Midwest Update - Spanish Peaks Holdings

In the Matter of Spanish Peaks Holdings II, LLC, 2017 WL 2979660, 64 BCD 105 (9th Cir. 2017)

Background

In a proceeding under Chapter 7 of the United States Bankruptcy Code (the “Code”), the United States Court of Appeals, Ninth Circuit (the “Ninth Circuit”), authorized the sale of property subject to bankruptcy proceedings free and clear of leasehold interests in a sale where the lessees did not request adequate protection for their leasehold interests prior to the sale and where the Chapter 7 trustee did not affirmatively reject the leases from the bankruptcy estate.

Spanish Peaks was a 5,700‑acre resort in Big Sky, Montana financed by a $130 million loan (the “Loan”) from Citigroup Global Markets Realty Corp. (“Citigroup”) to Spanish Peaks Holdings, LLC (“SPH”).  The Loan was evidenced by a note (the “Note”) secured by a mortgage and assignment of rents (the “Mortgage”).  Citigroup later assigned the Note and Mortgage to Spanish Peaks Acquisition Partners, LLC (“SPAP”).  A collection of interrelated entities owned the resort and managed the amenities.  In 2007, SPH leased restaurant space at the resort to Spanish Peaks Development, LLC (“SPD”) for 99 years in exchange for $1,000 per year in rent.  In 2008, SPD assigned its leasehold interest to The Pinnacle Restaurant at Big Sky, LLC (“Pinnacle”).  In 2009, SPH leased a separate parcel of commercial real estate at the resort to Montana Opticom, LLC (“Opticom”).  The lease had a term of sixty 60 years and an annual rent of $1,285.

In 2011, SPH began to default on its Loan payments and SPH, together with two related entities, petitioned for bankruptcy protection under Chapter 7 of the Code.  At the time of the bankruptcy filing, SPH’s largest creditor was SPAP which had a valid claim of more than $122 million secured by the Mortgage.  The trustee and SPAP agreed to a plan for liquidating substantially all of the debtors’ real and personal property through an auction.  In connection therewith, the trustee moved to the bankruptcy court for an order approving and authorizing the same.  The trustee represented that the proposed sale would be “free and clear of any and all liens, claims encumbrances and interests” except for specified encumbrances and that the other specified liens would be paid out of the proceeds of the sale or otherwise protected.  The Pinnacle and Opticom leases were not mentioned in either the list of encumbrances that would survive the sale or the list of liens for which protection would be provided. 

Noting the omission, Pinnacle and Opticom objected to the sale of the debtors’ assets free and clear of their leasehold interests, arguing that the Code gave them the right to retain possession of the property notwithstanding the sale.  Ultimately, the bankruptcy court entered an order approving the sale .  The underlying order held that the sale was free and clear of any “Interests”, a term defined to include any leases except any right a lessee may have under 11 U.S.C. §365(h).  Pinnacle and Opticom sought clarification that the order preserved their rights under the leases while CH SP Acquisitions, LLC (successor-in-interest to SPAP) sought to clarify that the order approved a sale free and clear of those interests. 

Ultimately, the bankruptcy court held that the sale was free and clear of the Pinnacle and Opticom leases. Pinnacle and Opticom appealed to the district court which affirmed the bankruptcy court ruling.  The district court held that the sale extinguished the leases because the foreclosure of the Mortgage would, under Montana law, terminate any leasehold interests junior to the Mortgage.  Opticom and Pinnacle then appealed to the Ninth Circuit.

The Ninth Circuit

The Ninth Circuit affirmed the lower court’s decision that the sale was free of the Pinnacle and Opticom leases. At issue was the apparent conflict between Sections 363 and 365 of the Code.

  • Section 363(f) of the Code authorized the trustee to sell the property of the estate free and clear of any interest in such property.  Section 363(e) of the Code provided that such sale shall be prohibited or conditioned as necessary to provide adequate protection of the interests of a party in the property. 
  • In contrast, Section 365 of the Code authorized the trustee to assume or reject any unexpired lease of the debtor, in which case the lessee in possession would have two options pursuant to Section 365(h) of the Code: treat the lease as terminated by the rejection or retain any rights under the lease to the extent that such rights are enforceable under applicable nonbankruptcy law. 

The Ninth Circuit noted that the majority courts that have addressed this issue have held that Sections 363 and 365 of the Code conflict when they overlap because, as stated in In re Churchill Props., 197 B.R. 283, 29 BCD 250 (Bankr. N.D. Ill. 1996), each provision seems to provide an exclusive right that when invoked would override the interest of the other.  Those courts held that the protection to the tenant under Section 365 of the Code trumps Section 363 of the Code based on the statutory interpretation canon that the specific prevails over the general and that the legislative history regarding Section 365 of the Code evidences a clear intent on the part of Congress to protect a tenant’s estate when landlord files bankruptcy.

The Ninth Circuit departed from this majority approach and, following the reasoning set forth by the Seventh Circuit in Precision Industries, Inc., v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537 (7th Cir. 2003), found that because Section 363 of the Code governs the sale of estate property while Section 365 of the Code governs the formal rejection of a lease, those sections do not conflict where there is a sale but no rejection of the lease. 

Applying this reasoning to the facts at issue, the Ninth Circuit held that since the leases were not “rejected” (interpreting this term as an affirmative declaration by the trustee that the estate will not take on the obligations of a lease made by the debtor) prior the sale by the trustee, and Pinnacle and Opticom did not ask for adequate protection of their leasehold interests until after the sale had taken place, Section 365 was not implicated and thus the property was transferred free and clear of the leases.