of any interest in such property. Although the interesting interplay between these two sections has never been adjudicated at the appellate court level, commentators have heretofore believed that a lessee's possessory interest protected by §365(h) would survive the sale of the debtor's property even when such sale is made free and clear of all liens, claims and interests. Although the Qualitech decision does not touch upon intellectual property rights, it raises significant concerns for licensees of patent rights who enjoy similar protection under §365(n) as those thought to be provided to lessees. Under the Qualitech ruling, those rights and interests may also be at risk in a sale "free and clear of interests" under §363.

Factual Background

The debtors in the underlying bankruptcy, Qualitech Steel Corp. and Qualitech Steel Holding Corp. (collectively "Qualitech" or "debtor"), owned and operated a steel mill in Pittsboro, Ind. Prior to bankruptcy, the debtor had entered into a lease with its tenant, Precision Industries Inc., for the property underlying a warehouse, built by Precision, for 10 years in exchange for a nominal rent of $1 per year. The lease further granted Precision exclusive possession of the warehouse until the end of the 10-year lease, at which time it would revert to the debtor, assuming no defaults under the agreements. The lease was never recorded.

The debtor filed for chapter 11 protection in March 1999, and in June of the same year sold substantially all of its assets at auction for a bid of $180 million. Precision, which had notice of the hearing, did not object to the sale. The resulting order transferred all of the debtor's assets free and clear of all liens, claims, encumbrances and interests. The sale order also reserved to the purchaser the debtor's rights to assume and assign executory contracts pursuant to §365. The sale of the debtor's assets closed in August 1999 without an assumption of the lease; therefore the lease agreements were de facto rejected. The new buyers subsequently changed the locks on the warehouse, and Precision filed a complaint in the U.S. District Court for trespass. That matter was ultimately referred to the bankruptcy court, where the buyer sought clarification that the sale order had extinguished Precision's possessory interests.

The bankruptcy court determined that the buyer had obtained title to the debtor's property free and clear of any possessory interest that Precision may have had under the lease and that such a continued right to possession after rejection of the lease was among the bundle of interests extinguished by the sale order. The court explicitly rejected the notion that the protection of §365(h) acted to preserve Precision's rights as a lessee in the face of a sale order, which the court found was "unequivocal and not left open to interpretation." Precision appealed to the district court, which subsequently reversed. That court determined at the outset that the provisions of §363(f) and 365(h) were in apparent conflict and, after surveying the legislative history of both provisions along with the divided case law on the subject, concluded that the provisions of §365(h) prevailed over those of §363(f), as applied to the rights of lessees. The debtor appealed.

Section 363 Prevails

The Seventh Circuit agreed with the bankruptcy court and overturned the district court's ruling. Initially, the appeals court determined that a tenant's possessory interests are within the scope of interests in the property in the bankruptcy estate.

Section 365(h) provides that if a debtor rejects an unexpired lease for real property under which the debtor is the lessor, the lessee may retain its rights under the lease for the balance of such term, including any renewal or extension for such rights. Therefore, the lessee may remain in possession of the leased premises, notwithstanding the debtor's decision to reject the lease. In this way, the statute strikes a balance between the respective rights of the debtor/lessor and its tenant. The lessee retains the rights to possess the property for the remainder of the term it bargained for, while the rejection frees the debtor/lessor of other burdensome obligations that it assumed under the lease, such as a duty to provide services to the lessee.

The appeals court enumerated three reasons why the terms of §365(h) do not trump the "free-and-clear" sale described in §363(f). First, the statutory provisions themselves do not suggest that one supersedes or limits the other. Both contain cross-references, indicating that certain of their provisions are subject to other statutory mandates. However, nowhere is there language indicating that the right to sell estate property free of "any interest" is subordinated to the protection of §365(h).

Second, the plain language of §365(h) suggests that it has limited scope. In particular, §365(h) applies if a trustee rejects an unexpired lease of real property. The court determined that what occurred was the sale of the property rather than a rejection of the lease. Although the effect of the sale was a de facto rejection, the court reasoned that nothing in the express terms of §365(h) suggests that it applies to a sale of the debtor's property, but is rather limited to a rejection situation. The court concluded that the two statutory provisions thus applied to distinct sets of circumstances.

Third, §363 itself provides for a mechanism to protect the rights of parties whose interests may be adversely affected by the sale of estate property. Specifically, §363 allows the courts to "prohibit or condition such...sale...as is necessary to provide adequate protection of such interests." Because a lease qualifies as an interest, the lessee of the property being sold under §363 would have a right to object to ensure that its interests are protected. Although such "adequate protection" does not necessarily grant a lessee continued possession of the property, it may demand that the lessee be compensated for the value of his leasehold, typically from the proceeds of sale.

Based on this rationale, the court concluded that the two statutory provisions can be construed in a way that does not disable §363(f) vis-à-vis leasehold interests.

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Until the ruling in Qualitech, many commentators believed that a licensee's interest in the debtor's intellectual property would survive a sale under §363.

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The Practical Effect of the Ruling

The practical effect of this ruling is that a lessee must be increasingly vigilant with respect to its rights under a commercial lease where the lessor is in bankruptcy. The lessee in Qualitech did not object to the sale free and clear of its possessory interest in the property. One can only speculate as to what would have happened had an objection been filed by the lessee at the time the sale was proposed. Correspondingly, a lawyer should advise his or her clients to "object early and often" to any motion to sell a debtor's assets under §363(f) and/or insist that any sale order protect the client's interest. Although the protections provided under the Bankruptcy Code may not allow the tenant to keep all of the beneficial aspects of the lease, the Qualitech ruling shows that if tenant sits on its rights, they may be lost in their entirety.

By obvious analogy, licensees of intellectual property must be similarly vigilant. The protections provided under §365(n) are very similar to those afforded by §365(h). Until the ruling in Qualitech, many commentators believed that a licensee's interest in the debtor's intellectual property would survive a sale under §363. Qualitech casts this assumption into doubt, and one is advised to provide the same advice to licensees as one would tenants: Be vigilant and aware if you want to protect your rights.