The Bankruptcy Code provides certain protections to buyers of bankruptcy estate assets and to entities that extend credit or financing to a trustee or chapter 11 debtor-in-possession ("DIP"). However, these safe harbors are available only if a buyer or lender is deemed to have acted in "good faith," a concept that is not defined in the Bankruptcy Code.

In TMT Procurement Corp. v. Vantage Drilling Co. (In re TMT Procurement Corp.), 2014 BL 244511 (5th Cir. Sept. 3, 2014), reh'g denied, No. 13-20622 (5th Cir. Oct. 23, 2014), the U.S. Court of Appeals for the Fifth Circuit vacated DIP financing orders of the bankruptcy court and district court, notwithstanding express findings by the lower courts that the lender had acted in good faith. Such findings ordinarily would have mooted any appeal in the absence of a stay pending appeal. The Fifth Circuit ruled that: (i) the appeals were not statutorily moot because, having been aware of an adverse claim to stock that was pledged as collateral for the DIP loan, the DIP lender lacked "good faith"; and (ii) the lower courts lacked subject-matter jurisdiction to enter the DIP financing orders. The ruling is a cautionary tale for any prospective asset purchaser or lender in a bankruptcy case. 

Safe Harbors for Orders Approving Sale of Estate Property and DIP Financing

Pursuant to section 363 of the Bankruptcy Code, a trustee or DIP may: (i) under subsection (c)(1), enter into ordinary-course transactions involving the use, sale, or lease of estate property without court authority; and (ii) under subsection (b), with court approval after notice and a hearing, use, sell, or lease estate property outside the ordinary course of business (with certain specified exceptions). Estate property may be sold free and clear of any interest in the property asserted by a third party under the circumstances set forth in section 363(f).

An order approving a sale under section 363(b) is stayed until 14 days after it is entered (subject to the court ordering otherwise), at which point the order becomes "final." See Fed. R. Bankr. P. 6004(h) and 8002. Moreover, unless the appellant obtains a further stay pending the resolution of its appeal, section 363(m) provides that any reversal or modification of the sale order on appeal has no effect on the validity of the sale to "an entity that purchased . . . such property in good faith."

Section 364(a) of the Bankruptcy Code authorizes a DIP or trustee to obtain unsecured credit and to incur unsecured debt in the ordinary course of business without court approval. A DIP or trustee may also obtain credit or incur debt outside the ordinary course of business on either an unsecured or secured basis with court approval under the circumstances specified in sections 364(b), 364(c), and 364(d).

Like section 363(m)'s safe harbor for good-faith purchasers, section 364(e) provides that, unless the party challenging an order authorizing credit or financing obtains a stay pending appeal: 

[t]he reversal or modification on appeal of an authorization . . . to obtain credit or incur debt, or of a grant . . . of a priority or a lien, does not affect the validity of any debt so incurred, or any priority or lien so granted, to an entity that extended such credit in good faith, whether or not such entity knew of the pendency of the appeal.

Thus, pursuant to sections 363(m) and 364(e), the failure to obtain a stay of an order approving a sale of assets or authorizing financing moots any appeal of the order where the purchaser or lender acted in good faith, a preclusion commonly referred to as "statutory mootness." 

The court in In re EDC Holding Co., 676 F.2d 945, 947 (7th Cir. 1982), explained the purpose of the section 363(m) and 364(e) safe harbors as follows:

These provisions seek to overcome people's natural reluctance to deal with a bankrupt firm whether as purchaser or lender by assuring them that so long as they are relying in good faith on a bankruptcy judge's approval of the transaction they need not worry about their priority merely because some creditor is objecting to the transaction and is trying to get the district court or the court of appeals to reverse the bankruptcy judge. The proper recourse for the objecting creditor is to get the transaction stayed pending appeal.

The Bankruptcy Code does not define "good faith." Courts have adopted various definitions. For example, in In re Mark Bell Furniture Warehouse, Inc., 992 F.2d 7, 8 (1st Cir. 1993), the First Circuit wrote that "[a] ‘good faith' purchaser is one who buys property . . . for value, without knowledge of adverse claims" (citations omitted). Lack of good faith is typically demonstrated by evidence of fraud, collusion between the buyer and other bidders or the trustee, or an attempt to take grossly unfair advantage of other bidders. See Collier on Bankruptcy ¶ 363.11 (16th ed. 2014) (citing cases).

In the context of DIP financing under section 364, "good faith" has been defined as " ‘honesty in fact in the conduct or transaction concerned.' " SeeUnsecured Creditors' Comm. v. First Nat'l Bank & Trust Co. of Escanaba (In re Ellingsen MacLean Oil Co.), 834 F.2d 599, 605 (6th Cir. 1987) (citing UCC § 1-201(19)). Good faith has been found lacking in cases where the lender was aware of the illegality of an action, extended financing or credit for an improper purpose (e.g., to gain an advantage in litigation), or failed to reveal material facts to the court. See In re Abbotts Dairies, Inc., 788 F.2d 143, 147 (3d Cir. 1986).

The proponent of good faith bears the burden of proof. See TMT Procurement, 2014 BL 244511, *6. Good faith should not be presumed. Specific findings of good faith should generally be included in any order approving a sale of assets or authorizing financing.

The Fifth Circuit examined statutory mootness under sections 363(m) and 364(e) in TMT Procurement.

TMT Procurement

In 2012, Vantage Drilling Company ("Vantage"), an offshore drilling company, sued Hsin-Chi Su ("Su") and certain other defendants in Texas state court for fraud allegedly committed in connection with a transaction whereby Vantage, in exchange for Su's services, issued approximately $100 million in stock to F3 Capital ("F3"), an entity controlled by Su. In the litigation (the "Vantage Litigation"), Vantage sought, among other things, a judgment imposing a constructive trust on the stock held by F3 as well as certain other related assets.

In 2013, more than 20 foreign marine shipping companies owned directly or indirectly by Su (collectively, the "debtors") filed for chapter 11 protection in the Southern District of Texas. At a hearing on various creditors' motions to dismiss the cases as having been filed in bad faith, Su offered to place approximately 25 million shares of Vantage stock held by F3 (which did not file for bankruptcy) into a court-administered escrow as security for, among other things, DIP financing. According to F3 and Su, such an escrow arrangement would not violate any court orders (including injunctions) issued in the Vantage Litigation.

Vantage sought an injunction from the court presiding over the Vantage Litigation that would prevent Su or F3 from transferring, selling, pledging, or otherwise encumbering the Vantage stock. Although it was not a creditor in the debtors' chapter 11 cases, Vantage also objected to the escrow motion before the bankruptcy court as a "party-in-interest."

The Vantage Litigation court ruled that any dispute over encumbering the Vantage stock should be resolved by the bankruptcy court, and it prohibited Su from pledging or disposing of the stock without court permission. The bankruptcy court subsequently approved the escrow arrangement, holding that: (i) F3 owned the Vantage stock; and (ii) because the shares owned by F3 were not subject to a constructive trust, they could be "placed in custodia legis without complaint by any other party who has claimed ownership in the shares."

Vantage appealed the order approving the escrow arrangement. The district court, which had withdrawn the reference of the chapter 11 cases to the bankruptcy court, initially denied the appeal as interlocutory, but agreed to reconsider its ruling. Before it could do so, the debtors filed an emergency motion for authority to borrow up to $20 million, $6 million of which they requested on an interim basis. The district court approved the interim financing. The interim financing order granted an unrelated lender (the "DIP Lender") a first-priority lien on the deposited Vantage stock and provided, among other things, that the DIP Lender had extended the financing to the debtors in good faith and was entitled to "the full protections of sections 363(m) and 364(e) of the Bankruptcy Code."

The district court re-referred the debtors' chapter 11 cases to the bankruptcy court in October 2013. Shortly afterward, the bankruptcy court entered a final order approving the DIP financing. Like the district court's interim order, the final order provided that the DIP Lender was "extending financing to the [debtors] in good faith and in express reliance upon the protections afforded by sections 363(m) and 364(e) of the Bankruptcy Code and [the DIP Lender] is entitled to the benefits of sections 363(m) and 364(e) of the Bankruptcy Code."

The bankruptcy court certified Vantage's appeal of the court's final DIP financing order directly to the Fifth Circuit, which consolidated the appeal with a pending appeal of the district court's interim DIP financing order. Vantage neither sought nor obtained a stay of any of the orders.

The Fifth Circuit's Ruling

Lack of Good Faith 

A three-judge panel of the Fifth Circuit vacated the rulings and remanded the case below. The court first addressed whether the appeals were statutorily moot because Vantage failed to obtain a stay pending appeal.

Vantage did not contend that the DIP Lender committed fraud, colluded, or attempted to take grossly unfair advantage of anyone in extending financing to the debtors. Instead, Vantage argued that the DIP Lender could not have acted in good faith because it was on notice of Vantage's adverse claim to the stock held by F3. The debtors countered that knowledge of an adverse claim should not preclude a finding of good faith because such a rule would undermine the purposes of section 363(m) and 364(e), both of which "contemplate situations where the good faith purchaser or lender has knowledge of the pendency of an appeal."

The Fifth Circuit acknowledged that "there is some power" in the debtors' argument. Even so, the court explained that knowledge of a pending appeal is distinct from knowledge of an adverse claim:

There is a difference, as demonstrated by this case, between simply having knowledge that there are objections to the transaction and having knowledge of an adverse claim. Having knowledge that there are objections to the transaction usually involves those situations in which "some creditor is objecting to the transaction and is trying to get the district court or the court of appeals to reverse the bankruptcy judge." . . . Having knowledge of an adverse claim requires something more. That is why the former does not preclude a finding of good faith, whereas the latter does. Here, the DIP Lender's knowledge was not simply limited to objections by creditors of the Debtors. The DIP Lender had knowledge that a third-party, entirely unrelated to the bankruptcy proceedings, had an adverse claim to the Vantage Shares. On these facts, the DIP Lender does not qualify as a good faith purchaser or lender.

Noting that the DIP Lender was clearly on notice that Vantage had a competing claim to the shares held by F3 when the DIP Lender provided financing, the Fifth Circuit ruled that the appeals were not statutorily moot because the DIP Lender did "not come within the meaning of ‘good faith' as envisioned by § 363(m) and § 364(e)."

Lack of Subject-Matter Jurisdiction 

The Fifth Circuit also held that the courts below erred in entering the financing orders because they lacked subject-matter jurisdiction over the Vantage stock held by F3 and the Vantage Litigation. Under 28 U.S.C. § 1334, the court explained, U.S. district courts have exclusive jurisdiction over "all cases under title 11"; this jurisdiction encompasses "all of the property, wherever located, of the debtor as of the commencement of such case, and of property of the estate." District courts also have "original but not exclusive jurisdiction of all civil proceedings arising under title 11, or arising in or related to cases under title 11." This jurisdiction is routinely referred to bankruptcy courts but can be withdrawn.

The Fifth Circuit concluded that the Vantage stock was not property of the debtors' estates because: (i) the debtors had no legal or equitable interest in the stock as of the bankruptcy petition date, such that the stock would be estate property under section 541(a)(1) of the Bankruptcy Code; (ii) the stock was not "[p]roceeds, product, offspring, rents, or profits of or from property of the estate" under section 541(a)(6); and (iii) the stock did not constitute property of the estate acquired after the petition date under section 541(a)(7) "because that provision is limited to property interests that are themselves traceable to ‘property of the estate' or generated in the normal course of the debtor's business." The court rejected the debtors' argument that they had acquired an interest in the stock after it was deposited into escrow pursuant to the lower courts' orders. According to the Fifth Circuit, the shares were not estate property under section 541(a)(7) because they "were not created with or by property of the estate, they were not acquired in the estate's normal course of business, and they are not traceable to or arise out of any prepetition interest included in the bankruptcy estate."

The Fifth Circuit also ruled that the debtors could not rely on the lower courts' financing orders to support subject-matter jurisdiction. According to the Fifth Circuit, the lower courts "could not manufacture in rem jurisdiction over the Vantage Shares by issuing orders purporting to vest" the debtors with an interest in the stock. Those orders, the court wrote, could not constitute "jurisdictional bootstraps" allowing the lower courts to "exercise jurisdiction that would not otherwise exist."

The court rejected the debtors' contention that the lower courts had jurisdiction to enter the financing orders because granting a lien on the Vantage stock was somehow "related to" the bankruptcy cases within the meaning of 28 U.S.C § 1334(b). The Fifth Circuit wrote that the dispute over the stock was unrelated to the debtors' pending chapter 11 cases because the outcome of the Vantage Litigation "could not conceivably affect the Debtors' estates." The only discernible link between the Vantage Litigation and the chapter 11 cases, the court explained, is that F3 and the debtors had a common owner—Su—which "is not enough." The Fifth Circuit further stated that bankruptcy jurisdiction does not extend to state law disputes "between non-debtors over non-estate property." Moreover, the court emphasized, the lower courts "improperly interfered" with the Vantage Litigation by ordering that the Vantage stock be deposited into escrow.

Finally, the Fifth Circuit rejected the debtors' argument that the lower courts had jurisdiction to enter orders approving the financing "because the orders deal with core proceedings involving the administration of the bankruptcy estate, the acquisition of credit, and the use of property, including cash collateral." The court held that the Vantage Litigation was not a "core" proceeding because the litigation was "not based on any right created by the federal bankruptcy law" but was "simply a state contract action."

Outlook

TMT Procurement is an important ruling, particularly for DIP lenders. The ruling highlights the need for any prospective lender to conduct sufficient due diligence to determine whether there are any adverse claims to collateral that a DIP or trustee intends to pledge as security for a DIP loan. It remains to be seen whether the increased risk borne by potential DIP lenders in connection with this issue will make DIP financing more expensive.

To be sure, the facts of TMT Procurement are unusual and unlikely to be replicated in most cases. Apart from the statutory mootness issue, the Fifth Circuit was plainly disturbed by what it perceived to be the lower courts' improper interference with state court litigation totally unrelated to the debtors' chapter 11 cases. The DIP Lender, however, paid the price for the lower courts' perceived transgressions. As an additional plot twist, because the DIP orders had not been stayed, a portion of the Vantage shares was sold to satisfy the DIP Lender's claim. Thus, as a result of the Fifth Circuit's ruling, a number of issues remain to be resolved by the bankruptcy court on remand.