U.S. Fifth Circuit Issues Important Decision Concerning Rights of a Tenant When the Landlord is in Bankruptcy

U.S. Fifth Circuit Issues Important Decision Concerning Rights of a Tenant When the Landlord is in Bankruptcy

Charles L. "Chuck" Stern , Jr.

Charles L. "Chuck" Stern , Jr.

May 17, 2022 01:20 PM

Bankruptcy court can be a confusing, even disorienting, place for the uninitiated, especially when rights to real property are involved. One situation that arises from time to time concerns the rights of a tenant when the landlord files for bankruptcy and the building is put up for sale. Two different provisions of the Bankruptcy Code come into play in this scenario:

  • Section 363(f) of the Bankruptcy Code allows the bankruptcy trustee to sell the landlord’s property “free and clear of any interest in such property of an entity other than the [bankruptcy] estate,” if certain conditions are met. This language suggests that such a sale could result in the tenant losing its rights under its lease.
  • Section 365(h) of the Bankruptcy Code addresses what happens to a tenant when the landlord no longer wants to be burdened by the tenant’s lease. Under this section, the landlord can be freed from its burdens (property maintenance, for example), but the tenant, if otherwise in compliance with its obligations under the lease, is still allowed to retain its right to continue in possession of the leased space for the remaining term of the lease. That is, the bankrupt landlord can’t force out a tenant who wants to remain and is complying with its obligations under the lease.

Courts from time to time have been asked to decide whether a sale of the bankrupt landlord’s property under Section 363(f) overrides Section 365(h) and allows the landlord to sell to the new owner “free and clear” of the tenant’s rights under the lease. To put it another way, can a tenant be forced out of its leased space as part of a “free and clear” sale of the landlord’s property? This seems like an esoteric question, but it has important practical consequences for tenants, who, depending on the answer, could find themselves losing their rented space solely because they had the misfortune to rent from a bankrupt landlord.

Two federal appeals courts have suggested that tenants can indeed be forced out as part of a landlord’s “free and clear” sale under Section 363(f). The Seventh Circuit, based in Chicago, held in a 2003 case called Precision Industries, Inc. v. Qualitech Steel SBQ, LLC that a sale under Section 363(f) overrode the lessee protections in Section 365(h). The Ninth Circuit, based in San Francisco, adopted the reasoning of the Seventh Circuit in a 2017 decision called In re Spanish Peaks Holdings II, LLC.

U.S. Fifth Circuit Weighs In

Until recently, though, the Fifth Circuit, which covers Louisiana, Texas, and Mississippi, had never addressed the issue.

It finally did so this past February in a short opinion called In re Royal Street Bistro, LLC. In that case, two lessees had objected to a free and clear sale of the debtor’s property, apparently because they wanted to preserve their leases and were concerned that the sale would terminate the leases. The bankruptcy court allowed the sale to proceed over their objection, relying in part on the Seventh Circuit’s decision in Precision Industries. The tenants then sought a stay of that ruling from the Fifth Circuit after failing to get a stay from the federal district court.

The Fifth Circuit refused to grant the stay, but in doing so, it made clear that it disagreed with the Seventh and Ninth Circuits on how free and clear bankruptcy sales affect the rights of tenants. It denied the stay because under Louisiana law, the objecting tenants’ leases were subordinate to a mortgage on the property and because the tenants each were several months behind in their rent and so were in breach of their respective leases.

But the Fifth Circuit criticized the lower courts for their reliance on Precision Industries, viewing that reliance as a “mistake” and cautioning other courts within the circuit against “blithely accepting [the Seventh Circuit’s] reasoning and textual exegesis.” To put it in layman’s terms, bankruptcy courts in the Fifth Circuit, including those in Louisiana, are likely to be more reluctant than courts in other parts of the country to terminate the occupancy rights of a tenant when a bankrupt landlord attempts to displace that tenant via a “free and clear” sale in bankruptcy.

The Lesson for Landlords and Tenants

There is a broader lesson here as well for landlords and tenants both. Bankruptcy raises complicated and unfamiliar issues, especially because a bankruptcy court, unlike most other courts, has the power under certain circumstances to alter the parties’ rights under a contract. When a party with which you have a contract files for bankruptcy protection, you should seek legal advice on how the bankruptcymay affect your rights to avoid any unpleasant surprises.

Precision Industries, Inc. v. Qualitech Steel SBQ, LLC 327 F.3d 537

In re Spanish Peaks Holdings II, LLC 872 F.3d 892

In Re: Royal Street Bistro, L.L.C., No. 22-30066

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