Precision Indus., Inc., v. Qualitech Steel SBQ, LLC: Bankruptcy Sale of Property "Free and Clear" of All Interests Wipes Out Property Lease

A federal appellate court has considered whether a property lease survives a bankruptcy trustee's sale of property subject to a lease when the sale is "free and clear" of all other interests.

Qualitech Steel Corporation and Qualitech Steel Holdings (collectively, "Debtor") entered into a lease agreement ("Lease") with Precision Industries, Inc. and Circo Leasing Company, LLC (collectively, "Lessee") for space on a site where the Debtor operated a steel mill. The Lease covered a ten-year period, and allowed the Lessee to build a warehouse on the Debtor's land which would be used to supply the Debtor's steel mill. The Lessee would own the warehouse, pay rent of $1/year, and, at the end of the lease, the Debtor had the option of purchasing the warehouse for $1.

During the term of the Lease, the Debtor filed for Chapter 11 bankruptcy under the federal bankruptcy code ("Code"). An auction took place of all the Debtor's assets, including the property which was subject to the Lease. All of the Debtor's property was acquired by the Debtor's creditors. Following a hearing where all objections to the sale could be made, the bankruptcy court approved the sale and stated that the Debtor's property was sold "free and clear of all liens, claims, encumbrances, and interests," except for those specified in the court's order. The Lease was not listed in the court's order.

Following the sale, the Debtor changed the locks on the warehouse and asserted that it now held title to the warehouse. The Lessee objected, arguing that it owned the warehouse and the Debtor had simply exercised its right to reject the Lease, pursuant to a Code section. The bankruptcy court ruled that the Debtor owned the warehouse, as the bankruptcy auction had wiped out the Lease. The Lessee appealed to a federal district court, and the district court reversed the bankruptcy court and ruled that the bankruptcy sale did not affect the Lease. The Debtor appealed.

The United States Court of Appeals for the Seventh Circuit reversed the district court, ruling that the auction had wiped out the Lease. The court had to resolve what some courts have seen as a conflict between two provisions of the Code. One section of the Code, section 363(f), allows a bankruptcy trustee to sell the debtor's property free and clear of all encumbrances on the property, while another section, section 365(h), of the Code protects the interests of leaseholders following a bankruptcy trustee's rejection of a lease.

The court first looked at the statutory language of each Code section. The court determined that the language of section 363(f) was broad enough to include a sale free and clear of a lease interest. While the language of that section is not specific, the section's use of "any interest" was broad enough to include a lease. Thus, the court determined that the bankruptcy auction wiped out the Lease.

Next, the court looked at the language of 365(h) to determine whether the provisions of that section took precedence over section 363, which was what the district court had decided when it ruled section 365 controlled over section 363. The court found no conflict in the statutory language used in each of the sections, and determined that there was no reason why the two sections could not be understood as working together. The court determined that section 365(h) only applied when a debtor has specifically rejected a lease, and it did not limit a bankruptcy trustee's ability to conduct a sale of the debtor's property pursuant to section 363(f) free and clear of a lease. Since there was no conflict between the two Code sections, the court ruled the Lease was wiped out.

The court stated that in order to protect its interests, the Lessee should have filed its objections to the bankruptcy auction prior to the bankruptcy court's confirmation of the auction. Since it failed to do so, the Lease was terminated when the bankruptcy court affirmed that the bankruptcy auction and ordered the Debtor's property sold free and clear of all liens.

Precision Indus., Inc., v. Qualitech Steel SBQ, LLC, 327 F.3d 537 (7th Cir. 2003).