Purchase and Sale of Assets

Qualitech Creates Confusion in Advising on Long-Term Leases

Bankruptcy Update

By Myron A. Bloom
June 17, 2005

Ever since the 7th U.S. Circuit Court of Appeals issued its decision in Precision Industries Inc. v. Qualitech Steel SBQ LLC, both bankruptcy practitioners and real estate attorneys have had difficulty advising entities contemplating entering into long-term leases, especially ground leases.

In Qualitech, the 7th Circuit held that a debtor-landlord could sell its real estate free and clear of the interests of its tenant under Section 363(f) of the Bankruptcy Code, thus apparently emasculating the seemingly inconsistent provisions of Section 365(h) of the code, which states that if a debtor-landlord rejects a real estate lease, the tenant may, under Section 365(h)(1)(A)(ii) of the code, remain in possession. From the perspective of lawyers, the holding of Qualitech seemed to take from the nondebtor tenant a valuable right - the right to possession - in which the tenant may have invested millions of dollars in reliance on the protection of Section 365(h) of the code.

For the real estate lawyer, especially, where clients may borrow substantial sums for tenant improvements, taking comfort in the fact that the return on investment will be worth the price, a sudden divestiture of a tenant's estate would be devastating. (This, of course, also goes for the lender, who may take liens on improvements as collateral for the loan.) Obviously, this result had to give both lenders and tenants pause when entering into long-term leases.

More recently, another court faced the identical issue and came out with a different result. In In re Haskell L.P., a hospital sold a medical facility to a third party in 1999 and then leased back from the third party a portion of the facility, consisting of a short-term stay facility and certain parking spaces. The next year, the owner of the facility placed a mortgage on the entire property, using the proceeds for improvements. The hospital appeared to protect itself well, obtaining from the owner as well as the lender tightly drawn nondisturbance agreements. The hospital also had a right to repurchase the entire facility at some later date. In addition, as the former owner, it held a junior mortgage on the entire property.

Things did not go well for the owner, and it filed for Chapter 11 protection in early 2004. In October of that same year, it sought permission to sell the entire property free and clear of liens and other interests, including the hospital's leasehold interest, by way of public auction. Predictably, the hospital objected, raising three issues with which the court dealt.

The hospital argued first that the debtor-lessor could not sell the property free and clear of the hospital's leasehold interest under Section 363(f) of the code, as none of the conditions provided for in that section of the code applied to its leasehold interest. It argued second that if a sale were to be approved, it nevertheless had rights to remain in possession under Section 365(h). The hospital argued finally that even if there were to be a sale, the hospital's leasehold interest was entitled to adequate protection pursuant to Section 363(e) and that no such protection could be afforded, on the facts presented.

The debtor-lessor argued that the lessee's positions were unsound. First, the owner contended that a sale was possible under Section 363(f) since it was at least hypothetically possible to compel the hospital to accept money for its interest, likening the owner's contemplated action to an eminent domain taking by a governmental authority. Second, it argued that under Qualitech and other authority, the rights of a lessee whose lease has been rejected by a lessor do not supersede the right of a debtor to sell property free and clear of interests in that property (including leasehold interests). Third, the debtor argued that the hospital's right to adequate protection does not guarantee a right of possession; here, the hospital had a lien that would attach to the proceeds to sale.

The matter was submitted to the bankruptcy court on a stipulated set of facts, two of which were especially important. One fact was that the amount due to the holder of the first mortgage was approximately $13 million, while the value of the entire premises was approximately $6.5 million. The second fact was that according to the tenant, the value of the tenancy owned by the hospital was very difficult, if not impossible, to quantify and that the value of the remaining term of the tenancy could not be quantified.

The bankruptcy court first examined the conditions under which a debtor can sell its property out of the ordinary course of business, recognizing first that if a party other than the debtor has an interest in property to be sold, a condition of sale is that such party's interest be given adequate protection; and second, that a debtor may sell property free of claims and interests only under certain conditions, one of which is that the party with the claim or interest could be compelled in a legal or equitable proceeding to accept a money satisfaction in exchange for its interest.

"Such interest," the court noted, is not defined in the Bankruptcy Code but has been interpreted to apply to leasehold interests. Accordingly, noted the court, the question presented is whether the holder of the interest - the leasehold - could be compelled to accept money in satisfaction of its interest.

The court next examined the need for the interest - the leasehold interest - to be, in the case of a sale, adequately protected. This means, stated the court, that if a sale is to occur, the debtor may exchange the interest for something else, but it must fall within the ambit of Section 361 of the code, such as, for example, the payment of money which is a reasonable substitute for that which is being taken. Most often, stated the court, in connection with sale free and clear of interests, the value of those interests will attach as a lien to the proceeds of sale.

Finally, the court considered the provisions of Section 365(h) of the code, which in part states that if a debtor-lessor rejects an unexpired lease, the other party to the lease may either treat the lease as terminated, or continue in possession and pay rent.

How, then, do these three code provisions interact as they apply to this case? The court started its analysis by rejecting the debtor's position that it need show that under Section 363(f)(5) only that it was hypothetically possible to compel the hospital to accept a money satisfaction in exchange for its leasehold interest. It found no authority to that effect and believed that the only logical interpretation of the statute requires that the debtor must be able to compel satisfaction by paying money.

The focus of this section, stated the court, is on whether or not the interest is reducible to a claim, which can then be dealt with. Here, the lessee could not be compelled to accept a money satisfaction. First, the unrebutted evidence was that the losses to the hospital from the loss of the leasehold were simply not capable of calculation. Second, the debtor-lessor could not offer anything to the lessee that would constitute adequate protection for the loss of the leasehold.

Almost certainly, it would not come from the proceeds of sale, given the amount of the secured claim and the unrebutted evidence of value. Even in Qualitech, the bellwether for allowing sales which effectively can cause a tenant to lose its leasehold, there was a recognition for the need to provide the tenant adequate protection for its loss. Finally, the court rejected the reasoning of Qualitech to the extent that the 7th Circuit held that that a sale could divest a tenant of its leasehold. To so hold, noted the court, would quite simply eviscerate the provisions of Section 365(h).

Accordingly, the request of the debtor-lessor to publicly auction the property free and clear of the hospital's lease was denied.

Clearly, this case does not solve the dilemma presented by the Qualitech holding. At most, it demonstrates the existence of a split that is not particularly comforting to lawyers advising tenants, or to the lenders who lend for, and take liens on, leasehold improvements. Perhaps one possible way of trying to "stack the deck" is to include in leases a provision stating that the tenancy is unique and that the loss to the lessee of its tenancy is not capable of being valued, or stating that the harm to the lessee cannot be satisfied by the payment of money, something which is commonly found in other forms of contracts. Until this area of the law is more fully developed, however, the issue will continue to give both business people and lawyers pause.

This article is reprinted with permission from the June 17, 2005 issue of The Legal Intelligencer.  Copyright 2005 ALM Properties, Inc.  Further duplication without permission is prohibited.  All rights reserved.