How does Bankruptcy Code Section 365 affect ground leases and leasehold mortgages?

Section 365(h), case law evolution, and the leasehold-mortgagee response

Section 365(h) of the U.S. Bankruptcy Code provides that if a debtor-landlord rejects a lease in its bankruptcy, the tenant has the option to either (a) treat the lease as terminated and assert a damages claim, or (b) retain its possessory rights under the lease for the remaining term plus renewal options. The provision is a cornerstone protection for ground-leased leasehold financing.

Precision Industries v. Qualitech Steel, 327 F.3d 537 (7th Cir. 2003), held that a Section 363(f) sale free and clear can extinguish a lessee's possessory interest notwithstanding Section 365(h). Mission Product Holdings v. Tempnology, 587 U.S. 370 (2019), held that rejection of a trademark license is a breach rather than a rescission. It is not a ground-lease holding. Counsel-specific bankruptcy advice is essential; case law application varies by jurisdiction and circumstance.

Practical leasehold-mortgagee response: the loan documents and the underlying ground lease's leasehold-mortgagee protection package work together with Section 365(h) to preserve the leasehold mortgagee's collateral. Recognition / non-disturbance from the fee owner, new-lease-on-foreclosure, and broad assignment rights all reinforce the bankruptcy protection.

Sponsor / leasehold-mortgagee counsel review at LOI is essential on any leasehold financing. The cost of catching a deficiency in the leasehold-mortgagee protection package at closing or after a fee-owner financial distress event is materially higher than the cost of careful ground-lease review at LOI. Not legal advice, engage qualified counsel.