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Recent Bankruptcy Case Raises New Hazards For Commercial Tenants and Intellectual Property Licensees

By Eric Snyder

Under section 363 of the Bankruptcy Code, a debtor in bankruptcy under certain circumstances can sell assets "free and clear" of any adverse "interest."  This provision helps debtors obtain better prices for the assets they sell, because the buyer is assured that any claims others may have to or against the assets being sold are extinguished.

Under Bankruptcy Code §365, a debtor can choose to assume or reject a contract that is still in effect, including a lease of real property or a license of intellectual property.  For most contracts other than leases or licenses, a rejection by the debtor means that the non-debtor party loses its rights under the contract and must accept only a pre-petition unsecured claim for damages for breach of contract.  But §365 has special provisions to govern rejection by a debtor who is a lessor of real property or a licensor of intellectual property (mainly patents and copyrights).  When the debtor rejects a real property lease, the lessee has the option under §365(h) of remaining in possession of the real property for the remainder of the lease term and any renewal or extension.  Accordingly, although the rejection of the lease frees the debtor/lessor from performing other contractual obligations under the lease, §365(h) protects the lessee's predominant interest: the right to remain in possession.  Similarly, if the licensor of intellectual property rejects the license, the licensee has the option under §365(h) of retaining its rights to use the intellectual property for the remainder of the term of the license even though the licensor need no longer perform its side of the contract.

But what happens if a lessor sells the leased property to a buyer under §363 without rejecting the lease first?  Does the lease survive or is it extinguished by the "free and clear" provisions of §363?  Last year, the Seventh Circuit Court of Appeals in Precision Industries v. Qualitech SBQ, LLC, 327 F.3d 537 (7 th Cir. 2003) decided that under §363, if the debtor sells the real estate that is subject to a lease without rejecting the lease first, the leasehold interest is wiped out upon the sale -- even though § 365(h) allows the lessee to remain in the leased property after rejection.  In other words, although a lessee's right to retain possession is protected when the debtor-lessor keeps the leased property as part of the reorganization plan, the lessee can lose this right if the debtor-lessor instead sells the property under §363(f).  This decision has potentially devastating ramifications for long-term leasees and leasehold mortgagees whenever a lessor files for bankruptcy.

The same problem potentially could affect licensees of intellectual property.  The provision in §365(n) that allows licensees to retain the right to use the licensed intellectual property even after the debtor-licensee rejects the license is very similar in concept and operation to the provision in §365(h) that allows lessees to retain their rights of possession even after the debtor-lessor rejects the lease.  Intellectual property licensees can be particularly hard hit because often they build their entire business on an intellectual property license.  So intellectual property licensees can be severely impacted by this issue as well.  In fact, even before the Seventh Circuit decided Precision , it had suggested in FutureSource LLC v. Reuters Ltd ., 312 F.3d 281 (7 th Cir. 2002) that a §363 sale of intellectual property conveyed the intellectual property free and clear of any licenses, even though §365(n) allows the licensee to continue to use the licensed intellectual property after the license is rejected.

How can a lessee or licensee protect itself against the consequences of the debtor selling the leased real estate or the licensed intellectual property? 

One way for a lessee (or leasehold mortgagee) to protect its interest is to prevent the sale in the first place or place conditions on it.  Section 363(f) permits a sale "free and clear of any interest" only in one of five circumstances: (1) applicable non-bankruptcy law permits such a sale; (2) the entity holding the interest consents; (3) the interest is a lien and the sale price exceeds the aggregate value of all liens against the property; (4) the interest is in bona fide dispute; or (5) the nondebtor entity could be compelled to accept a money satisfaction of its interest.   If one of these conditions exists, so that a "free and clear" sale under §363(f) can occur, then upon request by the lessee (or leasehold mortgagee), the Court "shall" prohibit or condition the sale "as is necessary to provide adequate protection of such interest" 11 U.S.C. §363(e).

The trickier question is what constitutes "adequate protection."  The Seventh Circuit in Precision held that "adequate protection" does not guarantee continued possession of property, "but it does demand, in the alternative, that the lessee become compensated for the value of the leasehold -- typically from the proceeds of sale."  There is often no way to know whether sufficient proceeds will be available to compensate the lessee; frequently there are not.  In these cases, although a lessee may argue that continued possession is the only form of "adequate protection" available to protect its interest, as a practical matter it may have to find a way to value its possessory interest, because the Court will often prefer to "cash out" the lessee rather than let its claims to possession get in the way of an asset sale.  To come up with a value, the Court will look to such matters as rental rate, mitigation of damages and what priority the adequate protection claim will retain in the bankruptcy proceeding.   All these issues should be assessed by the lessee carefully as soon as its lessor files for bankruptcy, so that it will be prepared to address the issue if it comes up.

Precision is of special concern to leasehold mortgagees when the ground lessor's fee interest has not been subordinated to the leasehold mortgagee.  In such a case, the lessee's interest can be "wiped out" by a §363 bankruptcy sale. Thus, as a result of Precision , leasehold mortgagees might consider seeking additional protections when they first take a mortgage, beyond the typical terms. 

Typically, a leasehold mortgagee insists on including or adding to the ground lease provisions that grant it important rights as a third-party beneficiary of the ground lease.  For example, a leasehold mortgagee may require (1) that the parties to the ground lease obtain the leasehold mortgagee's written consent before canceling, surrendering or modifying the ground lease; (2) the right to cure the lessee's default; (3) if the lessor declares the lease terminated, the right to nullify the termination or indefinitely postpone it by curing all defaults; and (4) if there is a termination, that the leasehold mortgagee be able to enter into a new lease with the lessor on the same terms as the terminated lease.

To avoid losing the mortgage lien under the Precision case as a result of a §363 sale, leasehold mortgagees might consider building in additional protections in both the ground lease and the leasehold mortgage.  These could include:

• if a bankruptcy petition is filed by or against the lessee or the lessor, the leasehold mortgagee would have the right to be notified immediately by the other party and would receive a copy of all notices and pleadings,
• if the lessor files for bankruptcy protection, the leasehold mortgagee would have the right to file all pleadings, claims and notices on behalf of the lessee in any such bankruptcy proceeding and the lessee will take no action in the bankruptcy against the wishes of the leasehold mortgagee, or contest any of the leasehold mortgagee's directions to the lessee during the bankruptcy proceeding;
• the lessee, or the leasehold mortgagee on behalf of the leasee, would have the right to object to any attempt by the lessor (in the event of a bankruptcy proceeding by or on behalf of the lessor) to sell the property "free and clear" of the lease and could affirmatively assert and purse its rights to adequate protection under §363(e) in such event; and
• the leasehold mortgagee could be authorized on behalf of the leasee to vote or consent in any proceeding concerning the lease. 

Holders of intellectual property licenses could seek similar types of protection as a result of the Seventh Circuit decision in FutureSource LLC v. Reuters Ltd ., which has a similar effect on intellectual property licenses as Precision has on leases.  Knowing ahead of time what can go wrong is critical in the course of negotiating an important deal like a license, lease or leasehold mortgage.

Finally, a lessee, mortgagee or licensee who finds that the debtor wants to sell under §363 the property that is leased or licensed should be careful to consider whether to object to a proposed "free and clear" sale and to timely pursue the objections, including taking the proper steps to seek adequate protection of its interests under §363(e).

If you have any questions about this article or any other bankruptcy matter, please feel free to contact Eric Snyder at 212-981-2328, or at esnyder@sillerwilk.com .

This article was prepared as a service to our clients and friends. This article does not constitute legal advice and should not be relied upon as legal advice by the reader or any other party.