The Ninth Circuit’s Bankruptcy Appellate Panel (the “BAP”) held on July 18, 2008, that the Bankruptcy Code (“Code”) did not authorize a bankruptcy court’s approving the sale of a debtor’s property free and clear of a junior lien outside the reorganization plan context. In re PW, LLC __ B.R. __, 2008 WL 2840659 (B.A.P. 9th Cir. July 18, 2008). It directed the bankruptcy court to ascertain on remand whether state law permitted a court to compel the junior lienholder to release its lien in exchange for payment of less than the face value of its claim. Id., at *13-*16. The BAP also held that [the] junior creditor’s appeal of the lien-stripping provision in a court-approved asset sale order was not moot, for the court could still grant effective relief without prejudicing any party. Id., at *3-*5. Moreover, it reasoned, the court could “hold that [the junior lien] remains attached to the property transferred …” Id., at *5.
Relevance of Lien-Stripping
This case shows how a secured creditor can lose its collateral. “Lien-stripping” is a court’s deeming a secured claim to equal “the judicially appraised value of the [Lender’s] collateral, even if the [Lender’s] total allowed claim is greater.” See Charles Jordan Tabb, The Law of Bankruptcy, § 7.29.b, at 556 (The Foundation Press, Inc. 1997). For an undersecured lender, such as the junior creditor in PW, a lien-stripping provision in a sale order would effectively deprive it of its collateral, eliminate its lien, and leave it with an unsecured claim. Here, by reason of the senior lender’s credit bid in the full amount of its $40 million claim for all of the debtor’s assets, the junior lien, securing a $2.5 million claim, was deemed by the bankruptcy court to be worthless.
The debtor, PW, LLC (“PW”), developed California real estate. Id., at *1. The senior lender (“DB”) held a first lien securing a $40 million claim on substantially all of PW’s assets. Id., at *1-*2 The junior lender (“CC”) held a second lien on the same assets with a $2.5 million claim. Id. After PW filed a Chapter 11 petition, the court ordered the appointment of a trustee. Id.
The trustee and DB agreed, with court approval, on the auction sale of PW’s assets. Id. DB would be the “stalking horse” bidder. Id. If there were no qualified overbidders, DB would buy PW’s property by credit bidding its debt and would pay the trustee a “Carve-Out Amount” to cover administrative fees and other expenses related to winding up the bankruptcy estate. Id.
Over CC’s objection, the bankruptcy court entered an initial order (“Sale Order”) authorizing the sale of PW’s assets free and clear of CC’s lien under Code § 363(f)(5) (property may be sold “free and clear” of a lien “only if … [the secured creditor] could be compelled in a legal or equitable proceeding, to accept a money satisfaction of [its lien]”). Id. When DB became the successful bidder by credit bidding the “entire amount of its debt” [Id., at *1], the court entered a second order confirming the sale and finding that DB was a good faith purchaser (“Sale Confirmation Order”). Id., at *3. Both the bankruptcy court and the BAP denied CC’s motion for a stay of the Sale Confirmation Order pending appeal. Id.
DB’s credit bid for all of PW’s assets provided no proceeds to which CC’s lien could attach. Id. Because CC received no payment on account of its valid secured claim and lost its lien when the sale closed, it appealed, seeking reversal of both the Sale and Sale Confirmation Orders. Id.
Lien Stripping Limited in Asset Sale Context
PW’s property sold for less than the aggregate amount of all claims secured by the property. Id., at *9. Holding that Code § 363(f)(3) “does not authorize the sale free and clear of a lienholder’s interest if the price of the estate property is equal to or less than the aggregate amount of all [liens on] the property being sold,” the sale, reasoned the BAP, could not be free and clear of CC’s lien in reliance on this statutory ground. Id., at *9-*11.
More important, in reversing the lower court, the BAP found that the trustee’s alternative statutory basis for the sale, Code § 363(f)(5), also did not necessarily support the Sale Order. Under Code § 363(f)(5), estate property may “only” be sold free and clear of an entity’s interest if that “entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.” The BAP thus directed the bankruptcy court to determine on remand whether there is an available legal or equitable proceeding through which a court could “compel” CC to release its lien “for payment of an amount that was less than” the full value of its claim. Id., at *11-15. Because the trustee and DB had failed to point to such a legal or equitable proceeding, the BAP instructed the bankruptcy court to “allow the parties to attempt to identify a qualifying proceeding under nonbankruptcy law (if one exists) that would enable them to strip [CC’s] lien and make the sale of PW’s property to DB free and clear…” Id., at *15-16.
The BAP also rejected the trustee’s reliance on the reorganization plan “cramdown” power (Code § 1129(b)) as “a qualifying legal or equitable proceeding.” Id., at *15-*16. Significantly, there was no reorganization plan pending when the lower court authorized the sale. “[U]se of the cramdown mechanism to allow a sale free and clear under § 363(f)(5) uses circular reasoning -- it sanctions the effect of cramdown without requiring any of § 1129(b)’s substantive and procedural protections.” Id., at *15. Cramdown, reasoned the BAP, can only be used “in the context of plan confirmation.” Id. Other “courts have [thus] been leery of using § 363(b) to gut plan confirmation or render it superfluous.” Id.
Lien-Stripping Issue Not Moot
Finding there existed a “live case or controversy” because it was “still possible to fashion some relief” for CC (e.g., the lien-stripping could be undone), the BAP held that CC’s appeal was not constitutionally moot in its entirety. Id., at *3-4. Although the BAP held that the appeal from the sale itself was equitably moot (primarily due to third party reliance on the Sale Confirmation Order and the closing of the Sale Transaction), an appeal challenging the lien-stripping was not. Id., at *4-5. Both parties were before the court; no third party action would be required to reestablish CC’s position; and no third party would be prejudiced by having relied on the bankruptcy court’s orders. Id. CC’s lien could just reattach to the transferred property. Id.
Moreover, although Code § 363(m)1∗ insulated the Sale and Sale Confirmation Orders on appeal (CC failed to obtain a stay pending appeal, and DB had acted in good faith), the Code’s protection did not apply to a lienstripping order under § 363(f). Id., at *5-7. Accordingly, the lien-stripping provision of the bankruptcy court’s Sale Order could be effectively modified on appeal. Id.
- An Appropriate Inter-Creditor Agreement Will Moot The Issue. Code § 363(f)(2), authorizing a sale if the junior creditor “consents,” would have mooted the dispute in PW had DB, the senior lender, obtained an appropriate inter-creditor agreement. The typical agreement contains the junior lender’s consent to a regularly conducted bankruptcy court-authorized sale of collateral.2
- Junior Lien May Attach to Transferred Property. Code § 363(f)(5) will support sales free and clear of a junior lienholder’s interest for less than the aggregate amount of all liens on the property being sold only if an actual state law mechanism exists to compel the junior lienholder “to accept a money satisfaction” of its lien. When a junior lender challenges the stripping of its lien, unless a selling trustee or Chapter 11 debtorin- possession can make an appropriate showing on the record to support the sale motion, including identifying the pertinent state law mechanism, the junior secured creditor’s lien will attach to the property sold.
- The Buyer’s Obligation. A prospective buyer at a § 363(b) asset sale should identify all asserted liens on the debtor’s property, and, if necessary (i.e., when no state law mechanism exists and the sale price is less “than the aggregate value of all liens”), provide for the treatment of all liens in the sale order. Alternatively, buying assets under a reorganization plan will enable a court to strip the junior creditor’s lien, but the plan process is usually lengthier than a § 363(b) sale.
- Lien Stripping Orders Vulnerable on Appeal. An appeal from an asset sale order may be equitably or statutorily moot under § 363(m) (reversal ineffective if no stay pending appeal obtained and purchase made in good faith), but an appeal from a lien-stripping provision will probably survive. Accordingly, when an affected secured creditor appeals, the purchaser at a § 363(b) asset sale may not effectively rely on a bankruptcy court order stripping the creditor’s lien.