In re Reval And The Protection Of Lessee Property Rights In The Face Of 11 U.S.C. 363

By: Aaron Z. Leaf

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

            For over a decade, courts have struggled with how to reconcile sections 363 and 365(h) of the United States Bankruptcy Code (the “Code”).[i] While neither statute working alone in bankruptcy cases presents much challenge, when invoked together some courts have found them to be incompatible.[ii] A court cannot simultaneously allow a trustee to sell property “ free and clear of any interest in such property”[iii] and allow a lessee to retain all rights that are “appurtenant to the real property for the balance of the term.”[iv] The United States Bankruptcy Court for New Jersey recently addressed sections 363 and 365(h) in In re Reval.[v] After years of poor financial performance, Revel AC, Inc. and its partners, filed petitions under chapter 11 of the Code.[vi] Debtors subsequently filed a motion under section 365(a) to reject lease agreements with its tenants.[vii] In response, IDEA Boardwalk and other lessees gave a notice of their intent to continue to exercise their “possessory leasehold rights under section 365(h).”[viii] Upon the debtor’s request, the court thereafter approved a sale of the debtors’ property to Polo North under section 363 of the Code.[ix] After finding that the agreement between the Debtors and Tenants were true leases,[x] the court addressed how the sale would affect Tenants section 365(h) possessory rights.[xi] The court held that the tenants possessory rights under section 365(h) eviscerates a debtor’s right under section 363of the Code to sell its property free and clear of any interest.[xii]

            The United States Bankruptcy Court for New Jersey and other courts, hold that section 363 of the Code has no affect on a tenant’s section 365(h) possessory rights for two reasons.[xiii] First, to maintain meaning in section 365(h), courts have read the statutes using the statutory interpretation principle Generalia Specialibus Non Derogant; the specific governs the general.[xiv]  Since section 365(h) specifically allows tenants to stay in the rented property for the term of their lease, and section 363(f) generally allows a debtor to sell all property free and clear of all claims, section 365(h) rights should usurp 363(f) rights; otherwise 365(h) rights would be inconsequential.[xv]  Second, legislative history indicates that section 365(h) was added to protect the rights of tenant’s regardless of the debtor leaser’s needs.[xvi]  A 1978 Senate report “remarked that under the terms of section 365(h), “the tenant will not be deprived of his estate for the term for which he bargained.””[xvii] The section-by-section analysis of the 1994 Amendments to the Code[xviii] states “section 365 of the Bankruptcy Code … mandate(s) that lessees cannot have their rights stripped away if a debtor rejects its obligation as a lessor in bankruptcy”[xix] and that section 365(h) “will enable the lessee to retain its rights that appurtenant to its leasehold.”[xx]                                                                                

            Many courts, including the highest court to have addressed this issue have found that sections 363 and 365 are perfectly consistent with each other and that section 363 rights eviscerate 365 rights.[xxi] The Seventh Circuit in Precision Industries vs. Qualitech looked to the language and structure of both sections to come to that conclusion.[xxii] First, the court examined the language of section 363, which states “[t]he trustee may sell property under subsection (b) or (c) of this section free and clear of any interest in such property of an entity other than the estate.”[xxiii] The court found that the words “any interest” were broad enough to mean any interest, including those of a lessee.[xxiv] Second, the court examined the statutory provisions themselves and found that sections 363 and 365 “contain cross-references indicating that certain of their provisions are subject to other statutory mandates.”[xxv] Since sections 363(f) and 365(h) lack similar cross-references, they should function the way they are written. Thus, according to the Seventh Circuit, section 363 eviscerates a lessees right when a property is sold. Third, the court found that the language of section 365(h) plainly only applies when “the trustee [or debtor-in-possession] rejects an unexpired lease of real property.”[xxvi] If a debtor “cancels” the lease via a section 363(f) sale, a lessee cannot invoke their section 365(h) rights because the scope of section 365(h) is limited to rejection by the debtor.[xxvii] The courts final point was that while this reading might seem unusually harsh to the lessee, the statute does provide the lessee with protection.[xxviii] Section 363(e) allows a lessee to petition bankruptcy courts to “prohibit or condition such ... sale ... as is necessary to provide adequate protection of such interest.”[xxix]

            Recently, the court in Dishi v. Bay Condos took a different approach.[xxx] Unsatisfied with the majority[xxxi] and minority view,[xxxii] the court examined the role of section 365(h) in isolation and found that the primary function of section 365(h) is to prevent the lessors’ “obligations under the lease” from “outweighing the benefits to the estate”.[xxxiii] The only right 365(h) provides to the lessee is to maintain the rights that are appurtenant to the leasehold in the event a debtor exercises his rejection powers.[xxxiv] In other words, 365(h) was not intended to provide debtor’s lessee with rights that they would “not enjoy outside of bankruptcy.”[xxxv] The Dishi court found this reading persuasive since Section 365(h) does not prevent a trustees from “avoid[ing] interests as a bona fide purchaser, or to avoid interest that were fraudulently transferred by the debtor.”[xxxvi] Thus, this reading of sections 365(h) and section 363(f) prevents an inapposite reading of the Code and allows both sections to function harmoniously with one another because they deal with different issues.[xxxvii]

            The inability for a debtor in bankruptcy to sell its property free and clear of interest on the property limits the flexibility the Code is meant to provide. Without section 365(h) tenants have little protection from a lessor who declares bankruptcy. Outside of section 363(e), which will give tenants little security, the only way for tenants to protect their property interests is by examining the prospective lessors financial information. In re Reval confirms New Jersey Bankruptcy Courts precedent that section 365(h) protects lessees from sales under section 363(f) despite the recent New York District court decision in Dishi. Unfortunately Reval fails to address any of the issues brought up by the Dishi Court and thus adds little in the discussion of which statutory interpretation is better.[xxxviii] Until a higher court or congress address the relationship between section 365(h) and 363, the debtor lessor and the lessee’s rights will largely be determined by geographic location.