Buyer Beware! The Battle Between Sections 363(f) and 365(h) of the Bankruptcy Code

March 2, 2015

So you want to purchase assets from a party that filed for bankruptcy because you believe that in most situations you will receive the bankruptcy court's blessing that the assets you want to purchase will be purchased and transferred to you free and clear of all liens, claims and encumbrances. While the bankruptcy court has the power to authorize a sale of assets free and clear of liens, claims and encumbrances, it is not without risk, especially for the unwary. For purposes of this article, let's assume you want to purchase a building that is occupied by one or more tenants who have leases with their landlord who has filed for bankruptcy and is now a debtor.

Purchasing Assets In Bankruptcy
Often times, another party may also have an interest in the same building that you are seeking to purchase. Such other interests could be in many forms such as a lien, easement or as in our example – a leasehold interest held by a tenant pursuant to a written lease. While the bankruptcy court has the power to authorize the sale of the building free and clear of all liens, claims and encumbrances under section 363(f) of the Bankruptcy Code, certain criteria must be met.[1]

What Did I Really Purchase?
Section 365(h) of the Bankruptcy Code provides tenants with certain rights when their landlord files for bankruptcy protection. There is a short time frame in which all unexpired leases of real property must be assumed or rejected in a bankruptcy case. Under section 365(h) of the Bankruptcy Code, if the landlord seeks to reject a lease in bankruptcy, the tenant has the ability to retain its rights under the lease, including the right of possession of the premises. Some courts have found that a sale free and clear of liens, claims and encumbrances includes free of any leases so that the tenants in our example do not have any rights to remain in possession of the premises at the building. However, other courts have found that Section 365(h) can be enforced in an asset sale so that the purchase of the building, which would otherwise be free and clear of all other interests, would still be subject to the rights of our tenants to remain in possession of their premises in the building you purchased. One court has found the decision depends upon the facts and circumstances of the particular case as to whether a tenant would have the right to remain in possession of its premises in the building being purchased. For example, when the tenant was an affiliate of the landlord, the court found that the tenant was not entitled to retain its possessory rights in the premises.

Therefore, the purchase of the building you believed would be vacant and free of other interests, including those of its tenants, could now be subject to the possessory rights of the tenants in the premises which you did not anticipate. Further complicating the issue, a tenant's possessory rights are usually determined by applicable state law. For anyone who has had to evict a tenant in New York City, landlord-tenant court can be a very expensive and frustrating experience.

Until recently, no court has tried to reconcile these two provisions of the Bankruptcy Code. However, in May of last year, the United States District Court for the Southern District of New York attempted to reconcile the two provisions. The District Court found as long as the sale of assets satisfies the criteria of section 363(f), as set forth in footnote 1 above, the sale can proceed free and clear of the tenant's possessory interests. However, such holding is a red herring.

Didn't I Purchase The Building Free Of Tenants?
If a court has found that our building may be sold free and clear of a tenant's possessory interests in the premises, regardless of how the court has made such determination, the tenant would still be entitled to what is known as adequate protection under section 363(e) of the Bankruptcy Code. Because adequate protection is defined the "indubitable equivalent" of the tenant's interest, adequate protection could be determined to mean possession or monetary compensation. Thus, even if our seller is successful in having the sale of the building approved, free and clear of the tenant's possessory interests, the tenant may still have the right to possession of the premises as adequate protection and you as purchaser could be saddled with an unanticipated tenant.

While this article has focused on real property purchases and leases, these same principles also apply to licensees of intellectual property. If you are seeking to purchase assets which include license agreements, the licensees under such license agreements may be entitled to retain their rights or be provided with adequate assurance.

When purchasing an asset in bankruptcy it is very important to keep in mind there may be other parties with rights to the property. It is very important to understand prior to a sale what leases or other interests may exist and, if possible, to know the intentions of the current tenants and other parties in interest. Therefore, it is imperative a purchaser of assets conducts proper due diligence in consultation with counsel well versed in bankruptcy as well as other relevant areas of law, including applicable state law.

This article appeared on the March 2nd, 2015 inforuptcy blog. Inforuptcy is a comprehensive resource for bankruptcy case information, bankruptcy assets for sale and leading bankruptcy news.

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