What happens when property that a trustee wants to sell in a section 363 sale is subject to unexpired leases that the trustee is empowered to reject under section 365(h)? The Ninth Circuit faced this conundrum in a recent case involving a luxury real estate development in Montana, Pinnacle Restaurant at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holdings II, LLC), 892 F.3d 892 (9th Cir. 2017).  Wrestling with a split between its sister circuits, the Ninth Circuit ultimately concluded that, “[w]here there is a sale, but no rejection (or a rejection, but no sale), there is no conflict,” and the trustee could properly proceed with the sale.

Spanish Peaks, a 5,700-acre resort in Big Sky, Montana, was financed by a $130 million loan secured by a mortgage and assignment of rents from Citigroup Global Markets Realty Corp. Citigroup assigned the note and mortgage to Spanish Peaks Acquisition Partners LLC (“SPAP”).

At issue on appeal were two leases at the resort. The first was a restaurant space that Spanish Peaks Holdings, LLC (“SPH”) leased for $1,000 per month to Spanish Peaks Development, LLC (“SPD”).  SPH and SPD later replaced the lease with a 99-year leasehold for $1,000 per year in rent.  SPD assigned its interest to The Pinnacle Restaurant at Big Sky, LLC (“Pinnacle”).  The second was a parcel of commercial real estate SPH leased to Montana Opticom, LLC (“Opticom”), for a term of 60 years and annual rent of $1,285.

SPH defaulted on its loan payments and filed, along with two related entities, Chapter 7 petitions in Delaware. SPAP, SPH’s largest creditor with a claim of $122 million secured by the mortgage, assigned its claim to CH SP Acquisitions, LLC (“CH SP”).  The trustee and SPAP agreed to a plan to liquidate “substantially” all of the debtors’ property through an auction with a minimum bid of $20 million.  The trustee sought approval for sale of the property “free and clear of all liens,” except for certain enumerated encumbrances and liens to be paid out of the sale proceeds or otherwise protected.

The Pinnacle and Opticom leases were mentioned neither on the list of surviving encumbrances nor on the list of protected liens.. Both entities thus objected to any sale “free and clear of [their] leasehold interests.” 872 F.3d at 895.  The bankruptcy court authorized the sale but did not rule on Pinnacle’s and Opticom’s objections.  The court instead deferred them until the hearing on the motion to approve the sale.

At the auction and approval hearing on June 3, 2013, CH SP won the auction with a bid of $26.1 million. Pinnacle and Opticom renewed their claim that their leases allowed them to retain possession and objected to the “free and clear” language in the proposed approval order.

The bankruptcy court approved the sale, holding that the sale was free and clear of any “Interests,” including any leases “except any right a lessee may have under 11 U.S.C. § 365(h), with respect to a valid and enforceable lease, all as determined through a motion brought before the Court by proper procedure.” Id. at 896.  After some procedural back-and-forth and another evidentiary hearing, the bankruptcy court found defects in Pinnacle’s and Opticom’s leases, and noted that they had neither requested adequate protection for their interests nor proven that they would suffer economic harm if their interests were terminated.  The bankruptcy court thus held the sale was free and clear of the Pinnacle and Opticom leases, and the district court affirmed.

On appeal, the Ninth Circuit considered whether the leases survived the sale to CH SP, which gave rise to an apparent conflict between the trustee’s ability to sell property of the estate under section 363 and authority to assume or reject unexpired leases under section 365(a) and (h). Section 365 gives a lessee in possession with two choices:  “treat the lease as terminated (and make a claim against the estate for any breach), or retain any rights—including a right of continued possession—to the extent those rights are enforceable outside of bankruptcy.” Id. at 898.

Other circuits had taken one of two approaches to the apparent conflict. The majority held that section 365 outweighed section 363 “under the canon of statutory construction that ‘the specific prevails over the general.’” Id. (internal citation omitted).

In contrast, the Seventh Circuit had held that “the statutory provisions themselves do not suggest that one supersedes or limits the other.” Id. (quoting Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537, 547 (7th Cir. 2003)).  In other words, section 363 confers a right to sell property free and clear of “any interest” without exempting leases protected under section 365, while section 365(h) focuses on the specific event of the rejection of an executory contract without reference to sales of estate property under section 363.  The Seventh Circuit explained:

Where estate property under lease is to be sold, section 363 permits the sale to occur free and clear of a lessee’s possessory interest—provided that the lessee (upon request) is granted adequate protection for its interest. Where the property is not sold, and the [estate] remains in possession thereof but chooses to reject the lease, section 365(h) comes into play and the lessee retains the right to possess the property.  So understood, both provisions may be given full effect without coming into conflict with one another and without disregarding the rights of lessees.

327 F.3d at 548.

The Ninth Circuit agreed with the Seventh Circuit’s approach as the best way to reconcile the two statutes, noting that while “[a] sale of property free and clear of a lease may be an effective rejection of the lease in some everyday sense, . . . it is not the same thing as the ‘rejection’ contemplated by section 365.” 872 F.3d at 899.

Here, then, the trustee had not rejected the Pinnacle and Opticom leases, so section 365 was not in play, and section 363(f)(1) authorized the sale of the property free and clear of the leases. The Ninth Circuit therefore affirmed the judgment of the district court.

In a unanimous opinion written by Justice Clarence Thomas, the Supreme Court today upheld a Ninth Circuit decision allowing a bankruptcy court to issue proposed findings of fact and conclusions of law on issues outside their constitutional jurisdiction for de novo review by the district court.  As previously reported here, the Supreme Court was presented with two questions: (i) whether Article III permits the exercise of the judicial power of the United States by bankruptcy courts on the basis of litigant consent, and, if so, whether “implied consent” based on a litigant’s conduct, where the statutory scheme provides the litigant no notice that its consent is required, is sufficient to satisfy Article III; and (ii) whether a bankruptcy judge may submit proposed findings of fact and conclusions of law for de novo review by a district court in a “core” proceeding under 28 U.S.C. § 157(b).

In reaching its decision, the Court relied on the reasoning set forth in Stern v. Marshall, a landmark bankruptcy decision on the constitutional limitations of bankruptcy judges’ power arising from the legal dispute between Anna Nicole Smith and the heirs of her former husband, the late J. Howard Marshall II.  In Stern, the Supreme Court held that, notwithstanding statutory authority granted by Congress, a bankruptcy court lacked constitutional authority to finally adjudicate certain claims reserved for Article III judges.  But, because the statute only explicitly allowed bankruptcy courts to issue findings of fact and conclusions of law on issues defined by the statute as “non-core,” the lower courts found a “statutory gap” in the treatment of claims defined by the statute as “core” that were outside of the scope of the bankruptcy court’s constitutional jurisdiction under Stern.  Applying the severability clause of the statute, the Court concluded:

We hold today that when, under Stern’s reasoning, the Constitution does not permit a bankruptcy court to enter final judgment on a bankruptcy related claim, the relevant statute nevertheless permits a bankruptcy court to issue proposed findings of fact and conclusions of law to be reviewed de novo by the district court.

Because it was not necessary to reach the first question presented, the Court “reserve[d] . . . for another day” the question of whether a party can consent to the Bankruptcy Court’s adjudication of a Stern claim.

In a follow-up to our post on the treatment of tax-sharing arrangements in bankruptcy, the Ninth Circuit held last month in an unpublished decision that a rebate that a holding company received pursuant to an ambiguous tax-sharing agreement (“TSA”) created a debtor-creditor relationship between the holding company and its banking subsidiary.  In the Matter of: Indymac Bancorp, Inc., (12-56218) (9th Cir., April 21, 2014).  As a result, the refund was property of the bankruptcy estate of the holding company, a significant windfall for the holding company and a significant loss to its subsidiary’s estate.  The Ninth Circuit’s decision is in contrast to the twin decisions of the Eleventh Circuit in the fall of 2013,[1] finding that two separate TSAs in unrelated cases created an agency relationship between a holding company and its subsidiary, thereby excluding the refund from the estate. See In Re Bamkunited Financial Corp., 12-11392 (11th Cir. Aug. 15, 2013); In Re Netbank, Inc., 12-13965 (11th Cir. Sept. 10, 2013)

As explained in our prior post, when a bankruptcy occurs, one affiliate may be holding the rebate for the entire conglomerate and the distinction between the relationships between the affiliated entities affects how that refund will be treated in bankruptcy.  If the TSA created an agency relationship, the refund will be excluded from the estate and the refund will be split as it would in the ordinary course of business.  If, however, the TSA create a debtor-creditor relationship, the entire refund becomes property of the estate holding the rebate and the other entities receive only an unsecured creditor claim for that refund – a potentially significant windfall for creditors of the rebate-holding entity and a significant loss of funds for creditors of the other entities of the conglomerate.

The Ninth Circuit distinguished Indymac from the Eleventh Circuit’s Netbank decision based on two factors: (i) that the Netbank case involved a TSA with an explicit incorporation of the Interagency Statement on Income Tax Allocation in Holding Company Structure (which the Indymac TSA did not), and (ii) that California law applied in Indymac rather than the Georgia law that governed Netbank.  The Ninth Circuit held that under California law, the TSA did not create a principal-agent relationship – despite specific language that appointed the holding company the subsidiary bank’s “agent and attorney-in-fact” because the subsidiary bank did not exercise control over its holding company’s activities with respect to any aspect of the tax filing.  Separately, the Ninth Circuit held that the TSA’s lack of language establishing a trust relationship was explicitly an indication of a debtor-creditor relationship under California law.

This case reinforces the need for a company considering the creation of a TSA to address explicitly how any tax refund will be treated in the event of a bankruptcy.  Given the varying decisions from courts on ambiguous TSAs and the potential effects of different state laws, a TSA that does not address how it should be interpreted in bankruptcy creates uncertainty as to where any tax refund may wind up in a bankruptcy, and creates the risk that in a bankruptcy resources of the estate will be wasted on litigation over the interpretation of an ambiguous TSA.

[1]               In re Bankunited Financial Corp., 12-11392 (11th Cir. Aug. 15, 2013); In Re Netbank, Inc., 12-13965 (11th Cir. Sept. 10, 2013)

On January 14, 2014, the Supreme Court heard oral arguments in Executive Benefits Insurance Agency v. Arkison, which revisits the issue of constitutional limits on federal bankruptcy judges’ power that the Supreme Court addressed two years ago in Stern v. Marshall.  The petition for certiorari challenged a Ninth Circuit decision and presented two questions to the Supreme Court about which lower courts have disagreed in the wake of Stern:  (i) whether Article III permits the exercise of the judicial power of the United States by bankruptcy courts on the basis of litigant consent, and, if so, whether “implied consent” based on a litigant’s conduct, where the statutory scheme provides the litigant no notice that its consent is required, is sufficient to satisfy Article III; and (ii) whether a bankruptcy judge may submit proposed findings of fact and conclusions of law for de novo review by a district court in a “core” proceeding under 28 U.S.C. § 157(b).

Executive Benefits Insurance Agency had relied on Stern to argue before the Ninth Circuit that the bankruptcy court that ruled in favor of Arkison, as trustee for the estate of Bellingham Insurance Agency, lacked constitutional authority to enter a final judgment in a fraudulent conveyance action against a non-claimant to the bankruptcy estate.  The Ninth Circuit agreed as to the fraudulent conveyance claims asserted by non-claimants, but also found that parties could waive their rights to an Article III hearing, which Executive Benefits had done by waiting until after briefing before the Ninth Circuit was complete to allege the Article III violation, thereby rendering the bankruptcy court’s ruling binding.  Further, the Ninth Circuit held that bankruptcy courts did have the power to submit findings of fact and conclusions of law in “core” proceedings even where they cannot enter a final judgment.

Executive Benefits argued to the Supreme Court that the Ninth Circuit’s decision was wrong because (i) assigning the authority to enter final judgment on private claims to non-Article III judges violates the separation of powers upheld by the Supreme Court in Stern and that the consent of private parties cannot cure an Article III defect; (ii) even if consent could cure an Article III defect, that consent must be knowing and voluntary; and (iii) the bankruptcy court lacked statutory authority to issue proposed findings of fact and conclusions of law in “core” proceedings.

In response, trustee Arkison emphasized the long history of consensual resolution of private rights in the judicial system, and noted that the Supreme Court has previously explained “as a personal right, Article III’s guarantee of an impartial and independent federal adjudication is subject to waiver.”  The trustee also compared bankruptcy judges to magistrate judges, thus suggesting that a ruling in favor of Executive Benefits could undercut the authority of magistrate judges in the judicial system.  The trustee noted that, although Executive Benefits’ consent to the bankruptcy court’s jurisdiction was properly implied, the Supreme Court need not decide this factual question.  Because an Article III district court conducted a full de novo review of the summary judgment order and entered its own judgment, Executive Benefits received the Article III consideration to which it was entitled.  Finally, the trustee asserted that bankruptcy judges may issue proposed findings of fact and conclusions of law on “Stern claims” if the parties do not consent to final judgment in bankruptcy court.

The U.S. Solicitor General’s office also argued as amicus in support of the trustee.  Both parties garnered support from numerous other amici, including seven states as well as Irving Picard, as trustee for the Securities Investor Protection Act (SIPA) liquidation of the Madoff estate, all joining in support of the trustee.

Early interpretation of the arguments suggests that a majority of the Supreme Court was likely not persuaded that the parties’ consent should control the parameters of bankruptcy judges’ power in cases like Executive Benefits.