In In re Royal St. Bistro, LLC, 26 F.4th 326 (5th Cir. 2022), the U.S. Court of Appeals for the Fifth Circuit recognized the rights of lessees when the debtor sells an asset free and clear of all liens, claims and encumbrances. The focus is not necessarily under bankruptcy law but under state law. Yet, before reaching state law domain, the Fifth Circuit first reviewed the rights of lessees when a lease is rejected under Section 365 of the Bankruptcy Code and when a debtor/trustee sells an asset free and clear under Section 363 of the Bankruptcy Code.
Under Section 365(h)1, if the lease is rejected, the debtor retains a continued right to lease the premises, including paying the rent, and offsetting rental obligations against obligations the debtor landlord failed to undertake, i.e., damages.
The lessee does not have the protections under Section 3632 that it does under Section 365(h). Moreover, if the buyer is found to have acquired the property free and clear, any reversal or modification of the order granting the sale is moot under Section 363(m) of the Bankruptcy Code. Thus, if a lessee wants to appeal an adverse decision, it must first obtain a stay pending appeal to avoid the effects of Section 363(m). Sometimes this is easier said than done.
In In re Royal St. Bistro , two lessees of the debtor’s property had objected to the sale of the property. The lessees were insiders of the debtor. The lessees urged that they were entitled to the rights under Section 365(h) of the Bankruptcy Code. The Fifth Circuit found that since the lease had not been rejected, Section 365 did not come into play. Instead, the Fifth Circuit narrowed the argument and focused on the lessees’ rights under state law. It rejected the bankruptcy court’s reasoning as being overly broad. There the bankruptcy court found that the lessees rights were junior to the rights of the mortgagee on the property, and that the mortgagee could have foreclosed under state law and wiped out the junior interests of the lease, i.e., the lessee, and the lease did not contain a non-disturbance clause that would have protected the lessees from foreclosure.
Citing the U.S. Supreme Court case, Butner v. United States, 440 U.S. 48, 54-57 (1979), the Fifth Circuit pointed out that only when the Bankruptcy Code overrides state law, will bankruptcy law control. Thus, whereas a lessee under Section 365 is afforded certain rights that would override state law, Section 363 does not provide for such protections and thus the state law controls.
Though this author agrees with the Fifth Circuit that unless the Bankruptcy Code overrides state law then state law controls, it stands to reason that the focus would then turn on the following: (a) whether under state law, the lease is junior to the rights of the mortgagee on the property had the debtor not filed bankruptcy; (b) whether upon foreclosure, the mortgagee could have wiped out the junior interests, such as a lease; and (c) whether the lease contains a “non-disturbance clause,” which would have protected the lessees from foreclosure.
So, the takeaway for any lessor or lessee is to focus on state law, and when doing so, review the lease and ask: Is there a non-disturbance or attornment clause3 or some other agreement like a subordination provision in favor of either the lender or lessee?
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- 11 U.S.C § 365(h)
(1) (A) If the trustee rejects an unexpired lease of real property under which the debtor is the lessor and—
(i) if the rejection by the trustee amounts to such a breach as would entitle the lessee to treat such lease as terminated by virtue of its terms, applicable nonbankruptcy law, or any agreement made by the lessee, then the lessee under such lease may treat such lease as terminated by the rejection; or
(ii) if the term of such lease has commenced, the lessee may retain its rights under such lease (including rights such as those relating to the amount and timing of payment of rent and other amounts payable by the lessee and any right of use, possession, quiet enjoyment, subletting, assignment, or hypothecation) that are in or appurtenant to the real property for the balance of the term of such lease and for any renewal or extension of such rights to the extent that such rights are enforceable under applicable nonbankruptcy law.
(B) If the lessee retains its rights under subparagraph (A)(ii), the lessee may offset against the rent reserved under such lease for the balance of the term after the date of the rejection of such lease and for the term of any renewal or extension of such lease, the value of any damage caused by the nonperformance after the date of such rejection, of any obligation of the debtor under such lease, but the lessee shall not have any other right against the estate or the debtor on account of any damage occurring after such date caused by such nonperformance.
(C) The rejection of a lease of real property in a shopping center with respect to which the lessee elects to retain its rights under subparagraph (A)(ii) does not affect the enforceability under applicable nonbankruptcy law of any provision in the lease pertaining to radius, location, use, exclusivity, or tenant mix or balance.
(D) In this paragraph, “lessee” includes any successor, assign, or mortgagee permitted under the terms of such lease. - 11 U.S.C § 363(f): The 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, only if—
(1) applicable nonbankruptcy law permits sale of such property free and clear of such interest;
(2) such entity consents;
(3) such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property;
(4) such interest is in bona fide dispute; or
(5) such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest. - The attornment clause obligates the tenant to recognize the new owner of the property as its landlord regardless of whether the new owner acquired the property through a normal sale or a foreclosure.
