PRECISION IN STATUTORY DRAFTING: THE QUALITECH QUAGMIRE AND THE SAD HISTORY OF § 365(h) OF THE BANKRUPTCY CODE ∗ ROBERT M. ZINMAN TABLE OF CONTENTS Introduction I. Section 365 of the Bankruptcy Code and the Landlord’s Bankruptcy A. The Road to § 365(h) B. The 1984 Amendments C. The 1994 Amendments D. What the Foregoing Legislative History Tells Us II. Qualitech and Sales Free and Clear of Leases in the Landlord’s Bankruptcy A. Peculiar Facts and Circumstances of the Case B. Looking Through the Facts to the Issue C. Was Qualitech Correct? D. Protection Under § 363 1. The Gate Keeper a. Section 363(f)(1) Practice Comment b. Section 363(f)(2) Practice Comment c. Section 363(f)(3) d. Section 363(f)(4) e. Section 363(f)(5) (i) Cramdown Under § 1129(b)(2) (ii) Eminent Domain (iii) Other Situations Involving Foreclosure ∗ Professor of Law, St. John’s University School of Law. The author wishes to express his sincere appreciation to his colleagues for their support and assistance with special thanks to Professor Richard Lieb for his impeccable advice and critical analysis and to numerous research assistants who have, at various times during the course of preparation for the Kratovil Conference and this Article, supplied thoughtful and incisive research on various aspects of the issues raised by the decision, including, in alphabetical order, Michael Blit, Alexander Chicco, Christian Errico, Eugene Fialkovskiy, Gino Tonetti-Tieppo, and Joseph Tully. 97 98 The John Marshall Law Review [38:97 f. Is the Gate Open? 2. Adequate Protection Under § 363(e) a. Requesting Adequate Protection b. Will Adequate Protection Be Available if the Lease Is Valueless? c. Credit Bidding and § 363(k) d. Encumbering the Fee Practice Comment e. Why Adequate Protection Under § 363(e) May Not Assuage the Concern of the Leasehold Mortgagee III. The Ripple Effect of Qualitech: Sections 363 and 365 in the Tenant’s Bankruptcy A. Sale of a Lease by the Tenant in Bankruptcy B. The Drafting of § 365(b),(c) and (f) C. The Statutory Language 1. The Role of the Courts 2. Lease Prohibitions on Assignment 3. Can the Lease Be Sold Free and Clear of an Anti- Assignment Provision? a. Is Restriction on Assignment an Interest in the Lease? b. Is § 363(b) a Bar to Sale Free and Clear? c. Can the § 363(f) Requirements Be Met? Practice Comment d. What Adequate Protection Would Be Available to the Landlord? D. Is the Ripple Effect on Tenant’s Bankruptcy Really a Problem? IV. Conclusion APPENDIX INTRODUCTION One day in 1994 leasehold investment and financing ended. As if someone turned off a faucet, lenders stopped making leasehold mortgage loans, and investments in leasehold estates ceased. The reason? A few lower court decisions found that the language of § 365(h) of the Bankruptcy Code,1 carefully drafted to protect the tenant when the lease is rejected in the landlord’s bankruptcy, protected only the tenant’s right to remain in possession for the balance of the term, and would not protect 1. The Bankruptcy Code, 11 U.S.C. §§ 101–1330 (2000), [hereinafter the Code]. Any reference herein to a section of the law, without more, is to a section of the Bankruptcy Code. The “carefully drafted” provisions of § 365(h) prior to the troublesome cases were found in the 1984 Amendments and discussed in Part I.B. of this Article. 2004] The Sad History of § 365(h) of the Bankruptcy Code 99 tenants not in possession, such as holders of ground leases, or tenant’s rights under covenants contained in the lease.2 This flight from leasehold investments occurred notwithstanding the fact that any reasonable analysis and study of the language of § 365(h) would show that these cases were incorrectly decided. There were also cases that went the other way.3 In response to the crisis thus created, Jack Marino, then of Chicago Title and Trust Co.,4 put together a group of people representing landlords, tenants, lenders, borrowers, and trade groups to hammer out a suggested amendment to the Bankruptcy Code to correct the problem.5 Bankruptcy legislation was pending in Congress at the time, and faced with the clout of a group representing all sides of leasehold investment, Congress responded,6 and leasehold investments began again. This crisis in leasehold financing is recounted to illustrate two things. First, that leasehold investments, and especially leasehold mortgages, are very fragile. Any hint that the security for the loan may be terminated or modified if a landlord, not a party to the loan, files in bankruptcy, can send out shock waves. Second, that crisis illustrates that the consequences of this fragility can be overcome by determined efforts in Congress. This is important because the recent Seventh Circuit decision in Precision Industries, Inc. v. Qualitech Steel SBQ7 has the potential again to completely disrupt leasehold investments, and has already caused great concern in the real estate investment community.8 And well it should. For Qualitech held, in essence, 2. See Case Discussion infra Part I.C. 3. Id. 4. Mr. Marino is presently Executive Vice President of Ticor Title Insurance Company in New York. 5. This informal committee will be referred to herein as the “Marino Committee.” 6. See discussion of the 1994 amendments infra Part I.C. 7. 327 F.3d 537 (7th Cir. 2003). 8. See, e.g., Christopher C. Genovese, Precision Industries v. Qualitech Steel: Easing the Tension Between Sections 363 and 365 of the Bankruptcy Code?, 39 REAL PROP. PROB. & TR. J. 627, 649 (2004) (concluding that “lessees must remain vigilant when their lessors file for bankruptcy or risk losing their leasehold interest to a sale free and clear”); Michael St. Patrick Baxter, Section 363 Sales Free and Clear of Interests: Why the Seventh Circuit Erred in Precision Industries v. Qualitech Steel, 59 BUS. LAW. 475 (2004) (stating case “will have profound implications not only on bankruptcy sales but on real estate leasing and real estate lease financing”); John C. Murray, Precision Industries: Debtor-Lessor’s Property May Be Sold “Free and Clear” of Unexpired Lease, 18 PROB. & PROP. 10, 16 (Mar./Apr. 2004) (stating Precision Industries decision sent “shockwaves” throughout the real estate industry and could prove “potentially devastating”—although he found significant protection for the lessee under § 363); Jerald I. Ancel et al., Can a § 363 Sale Dispossess a Tenant Notwithstanding § 365(h)?, 22 AM. BANKR. INST. J. 18, 31 (2003) (finding Qualitech “leaves unanswered the . interesting and far- 100 The John Marshall Law Review [38:97 that a landlord in bankruptcy could ignore the complex provisions of § 365(h), designed and carefully nurtured over the years, to protect the tenant when the landlord is in bankruptcy by selling its fee interest free and clear of the lease under § 363. Suddenly all the protection for the tenant when a lease is rejected9 in a landlord’s bankruptcy became subject to question. What makes matters worse is that application of the normal rules of statutory interpretation seems to indicate that Qualitech was correctly decided.10 Thus it is likely to be followed by other courts. The Qualitech result, however, certainly was not contemplated or intended at the time the Bankruptcy Code was drafted.11 In addition to the problems created by the case itself, the decision in Qualitech had a ripple effect in many areas, including the possible application of the principles enunciated in the case to situations where the tenant, rather than the landlord, is in bankruptcy, and attempts to sell the lease under § 363 under circumstances where an assignment would not be permitted under § 365, a result that could thoroughly disrupt shopping center investments.12 This Article is not intended as support, for or a criticism of the Qualitech decision. Nor is it intended to predict whether the problems and risks resulting from the decision may or may not ultimately be resolved by the courts. The purpose of this Article is reaching question of what happens when lessees . request adequate protection [after the property is ordered sold free and clear of lease]”); 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, 30 (2003) (finding that Qualitech “raises significant concerns for licensees of patent rights” whose protection under § 365(n) may be overcome by sale free and clear under § 363(f)). As an illustration of the concern in the real estate community, the highly respected editor of the on-line real property lawyer’s listserv “Dirt”, Professor Patrick A Randolph, Jr., had this to say: “[Qualitech] is a bombshell on the order of magnitude of Durrett and Fleet Factors, and interested parties should seek to muster support for a petition for en banc rehearing and, if necessary, a Supreme Court appeal. It puts virtually all long term leases and leasehold mortgages in mortal danger when the landlord files for bankruptcy.” Posting of Patrick A. Randolph, [email protected], to [email protected] (Apr. 29, 2003) (on file with author). 9. Section 365(a) authorizes the trustee, subject to the court’s approval, to assume or reject executory contracts and unexpired leases of the debtor. In Chapter 11, § 1107(a) provides that a debtor in possession, with certain limitations, has all of the rights (other than compensation) and powers of a trustee. 10. Baxter, supra note 8, adamantly takes the opposite position, claiming that the Seventh Circuit was clearly wrong in its determination. His views will be discussed in the material below. 11. The Code was signed into law by President Carter on November 6, 1978.