March 01, 2004

Precision Industries, Part 2: How Lessees and Leasehold Mortgagees Can Protect Themselves (2004, 18:02)

Precision Industries, Part 2: How Lessees and Leasehold Mortgagees Can Protect Themselves

Probate and Property, March/April 2004, Volume 18, Number 2

By John C. Murray
John C. Murray practices law with First American Title Insurance Company in Chicago, Illinois.

The Seventh Circuit’s recent decision in Precision Industries, Inc. v. Qualitech SBQ, LLC, 327 F.3d 537 (7th Cir. 2003), highlights the risks that lessees (and leasehold mortgagees) face when a debtor-lessor files for bankruptcy. The decision is analyzed in Precision Industries, Part 1: Debtor-Lessor’s Property May Be Sold “Free and Clear” of Unexpired Lease, at page 10 in this issue of Probate & Property. This article offers strategies and drafting tips to minimize the risks identified by the Precision Industries case.

Retaining Possession Under Section 365(h)

The Bankruptcy Code contains protection for leasehold interests when a lessor files for reorganization under Chapter 11. Most notably, Section 365(h) provides that when a debtor-lessor seeks to reject an unexpired lease, the lessee has the option of remaining in possession of the property for the remainder of the lease term and any renewal or extension. 11 U.S.C. § 365(h). Accordingly, although the rejection of the lease frees the debtor-lessor from performing other contractual obligations under the lease, Section 365(h) protects the lessee’s predominant interest—the right to remain in possession.

The Precision Industries decision raises the specter of the possible loss of a lessee’s Section 365(h) protections under certain circumstances. The court held that Section 365(h) was inapplicable when the bankruptcy court permits a lessor to sell the property “free and clear of any interest of such property of an entity other than the estate” under Section 363(f). 11 U.S.C.§ 363(f). In other words, although a lessee’s right to retain possession is protected when the debtor-lessor keeps the property as part of the reorganization plan, the lessee loses this right if the debtor-lessor instead elects, and is permitted, to sell the property under Section 363(f).

Stating the problem in this way suggests that one obvious way for a lessee (or leasehold mortgagee) to protect its interest is to prevent the bankruptcy court from authorizing a Section 363(f) sale in the first place. The Code provides that a sale “free and clear of any interest” can occur only in one of five circumstances:

1. if applicable nonbankruptcy law permits such a sale;
2. the entity holding the interest consents;
3. the interest is a lien and the sale price is greater than the aggregate value of all liens against the property;
4. the interest is in bona fide dispute; or
5. such entity could be compelled to accept a money satisfaction of the interest.

Id. Given these limited circumstances, a Section 363(f) sale should rarely occur over a lessee’s or leasehold mortgagee’s objections. Indeed, as explained in the companion article, it is curious how such a sale could be authorized in the Precision Industries case itself. The court does not explain the basis for the sale, but merely assumed—from the lessee’s failure to raise the issue—that one of the five conditions had been met. 327 F.3d at 546 n.3.

The Lessee’s Right to Adequate Protection

For the rare case in which a leasehold interest meets one of the five conditions for a Section 363(f) sale, the Code provides a second means of protecting the lessee/leasehold mortgagee’s interest. Section 363(e) provides that, upon request of any entity that has an interest in such property, the court shall prohibit or condition such sale “as is necessary to provide adequate protection of such interest.” 11 U.S.C. § 363(e).

It is important to note, however, that Section 363(e), by its express terms, comes into play only upon the request of an entity holding an interest subject to a Section 363 sale. See Colarusso v. Canzano, 295 B.R. 166, 175 (B.A.P. 1st Cir. 2003) (ruling that claimant’s failure to object to sale of property free and clear of adverse possession claim or to seek adequate protection under Section 363(e), coupled with her participation in sale as a bidder, constituted “consent” to sale under Section 363(f)(2)). It is difficult to understand why the lessee in the Precision Industries case failed to seek protection under this section before entry of the sale order by the bankruptcy court. The case illustrates, however, the serious consequences of a failure to do so.

If the issue is properly raised by the lessee, a more difficult question arises as to what constitutes adequate protection. The Precision Industries decision stated that “adequate protection” does not guarantee continued possession of the property, “but it does demand, in the alternative, that the lessee be compensated for the value of its leasehold—typically from the proceeds of the sale.” 327 F.3d at 548. At a sale free and clear of any interest in the property, any holder of any interest in the property (including a lessee) will be permitted to bid. If that holder is the high bidder, the holder will be able to offset the value of its interest against the purchase price of the property. In most cases, however, it is questionable whether sufficient proceeds will be available to compensate the lessee. If there are other secured claims against the property (a fee or leasehold mortgage or a judgment lien), those claims could take priority over the lessee’s unsecured claim to the sale proceeds.

Under these circumstances, a lessee has a credible argument that continued possession is the only form of “adequate protection” that will protect the lessee’s interest. A similar argument could be made if the lessee has a unique location, or has spent significant funds on lessee improvements. Cf. In re Port Angeles Waterfront Associates, 134 B.R. 377, 381 (B.A.P. 9th Cir. 1991) (dissenting opinion noted that debtor, which had not defaulted under the lease, would lose $3.5 million of improvements it had made on the leased property).

If compensation would be adequate, the lessee’s attorneys face the question of how to value the lessee’s possessory interest. See In re Taylor, 198 B.R. 142, 160 n.18 (Bankr. D.S.C. 1996) (“While the court declines to set a value at this time in as much as it’s unnecessary in this ruling the Court believes the lease interests do have considerable value and will ascribe a value when necessary in this case”); see also Jerald I. Ancel, Marlene Reich & Jeffrey J. Graham, Can a § 363 Sale Dispossess a Tenant Notwithstanding § 365(h)?, 22 Am. Bankr. Inst. J. 18 (2003); Peter N. Tamposi, Tenants Beware—Your Lease Rights May Be Subject to Termination by the Bankruptcy Court—Licensees of Intellectual Property Take Note: You May Be Next, 22 Am. Bankr. Inst. J. 30 (2003).

In determining this value, some obvious questions that the lessee’s counsel must address include: Is the value determined by the lease rental rate? Is it determined by reference to the rental rate of other leases in the same building (assuming a multi-lessee property)? Is it determined by similar leases at properties in the same geographical area? Must mitigation of damages, or special lessee-improvement allowances or rent (or other) concessions, be taken into account? Counsel must also consider whether the lessee’s adequate protection claim for its possessory interest should be treated as an administrative expense because it survives rejection (as opposed to being treated as a pre-petition unsecured claim). In short, the Precision Industries case raises more questions than it answers.

Extent of Lessee’s “Interest” Under Section 365(h)

Even in those situations when a court is willing to protect the lessee’s right to possession under Section 365(h) when the debtor-lessor sells or conveys the property under Section 363(f), certain provisions of the lease may not be enforceable against the new lessor. Section 365(h)(1)(A)(ii) allows lessees to retain only those rights “that are in or appurtenant to the real property[.]” Thus, nonappurtenant rights are not protected.

For example, in C.H.E.G., Inc. v. Millennium Bank, 121 Cal. Rptr. 2d 443 (Cal. Ct. App. 2002), the court held that Millennium Bank, which purchased an industrial building in a Chapter 11 bankruptcy sale “free and clear of all liens, encumbrances and interests,” did not thereby assume an obligation to pay a commission to a third-party broker under a provision in the lease providing for such commission upon a sale to the lessee. The court reasoned that CHEG’s right to a commission provided no benefit to the lessee and was not a right appurtenant to the property. Therefore, the court held, it was not an interest that qualified for protection under Section 365(h).

The court acknowledged the difficulty in reconciling Sections 363(f) and 365(h). The court struggled with this dichotomy, finding that for purposes of Section 363(f), CHEG’s interest in the lease was an obligation connected to, or arising from, the property being sold, but concluding that for purposes of Section 365(h), CHEG’s right to a commission was not a right that was “in or appurtenant to the property” and therefore not a protected interest under that section. Id. at 512–13.

Leasehold Mortgagee Concerns

The Precision Industries decision is of special concern to leasehold mortgagees when the fee interest of the ground lessor has not been subordinated to the leasehold mortgage. If the lessee’s interest is “wiped out” under a Section 363 bankruptcy sale, or if the lease is rejected or deemed rejected under Section 365, the leasehold mortgage could also fall and the leasehold mortgagee would become an unsecured creditor in the debtor-lessor’s bankruptcy proceeding.

To protect themselves, leasehold mortgagees commonly insist on a provision in (or an amendment to) the underlying ground lease that grants the ground lessee permission to mortgage all or part of its leasehold estate and grant any future leasehold mortgagee numerous rights as a third-party beneficiary of the ground lease. The leasehold mortgage, in turn, will contain “leasehold mortagee protection provisions” such as (1) a requirement that the parties to the ground lease obtain the leasehold mortgagee’s written consent before cancellation, surrender, or modification of the ground lease; (2) the right to cure the lessee’s defaults; (3) the right, if termination were to be declared by the lessor, to nullify the termination or indefinitely postpone it by curing all conditions of default; and (4) the right, if termination were to be realized, of the leasehold mortgagee to enter into a new lease with the lessor on the same terms as the terminated lease.

As a result of the Precision Industries case, attorneys for leasehold mortgagees may seek to build in additional protections (in both the ground lease and the leasehold mortgage). Such clauses could provide, for example:

• If a bankruptcy proceeding is filed by or against the lessee or the lessor, the leasehold mortgagee will be immediately notified and will receive copies of all notices, pleadings, schedules, and the like.
• The leasehold mortgagee will be entitled to file all pleadings, claims, notices, proofs, objections, acceptances, rejections, and so on, on behalf of the lessee in any such bankruptcy proceedings, and the lessee will take no action therein against the wishes of the leasehold mortgagee or contest any of the leasehold mortgagee’s directions to the lessee or documents or pleadings filed on the lessee’s or its own behalf in the bankruptcy proceeding.
• The lessee, or the leasehold mortgagee on behalf of the lessee, will object to any attempt by the lessor (in the event of a bankruptcy proceeding filed by or on behalf of the lessor) to sell the property free and clear of the lease and will affirmatively assert and pursue its right to adequate protection under Section 363(e) in such event.
• The leasehold mortgagee is authorized, on behalf of the lessee, to vote or consent in any proceedings concerning the lease.

Including these types of clauses in the ground lease and the leasehold mortgage may help ensure that the leasehold mortgagee has standing to object to the Section 363(f) sale or, alternatively, to seek adequate protection under Section 363(h)(3). As stated earlier, Section 363(e) provides that upon request of any entity that has an interest in such property, the court shall prohibit or condition such sale “as is necessary to provide adequate protection of such interest.” Insertion of comprehensive mortgagee protection provisions in leasehold mortgage documents strengthens the leasehold mortgagee’s argument that it is in fact a party with an “interest” whose rights should be protected.

One caveat should be noted, however, regarding the last of the four clauses proposed above because there may be some question as to whether the bankruptcy court will allow the lessee to assign its voting rights. Although case law is sparse in this area—probably because most disputes are resolved through voluntary and consensual compromises to prevent costly and time-consuming litigation—the bankruptcy courts are divided on the enforceability of a waiver or assignment of a creditor’s right to vote its claim. Compare In re 203 N. LaSalle Street Partnership, 246 B.R. 325, 330–32 (Bankr. N.D. Ill. 2000) (rejecting the first mortgage lender’s request to vote claim of subordinate lienholder as provided in consent and subordination agreement executed by subordinate lienholder in connection with earlier workout of the first mortgage loan), with In re Curtis Center Ltd. Partnership, 192 B.R. 648, 659–60 (Bankr. E.D. Pa. 1996) (upholding subordination agreement remarkably similar to the intercreditor agreement in 203 North LaSalle, including right to vote claim of subordinate lienholder).

Springing Guarantees

Leasehold mortgagees should also be aware that inserting additional “leasehold mortgagee protection” provisions in the leasehold mortgage (or ground lease) is not a cure-all. The clauses offer only limited protection because such provisions are not self-actuating, which is to say, they will not automatically assure the leasehold mortgagee of standing in a bankruptcy proceeding and will do little to protect the leasehold mortgagee if the lessee does not honor its affirmative obligations as set forth in such provisions.

To further motivate the lessee to comply with such affirmative obligations, it may be prudent (when possible) to seek a “springing guarantee” from a creditworthy third party. Under the springing guarantee, the lessee’s obligations under the lease (or some agreed-upon portion thereof) are guaranteed, but the guarantee becomes effective only upon the occurrence of certain future events, such as the following: the filing of a bankruptcy petition by or against the lessee or the lessor; the assertion of claims or relief against the leasehold mortgagee, including the institution of litigation by the lessee seeking injunctive relief, or otherwise seeking to prevent the leasehold mortgagee from exercising its rights and remedies as provided in the leasehold mortgage or the ground lease (including the enhanced “leasehold mortgagee protective provisions” described above); the contesting of actions taken by the leasehold mortgagee on its own or the lessee’s behalf in the lessee’s or the lessor’s bankruptcy proceeding; or the violation of certain “bad acts” covenants in the ground lease or the leasehold mortgage. For a perspective on springing guarantees, see Marvin Leon, Exploding and Springing Insider Guarantees of Real Estate Loans: As a Bankruptcy Protection Device, They May Prove to Be Duds, Prob. & Prop. 57 (Jan./Feb. 2004).


The Precision Industries case, although one of first impression at the federal appellate level regarding the interplay between Sections 363(f) and 365(h), is not as alarming as it may first appear. Attorneys representing lessees and leasehold mortgagees simply need to be cognizant of this decision and add the appropriate additional protective provisions to their lease and leasehold mortgage documents. Bankruptcy counsel for lessees and leasehold mortgagees (when the lessor is the debtor) also must be careful to timely and forcefully raise objections, when warranted, to a proposed “free and clear” sale of the property by the debtor-lessor under Section 363(f) and take the proper steps to seek adequate protection of the leasehold (or leasehold mortgage) interest under Section 363(e).