Sale 'Free And Clear' Does Not Extinguish Sublessee's Right To Remain In Possession

The ability of a trustee or chapter 11 debtor in possession ("DIP") to sell bankruptcy estate assets "free and clear" of competing interests in the property has long been recognized as one of the most important advantages of a bankruptcy filing as a vehicle for restructuring a debtor's balance sheet and generating value. Still, section 363(f) of the Bankruptcy Code, which delineates the circumstances under which an asset can be sold free and clear of "any interest in such property," has generated a fair amount of controversy. This is so in part because the statute itself does not define "interest."

Although generally acknowledged to encompass liens and security interests, section 363(f)'s scope would appear to be much broader, taking into account both the language of the provision and its underlying purpose. Broadly applied, however, section 363(f) arguably conflicts with certain other provisions of the Bankruptcy Code.

One of those provisions is section 365(h)(1). Section 365(h)(1) provides that, if the trustee or DIP rejects an executory real property lease under which the debtor is the lessor, the nondebtor lessee (and any permitted successor or assign, pursuant to subsection (h)(1)(D)) has the option to retain its rights under the lease for the balance of the lease term. Courts disagree as to whether the rights of a lessee or sublessee under section 365(h)(1) are effectively extinguished if the leased real property (or the lease itself) is sold free and clear of any "interest" under section 363(f). This was the thorny question addressed by the bankruptcy court in In re Zota Petroleums, LLC, 2012 BL 259645 (Bankr. E.D. Va. Oct. 1, 2012).

SALES FREE AND CLEAR

Section 363(f) of the Bankruptcy Code authorizes a trustee to sell property "free and clear of any interest in such property of an entity other than the estate" under any one of five specified conditions. These include, among other things, if applicable nonbankruptcy law permits a sale free and clear, if the sale price exceeds the aggregate value of all liens encumbering the property, or if the interest is in bona fide dispute. A bankruptcy court's power to order sales free and clear of competing interests without the consent of the party asserting the interest has been recognized for more than a century. See Ray v. Norseworthy, 90 U.S. 128, 131–32 (1875); Van Huffel v. Harkelrode, 284 U.S. 225, 227 (1931). It promotes the expeditious liquidation of estate assets by avoiding delay attendant to sorting out disputes concerning the validity and extent of competing interests, which can later be resolved in a centralized forum. It also facilitates the estate's realization of the maximum value possible from an asset. A prospective buyer would discount its offer significantly if it faced the prospect of protracted litigation to obtain clear title to an asset. Pending the bankruptcy court's resolution of any disputes, section 363(e) of the Bankruptcy Code provides that the nondebtor is entitled to "adequate protection" of its interest. This most commonly takes the form of a replacement lien on the proceeds of the sale.

"ANY INTEREST" BROADLY CONSTRUED

Section 363(f) has been applied to a wide range of interests. Courts, however, have sometimes struggled to comprehend the precise scope of the term "interest," which is defined nowhere in the Bankruptcy Code or its accompanying legislative history. Most courts reject the narrow approach adopted by courts that find section 363(f) to be confined to in rem property interests or only those claims which have already been asserted at the time the property is sold. Instead, the majority construe the term broadly to encompass...