On Jan. 24, 2005, the U.S. Court of Appeals for the Sixth Circuit issued an opinion that follows a line of case law dealing with the protections to be afforded assignees of unexpired leases and executory contracts under Bankruptcy Code §365. Subject to certain restrictions, Code §365(a) permits a trustee or debtor to assume or reject unexpired leases of the debtor.² Code §363(b)(1) authorizes a trustee or debtor-in-possession (DIP)to "use, sell or lease" property of the debtor's estate other than in the ordinary course of business.³ When a bankruptcy court authorizes a §363 sale of estate property, the Code affords certain protections to the purchaser in the transaction. Among those protections is Code §363(m), which provides that a purchaser or lessee of property of the estate is protected from reversal on appeal of the order authorizing the sale or lease of property pursuant to §363(b) or (c), where the purchaser acted in good faith and the party challenging the sale order failed to obtain a stay of such order pending appeal.

Some courts have held that §363(m) applies not only to appeals of sale orders, but also to appeals of orders authorizing assignment of unexpired leases that have been assumed under §365. These courts have reached this conclusion notwithstanding the fact that §365 does not contain a "statutory mootness" provision similar to §363(m). As discussed in this article, the Sixth Circuit has joined the majority of courts in its recent ruling in Weingarten Nostat Inc. v. Service Merchandise Co. Inc.⁴ In this case, the Sixth Circuit read §§365 and 363(m) together and dismissed as moot an appeal of an order authorizing the assignment of a lease. While the court's reading of the Code and its pragmatic results are undoubtedly correct, it remains to be seen whether the U.S. Supreme Court would uphold the rulings of these courts.

The Weingarten Opinion

The facts in Weingarten are fairly straightforward and commonplace, especially in a retail bankruptcy. On March 27, 1999, Service Merchandise Co. Inc. filed for chapter 11 protection in the U.S. Bankruptcy Court for the Middle District of Tennessee. In connection with the liquidation of its assets, Service Merchandise sold the designation rights to most of its retail leases to an entity named KLA/SM LLC pursuant to §363. One of the affected leases was a lease of a 50,000-square-foot store located in Jacksonville, Fla. The landlord under this lease was Weingarten Nostat Inc.

Also located in the shopping center was a Jo-Ann's Etc. store. The Jo-Ann's lease contained a provision entitling Jo-Ann's to reduce its rent by one third or terminate the lease in the event that a competitive retailer moved into the shopping center. The purchaser of the designation rights, KLA, designated JLPK LLC as the assignee of the Service Merchandise lease. Service Merchandise then notified Weingarten of the assumption and assignment of the lease to JLPK and the simultaneous sublease by JLPK to Michaels Stores Inc., a company also engaged in the business of selling art and craft supplies. Upon learning about the Michaels' sublease, Jo-Ann's gave notice to Weingarten that it considered the opening of Michaels to be in direct violation of its lease, and consequently, that it intended to pay reduced rent as provided for under its lease.

The landlord objected to the proposed assignment and sublease, alleging that the sublease to Michaels failed to meet the shopping center "adequate protection" requirements of §365(b)(3) because (1) the proposed assignee was not similar to Service Merchandise at the time the lease was originally consummated, in terms of operating history and financial performance; (2) the proposed assignment and sublease breached Weingarten's lease with Jo-Ann's; and (3) the proposed assignment and sublease would disrupt the tenant mix in the shopping center. The bankruptcy court overruled Weingarten's objection and entered an order approving the sale and assignment of the lease, pursuant to §§363 and 365(a) of the Code.⁵

After entry of the bankruptcy court's order, Weingarten requested a stay pending appeal. The district court denied Weingarten's motion, and affirmed the bankruptcy court's order.⁶ Weingarten then appealed to the Sixth Circuit for an emergency stay of the bankruptcy court's order or, in the alternative, for a writ of mandamus. However, two days after the district court denied the motion for a stay pending appeal, Service Merchandise assumed and assigned the lease to JLPK. JLPK paid KLA for the designation and executed the sublease with Michaels. Michaels then took possession of the premises and invested in configuring its new space. Thereafter, the district court denied Weingarten's request for reconsideration of its decision denying the stay motion and affirmed the bankruptcy court's order.⁷ Weingarten appealed the district court's order, and while its appeal was pending, Service Merchandise moved to dismiss the appeal as moot under §363(m).

The Sixth Circuit held that Weingarten's failure to obtain a stay required the dismissal of its appeal as moot under §363(m). The court based its ruling on (1) the language and legislative history of Code §§363 and 365, (2) the policies underpinning §363(m) and (3) the reasoning and holdings of prior rulings of other courts on this issue.

The Sixth Circuit began its analysis by noting that §363(m) is predicated on the need to encourage participation in bankruptcy asset sales by affording finality to judgments approving sales in bankruptcy, which in turn enhances the sale value of a debtor's assets.⁸ Even where an appeal is not moot as a constitutional matter (because a court could fashion some remedy), the policy of favoring finality in bankruptcy sales, as reflected in §363(m), requires that certain appeals nonetheless be treated as moot absent an order staying the sale.⁹

In deciding whether §363(m) applied to the assumption and assignment of a lease under §365, the Sixth Circuit considered applicable legislative history and the plain meaning of §§363 and 365. Specifically, the Sixth Circuit noted that the legislative history of §363(b), which allows a debtor to use, sell or lease property of the estate outside the ordinary course of business, indicates that the section is intended to be interpreted broadly and that the term "property of the estate" is defined expansively to include leasehold interests of the debtor.¹⁰ Moreover, the Sixth Circuit noted that §365 gives the debtor broad power to assume and assign an unexpired lease in order to maximize the value of the debtor's estate and to assign an unexpired lease, even where such assignment is prohibited by the lease or applicable non-bankruptcy law, provided that the assignee gives adequate assurance of future performance.¹¹

Having considered applicable legislative history and the language of the statute, the Sixth Circuit analyzed a number of cases holding that §363(m) applies to orders authorizing the assignment of a lease. The Sixth Circuit highlighted several decisions that reason that since a lease is property of the estate, the assignment of a lease for consideration is a sale under §363, and as such, the "statutory mootness" provision of §363(m) is necessarily triggered.¹²

The court reached its conclusion even though Service Merchandise did not assign the lease directly to JLPK.¹³ Rather, JLPK paid KLA for designating JLPK as assignee of the lease, and, pursuant to the designation rights agreement, Service Merchandise complied.¹⁴ The Sixth Circuit reasoned, however, that because Service Merchandise's assignment of the lease to JLPK pursuant to the designation-rights agreement with KLA was effectively a single transaction, Service Merchandise sold the lease to Michaels pursuant to §§363 and 365, and the protections of §363(m) therefore applied.¹⁵

In reaching its holding, the Sixth Circuit relied extensively on the decision of the U.S. Court of Appeals for the Third Circuit in In re Rickel Home Centers Inc.¹⁶ In this case, the Third Circuit dismissed as moot, under §363(m), the appeal of a shopping center landlord from an order approving the assumption and assignment of a retail lease. The Third Circuit noted that cases applying §363(m) to the sale and assignment of leases reflect the policy of §363(m) to afford finality to the orders and judgments of the bankruptcy court relied on by third parties in ordering their affairs.¹⁷ The Sixth Circuit expressly approved of the reasoning in Rickel and found that the facts of Rickel were substantially similar to the facts in the case before it.¹⁸ Accordingly, the Sixth Circuit denied Weingarten's appeal as moot under §363(m).¹⁹

The Majority Rule

Bankruptcy Code §363(m) requires dismissal of an appeal of an order authorizing assumption and assignment of a lease for consideration where the assignee has acted in good faith and a stay of the order pending appeal has not been granted. The Weingarten decision is clearly in accord with the rulings of other circuit courts that have dealt with this issue. These courts generally give significant weight to the Third Circuit's Rickel opinion. In Rickel, the debtor was a home-improvement chain that sought to sell certain of its interests in leased property. The bankruptcy court granted the debtor's motion to sell the leases over an affected landlord's objection that the lease at issue contained a use restriction that, the landlord argued, prohibited the assignment of the lease to the proposed assignee. In granting the sale motion, the court relied on Code §§363, 365(a) and 365(f).

The landlord did not attempt to obtain a stay of the order authorizing the sale, but rather appealed the court's decision approving the sale of the leases, including the landlord's lease. The debtor sought to dismiss this appeal as moot, pursuant to §363(m). The Third Circuit specifically found that the "statutory mootness" provisions of §363(m) applied to the challenged transaction and dismissed the appeal. It is important to note, however, that the Third Circuit rejected a per se approach that would require dismissal of any appeal as moot where the appellant has failed to obtain a stay of the order from which the appeal is taken.²⁰ Rather, the Third Circuit applied a bifurcated analysis, holding that "two conditions [must] be met before an appeal becomes moot under §363(m): (1) the underlying sale or lease must not have been stayed pending appeal, and (2) reversing or modifying authorization to sell or lease would affect the validity of the sale or lease."²¹

The court in Rickel found that both conditions were satisfied with respect to the transaction at issue. In doing so, the court rejected the landlord's argument that §363(m) is inapplicable to an assignment of leases.²² As in Weingarten, the court determined that a debtor's interest in unexpired leases is clearly property of the estate pursuant to Code §541.²³ Because the lease at issue was property of the estate, the court reasoned that §363(m) applied to a sale of the lease "notwithstanding that §365 applies to the particular mechanics of conveyance."²⁴ The court held that the policies underlying §363(m) "not only to afford finality to the judgment of the bankruptcy court, but particularly to give finality to those orders and judgments upon which third parties rely" would be furthered by dismissal of the landlord's appeal as moot.²⁵ In light of (1) these policies, (2) the fact that the landlord had not obtained a stay pending appeal and (3) the fact that the purchaser had relied on the bankruptcy court's authorization, had taken possession of the property and had expended substantial funds to renovate the leased property, the court dismissed the appeal as moot pursuant to §363(m).²⁶

As indicated, rulings on this issue from other jurisdictions are in accord with the Rickel and Weingarten decisions. Another leading case is In re Adamson Co. Inc.²⁷ in which a lessor, without first obtaining a stay, appealed an order of the bankruptcy court authorizing a debtor-manufacturer to sell substantially all of its assets and assume and assign a lease for its manufacturing plant to the purchaser. In dismissing the appeal, the court considered that the purchaser had relied on the bankruptcy court authorization and had irrevocably altered certain of the assets it had purchased.²⁸ Importantly, however, the court held that "this reasoning, while supportive of §363(m), is not necessary for our decision."²⁹ This indicates that the Fourth Circuit, unlike the Third Circuit in Rickel, applied a per se approach in which the failure of a landlord-appellant to obtain a stay of an order authorizing assignment of a lease pending appeal will require dismissal of such appeal as moot pursuant to Code §363(m). Further, as in Rickel, the court disposed of the landlord's argument that §363(m) does not apply to assignments of leases, stating that this argument "ignores both the plain language and the purpose
of §363(m)."³⁰

Although the circuit courts are in agreement that §363(m) applies to orders assigning leases to third-party purchasers, the courts apply differing strains of reasoning to reach this conclusion.³¹ The majority of the circuit courts have adopted a per se rule.³² For example, in In re Exennium Inc., the Ninth Circuit seemingly applied the per se approach as followed in the Adamson case, and held that where no stay of an order authorizing the sale of four real estate leases and related personal property had been obtained, neither the Bankruptcy Appellate Panel nor the appeals court had the power to overturn the sale of the leases.³³ Further, in In re Stadium Management Corp., the First Circuit considered an appeal by a lessor whose long-term lease had been assigned as part of the sale of a football stadium, where no stay of the order authorizing such sale and assignment had been obtained.³⁴ The court did not apply a per se approach, but rather examined the extent to which the assignment of the lease was intertwined with the sale transaction. The court in Stadium Management held that because the lease assignment had been an integral part of the sale transaction under §363(b), the assignment was subject to the stay requirement of §363(m), and therefore the appeal was moot and must be dismissed.³⁵

Departure from the Majority Rule: The Dart Drug Stores Case

The majority rule is clearly that the "statutory mootness" provision of §363(m) requires dismissal of an appeal from an order approving assignment of a lease where the appellant did not obtain a stay of such order and where the purchaser conducted itself in good faith.³⁶ In fact, only one case, In the Matter of Dart Drug Stores Inc.,³⁷ departs from this majority rule. In Dart Drug, a shopping center landlord appealed an order of the bankruptcy court approving assignment of the landlord's lease, which the debtors in that case had previously successfully assumed pursuant to §365.³⁸ The court, relying extensively on the Third Circuit's decision in In re Joshua Slocum Ltd.,³⁹ held that since assignment of leases are governed by §365, the mootness provision of §363(m) simply does not apply to appeals of an order authorizing a lease assignment.⁴⁰ However, since the principle of the Joshua Slocum case has been limited by the courts' rulings in the Rickel and Krebs decisions, Dart Drug may be of no precedential value.⁴¹

Conclusion

The overwhelming majority of the courts considering the issue have held that, notwithstanding the notable absence of a "statutory mootness" provision within the text of §365, an appellate court is bound by §363(m) to dismiss as moot an appeal of an order authorizing the assignment of an assumed lease for valuable consideration where the assignee acted in good faith and where the complaining landlord-appellant has not obtained a stay order. In light of this substantial body of case law, a prudent landlord should make every effort to obtain a stay of an order authorizing a debtor to assign the landlord's lease to a third-party purchaser, assignee or subtenant, prior to expending resources appealing the bankruptcy court's order. And the debtor and assignee should make sure to seek authority for the transaction under §363(b) as well as §365(f) and to integrate the assignment of the lease with any related sale where possible.

However, in light of the U.S. Supreme Court's line of decisions applying the "plain meaning" of the Code,⁴² it is unclear if that court would affirm the circuit courts' rulings that §363(m) applies to orders authorizing assignment of leases. It is not difficult to see, in light of recent "plain meaning" decisions, that the Supreme Court might hold that if Congress intended assignees of leases to have the protections extended to good-faith purchasers under §363(m) or lenders under §364(e), it would have included that protection
in §365.

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Footnotes

¹ The author greatly acknowledges the assistance of Evelyn J. Meltzer and James Carignan, associates in the Wilmington, Del., office of Pepper Hamilton, in the preparation of this article. Return to article

² 11 U.S.C. §365(a). Return to article

³ 11 U.S.C. §363(b)(1). Return to article

⁴ Weingarten Nostat Inc. v. Serv. Merch. Co. Inc., 2005 WL 129731 (6th Cir. 2005). Return to article

⁵ Id. at 2. Return to article

⁶ Id. Return to article

⁷ Id. Return to article

⁸ Id. at 3. Return to article

⁹ Id. Return to article

¹⁰ Id. at 4. Return to article

¹¹ Id. Return to article

¹² Id. Return to article

¹³ Id. at 5. Return to article

¹⁴ Id. Return to article

¹⁵ Id. Return to article

¹⁶ In re Rickel Home Ctr. Inc., 209 F.3d 291 (3d Cir. 2000). Return to article

¹⁷ Weingarten Nostat Inc. v. Serv. Merch. Co. Inc., 2005 WL at 5. Return to article

¹⁸ Id. Return to article

¹⁹ Id. Return to article

²⁰ Id. at 298 (citing Krebs Chrysler-Plymouth Inc. v. Valley Motors Inc., 141 F.3d 490, 498 (3d Cir. 1998) ("[i]n construing §363(m), we have rejected a per se rule 'mooting appeals absent a stay of the sale or lease at issue....'"). Return to article

²¹ In re Rickel Home Ctr. Inc., 209 F.3d at 298. Return to article

²² Id. at 300. Return to article

²³ Id. (citing Krebs, 141 F.3d at 491; In re Arizona Appetito's Stores Inc., 893 F.2d 216, 218 (9th Cir. 1990)). Return to article

²⁴ In re Rickel Home Ctr. Inc., 209 F.3d at 302 (quoting Krebs, 141 F.3d at 498); see, also, In re Adamson Co. Inc., 159 F.3d 896, 898 (4th Cir. 1998) ("[i]t is elementary that a leasehold is personal property and possibly of value to the debtor's estate, thus the assignment of a lease...is a sale of property to which §363(m) applies"). Return to article

²⁵ In re Rickel Home Ctr. Inc., 209 F.3d at 303-04 (quoting In re Abbotts Dairies of Pa. Inc., 788 F.2d 143, 147 (3d Cir. 1986)); see, also, In re Sax, 796 F.2d 994, 997-98 (7th Cir. 1986); Pittsburgh Food & Beverage Inc. v. Ranallo, 112 F.3d 642, 650-51 (3d Cir. 1997); In re Gilchrist, 891 F.2d 559, 561 (5th Cir. 1990). In further support of its holding, the court relied on other circuit court cases that had reached the same conclusion. See, e.g., In re Exennium Inc., 715 F.2d 1401 (9th Cir. 1983) (dismissing as moot an appeal from an order of bankruptcy court authorizing an asset sale including the assignment of four leases pursuant to Code §363(m)). Return to article

²⁶ In re Rickel Home Ctr. Inc., 209 F.3d at 305; see, also, Cinicola v. Scharffenberger, 248 F.3d 110 (3d Cir. 2001) (where bankruptcy court entered an order authorizing debtors to assume and assign several physician employment contracts over physicians' objections, and where physicians appealed such order without first obtaining a stay pending appeal, the Third Circuit relied on Rickel and upheld the bankruptcy court's order). Return to article

²⁷ In re Adamson Co. Inc., 159 F.3d 896, 897 (4th Cir. 1998). Return to article

²⁸ Id. at 898. Return to article

²⁹ Id. (emphasis added). Return to article

³⁰ Id. The Adamson court's "plain language" holding presents one interesting point of contention. The "plain language" of Code §363(m) referred to in Adamson is that §363(m) applies to "a sale or lease of property." Adamson, 159 F.3d at 898 (quoting 11 U.S.C. §363(m)). However, as explained infra, the court in In re Dart Drug Stores Inc., 1992 WL 308552 (D. Md. Oct. 15, 1992)—the only case that departs from the majority rule—stated that the plain "language of §363(m), which governs only authorization under §363(b) or (c) of a sale of (sic) lease of property, is inapplicable." Return to article

³¹ See Comco Assoc. v. Faraldi Food Indus. Ltd., 170 B.R. 765 (E.D.N.Y. 1994). Return to article

³² See Pittsburgh Food & Beverage v. Ranallo, 112 F.3d 645, 650-51 (3d Cir. 1997) (citing decisions of the 1st, 2nd, 5th, 7th, 11th and D.C. Circuits adopting per se rule). The Ninth Circuit also applies a per se rule. See Onuli-Kona Land Co. v. Estate of Richards (In re Onouli-Kona Land Co.), 846 F.2d 1170, 1172-73 (9th Cir. 1988). Return to article

³³ In re Exennium Inc., 715 F.2d 1401 (9th Cir. 1983) (citing In re Combined Metals Reduction Co., 557 F.2d 179, 187-90 (9th Cir. 1977); In re Royal Properties Inc., 621 F.2d 984, 986-87 (9th Cir. 1980)). Like Adamson but unlike Rickel, the Ninth Circuit has seemingly adopted a per se rule that an appeal of an assignment of leases absent a stay of the order authorizing such assignment violates §363(m) and must be dismissed. Exennium, 715 F.2d at 1404 ("§363(m) does not require the purchaser to take irreversible steps consummating the sale, thus making its overturning a hardship to the buyer, before the absence of a stay will be operative"). Return to article

³⁴ In re Stadium Mgmt Corp., 895 F.2d 845 at 846 (1st Cir. 1990). Return to article

³⁵ Id.; see, also, In re Am. Banknote Corp., 2000 WL 815910 (S.D.N.Y. 2000) ("the weight of persuasive authority and the statutory language read in conjunction with the policies underlying the Bankruptcy Code" required the application of the statutory mootness provision of Code §363(m) to orders authorizing assignment of lease under §365). Return to article

³⁶ Salazar, Luis, "Section 363(m) Mootness and Leases: Appeal-proofing §365 Lease Assumption and Assignments," 10 J. Bankr. L. & Prac. 459, 467 (July/Aug. 2001). Return to article

³⁷ In the Matter of Dart Drug Stores Inc., 1992 WL 308552 (D. Md. 1992). Return to article

³⁸ Id. at 1. Return to article

³⁹ In re Joshua Slocum Ltd., 922 F.2d 1081 (3d Cir. 1990). Return to article

⁴⁰ Dart Drug at 2 ("[t]his court finds the rationale of In re Joshua Slocum Ltd....most persuasive and agrees that §363(m) is inapplicable to the matter at bar"); see, also, Shapiro v. Saybrook Mfg. Co. (In re Saybrook Mfg. Co.), 963 F.2d 1490, 1493-94 (11th Cir. 1992) (holding that mootness provision found in §364, which relates to extensions of credit and priority of liens in bankruptcy, did not bar an appeal testing the validity of a bankruptcy court order approving cross-collateralization financing). Return to article

⁴¹ Salazar, 10 J. Bankr. L. & Prac. at 466. Return to article

⁴² See, e.g., U.S. v. Ron Pair E'prises. Inc., 489 U.S. 235, 242 (1989) (quoting Griffin v. Oceanic Contractors Inc., 458 U.S. 564, 571 (1982)) (holding, in a case dealing with Code §506, that "[t]he plain meaning of legislation should be conclusive, except in the rare cases in which the literal application of the statute will produce a result demonstrably at odds with the intentions of the drafters"). The Supreme Court has continued to apply this "plain meaning" standard in interpreting sections of the Code. See Lamie v. U.S. Trustee, 540 U.S. 526, 534 (2004) ("[i]t is well established that when the statute's language is plain, the sole function of the courts—at least when the disposition required by the text is not absurd—is to enforce it according to its terms"). Return to article