Closing the Loophole in Commercial Landlord Bankruptcies: Why the Ninth Circuit Made the Right Decision in Matter of Spanish Peaks Holdings Ii, Llc

• Citation: Vol. 35 No. 1
• Publication year: 2019

Closing the Loophole in Commercial Landlord Bankruptcies: Why the Ninth Circuit Made the Right Decision in Matter of Spanish Peaks Holdings II, LLC

Bradford N. Barnhardt

CLOSING THE LOOPHOLE IN COMMERCIAL LANDLORD BANKRUPTCIES: WHY THE NINTH CIRCUIT MADE THE RIGHT DECISION IN MATTER OF SPANISH PEAKS HOLDINGS II, LLC

ABSTRACT

The Ninth Circuit's recent decision in Matter of Spanish Peaks Holdings II, LLC exposes a major loophole in the Bankruptcy Code in the landlord-tenant context. To exploit this loophole, real estate developers can establish two entities and have them enter into a lease as landlord and tenant, with the lease's terms heavily favoring the tenant. Then, should the landlord have to file for bankruptcy relief and liquidate its encumbered property, most lower courts will let the tenant retain possession for the duration of the lease. In this way, the developer will receive a financial windfall in the form of either a buyout or the opportunity to continue running the tenant's business on the purchaser's land. This windfall will come at the expense of the landlord's creditors, since encumbered land sells for less at auction. The majority approach therefore fails to balance the Bankruptcy Code's competing goals of maximizing creditor recovery and protecting tenants.

To prevent such an abuse of the bankruptcy system, the Ninth Circuit adopted a rule that requires tenants to request adequate protection prior to the bankruptcy auction to receive continued possession or compensation. Because the tenants in Spanish Peaks failed to make such a request, the Ninth Circuit held that it was appropriate to terminate their leases without compensation. The court left open the more difficult question of what it would have done had the tenants requested adequate protection. This Comment explores that remaining issue. It first argues that Spanish Peaks was a result-oriented opinion aimed at depriving two tenant entities of continued possession or compensation. It next proposes a way for judges to fashion adequate protection so as to minimize the impact of an undeserving tenant's recovery on the landlord-debtor's legitimate creditors. Since the Ninth Circuit's holding allows judges to minimize tenant recovery and thereby deter developers from exploiting the loophole in the Bankruptcy Code, this Comment concludes that the minority approach of fashioning adequate protection is more pragmatic than the majority approach of always granting continued possession.

[Page 192]

INTRODUCTION

The Ninth Circuit's recent decision in Matter of Spanish Peaks Holdings II, LLC ("Spanish Peaks") has deepened an already great divide among the courts regarding what to do with a commercial tenant's leasehold interest when a landlord sells its encumbered land at bankruptcy auction.¹ Applying § 365 of title 11 of the U.S. Code (the "Bankruptcy Code"), most courts hold that any tenants automatically get to remain in possession until the lease expires.² Spanish Peaks departed from this majority approach because the sophisticated landlords involved devised a savvy way to abuse it.³ Specifically, under the majority approach, an individual can establish two entities and have both entities enter into a lease as the landlord and tenant with terms that heavily favor the tenant entity. Then, should the landlord entity's business fail, forcing it to seek bankruptcy relief and liquidate its property, courts will permit the tenant entity to continue encumbering the land for the duration of the lease. The fact that the land comes with a bad bargain will presumably lower its value at auction, raising less money for the landlord's creditors.⁴ Worse, to obtain full, unencumbered fee simple in the land, the purchaser will have no choice but to buyout any tenants. A tenant with a heavily one-sided, long-term lease could presumably demand (and receive) a high price. The individual whose landlord entity had just filed for bankruptcy relief would receive a huge windfall from such a buyout, since it would allow that person to recoup losses at the expense of any creditors. Therefore, there is a tremendous financial incentive for people to arrange real estate developments in a way that allows some recovery in case of bankruptcy liquidation.

[Page 193]

To avoid landlord recovery under this scenario, the Ninth Circuit adopted an approach that deprived commercial tenants of automatic continued possession.⁵ Courts that follow the Ninth Circuit's "minority approach" to landlord bankruptcies hold that, under 11 U.S.C. § 363, trustees can sell property free and clear of a tenant entity's lease, provided that on request of the tenant, the bankruptcy judge grants it "adequate protection" for its interest.⁶ In Spanish Peaks, the tenants failed to request adequate protection; therefore, the circuit court authorized a sale of the encumbered land free and clear of their leasehold interests.⁷ The Ninth Circuit left open the more difficult question of what it would have done had the tenant entities sought to protect their rights prior to the bankruptcy auction.⁸ Accordingly, no one knows exactly what adequate protection will look like under § 363(e).⁹ Only the Southern District of New York, in Dishi & Sons v. Bay Condos LLC ("Dishi & Sons"), has discussed the adequate protection problem in this context. In Dishi & Sons, the court stated in dicta that continued possession would have been the appropriate form of adequate protection under the circumstances.¹⁰ However, the Ninth Circuit in Spanish Peaks suggested that there could—and should—be other forms of adequate protection, although it did not say what those other forms might be.¹¹ Still, letting the tenants recover anything would not only be contrary to the Bankruptcy Code's goal of maximizing creditor recovery,¹² but it would also leave open the loophole that the landlord in Spanish Peaks attempted to exploit.¹³

Many judges will soon have to face this adequate protection problem in the commercial landlord-tenant context, considering that the minority approach posited by Spanish Peaks, which requires tenants to timely request adequate

[Page 194]

protection, appears to be trending.¹⁴ Indeed, in Spanish Peaks the Ninth Circuit became the second of two federal circuit courts of appeals to adopt it.¹⁵ Thus, not only does the minority view now bind at least twelve states and the Western District of Pennsylvania,¹⁶ but the weight of two circuit court opinions suggests that judges in other parts of the country will begin adopting it as well.¹⁷ Therefore, in future landlord bankruptcies, well-informed tenants will likely ask for adequate protection as a precautionary measure,¹⁸ which means that many judges will soon be forced to provide "adequate protection" for tenants under § 363(e).

This Comment explores the open issue of what a bankruptcy judge should have done had the tenants diligently requested adequate protection in Spanish Peaks. It proceeds in three parts. Part I begins by providing an overview of the two approaches to landlord bankruptcies, and then gives the facts of Spanish Peaks. Next, Part II argues that Spanish Peaks was a result-oriented opinion aimed at depriving the undeserving tenant entities of adequate protection. Given the outcome-oriented nature of the Ninth Circuit's decision, this Comment explores how a bankruptcy judge could have avoided granting compensation or continued possession to the tenants, even if they had requested adequate protection. Finally, Part III asserts that the minority approach is more practical than the majority approach because it offers judges more flexibility in dealing with the leases of commercial tenants; it is therefore less vulnerable to exploitation by sophisticated landlords. This Comment is limited to landlord

[Page 195]

bankruptcies in the commercial context and is agnostic with regard to residential leases.

I. BACKGROUND

A. Two Approaches to Landlord Bankruptcies

1. The Majority Approach

Courts are split on what to do with a commercial tenant's leasehold interest when a trustee or debtor-in-possession sells encumbered property in a bankruptcy sale.¹⁹ While the only two circuit courts that have considered the issue required tenants to request adequate protection prior to the auction to receive the protections of the Bankruptcy Code,²⁰ most bankruptcy courts and district courts hold that tenants do not need to do anything to remain in possession for the duration of the lease.²¹ For instance, the Bankruptcy Court for the District of South Carolina in In re Taylor granted the tenant continued possession until the lease's expiration.²² In Taylor, the landlord-debtor leased out his five nursing homes to five related entities, collectively called the "Magnolia Entities."²³ After filing for chapter 11 bankruptcy, the debtor made a motion to sell the five nursing home facilities free and clear of the Magnolia Entities' leasehold interests pursuant to 11 U.S.C. §§ 363(b)(1) and (f).²⁴ The Magnolia Entities objected, and the bankruptcy court faced the issue of whether § 363 authorizes a sale of land free and clear of a lessee's interest.²⁵

Like most lower courts that have considered this issue, the bankruptcy court denied the landlord-debtor's request under § 363 to sell the encumbered properties free and clear of the tenants' leases.²⁶ Instead, the court held that § 365(h) trumps § 363 and thus entitles a tenant in a landlord bankruptcy to elect

[Page 196]

either continued possession or a cause of action for breach of contract.²⁷ In reaching its conclusion, the court applied two lines of reasoning. First, the court invoked the canon generalia specialibus non derogant, or a specific provision prevails over a conflicting general provision.²⁸ Under this interpretive principle, the court determined that § 365(h), which "specifically references the situation where the debtor is the lessor and with great particularity sets forth the rights and duties of the lessor and lessee," should...