Under Section 363(f) of the Bankruptcy Code, a debtor or trustee can sell estate assets “free and clear of any interest” in such assets. This short, simple string of six words represents one of the most powerful tools in the bankruptcy professional’s arsenal. In many situations, section 363(f) allows the bankruptcy estate to unlock the value of certain assets that might be wholly unmarketable, or otherwise severely diminished in value on account of unknown or unasserted claims against such assets or due to uncertainty regarding the amounts of, or relative priority among, secured claims against such assets. In some cases, access to section 363(f) is the primary driving force behind a bankruptcy filing.
Something this powerful and useful isn’t available to debtors simply because they’ve filed a bankruptcy case. Before the estate can extract the benefits of the ability to sell an asset free and clear of interests, the code requires that a debtor or trustee satisfy one of the conditions enumerated in sections 363(f)(1)-(5). In In re Southern Manufacturing Group, the Bankruptcy Court for the District of South Carolina recently denied a Chapter 7 trustee’s motion to sell substantially all the debtor’s assets free and clear of liens, claims, encumbrances and other interests, notwithstanding the fact that the sale was likely the estate’s best chance of securing a return for unsecured creditors, reminding us that you can’t buy your way into a 363(f)(1) order.
I’ll Give You all I’ve Got to Give
Axis Capital (“Axis”) held an $890,000 claim against the estate secured by a first priority, blanket lien against all the estate’s assets. There were also five additional liens junior to Axis’ lien securing an aggregate of $936,000 in claims against the estate (the “Junior Liens”). The Chapter 7 trustee (the “Trustee”) and a third-party buyer, Cornucopia Resources, Inc., (“Cornucopia”) struck a deal where Cornucopia would purchase substantially all the estate’s assets (the “Assets”) for $605,000. This is the point where we furrow our collective brows and think “why would a trustee waste its time ‘selling’ an asset that is completely underwater?” To which the disembodied voice of the author would respond “stop furrowing and keep reading.” Cornucopia and the Trustee structured the sale so that (a) $30,000 of the sale price would be remitted back to the estate, free and clear of all liens and (b) the debtor’s receivables would be remain in the estate, also free and clear of all liens. The Trustee estimated that the receivables were worth approximately $40,000. The Trustee would also “retain” Axis’ senior lien position vis-a-vis the holders of the Junior Liens (the “Junior Lienholders”). The trustee’s motion to sell the Assets free and clear of liens, claims, encumbrances and other interests, was premised on the Trustee’s satisfaction of sections 363(f)(1),(2), and (5).
You Don’t Get No Diamond Rings (Unless You Satisfied 363(f)(1), (2), (3), (4), or (5))
Section 363(f)(1) permits a “free and clear” sale if “applicable nonbankruptcy law permits sale of such property free and clear of such interest.” The Trustee argued that South Carolina’s foreclosure statute- S.C. Code Ann. § 36-9-610-was “applicable nonbankruptcy law” that permitted the sale as structured. The court disagreed with the Trustee’s reasoning on two separate bases. Relying on the bankruptcy court decisions in In re Jaussi, Dishi & Sons v. Bay Condos LLC, and the leading bankruptcy treatise, Colliers on Bankruptcy, the court read 363(f)(1) as applicable only when an owner of property could sell such property free and clear of interests under “applicable nonbankruptcy law.” The South Carolina foreclosure statute, of course, contemplates a secured creditor forcing a sale of collateral rather than a sale by the owner of the property that constitutes the collateral. The court also observed that the foreclosure statute contained a distribution waterfall which did not contemplate a scenario where certain proceeds or assets would remain with (or flow back to) a debtor.
Having denied approval of the sale under 363(f)(1), the court turned to the Trustee’s claim that the sale satisfied section 363(f)(2). Section 363(f)(2) permits a “free and clear” sale if “such entity consents.” The trustee argued that all the junior lienholders had received proper notice of the sale, thus, they were deemed to have consented to the sale by their failure to object. The court noted that there was a split of authority on whether the failure to respond to or otherwise object to a 363(f) sale constituted “implied” consent to such sale. The court acknowledged that consent could be implied under certain circumstances and cited to cases where the affected interest was a license to use intellectual property, where the sale proceeds were sufficient to pay all non-responsive parties in full, or that the lien was already subject to a bona fide dispute, as examples where consent could be implied. None of those circumstances, the court noted, were present in the current case. The court ultimately concluded that, where liens are perfected, and where there were no mitigating circumstances, the more reasonable inference is that the silence implies the lack of consent. Thus, the court ruled that the Trustee had failed to satisfy section 363(f)(2).
Finally, the court turned to section 363(f)(5). Section 363(f)(5) permits a sale free and clear of any interest when “such entity [holding the interest] could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.” The court noted that it was not aware of any “legal or equitable” proceeding under state law (nor had the Trustee provided evidence of such law) that would compel no payment to the Junior Lienholders while redirecting payment to the estate. Given that the proceeds of the sale would provide nothing to the Junior Lienholders, the court found that 363(f)(5) was simply inapplicable under the circumstances.
I Don’t Care too Much for Money (Or these Other Options)
Had the court approved the sale, the Trustee would have filed an objection to the Junior Lienholders’ claims seeking a determination that they were fully unsecured. The junior lienholders would then have been relegated to sharing estate distributions with other unsecured creditors. Thanks to the sale, however, the amount of estate funds available for distribution to unsecured creditors would have increased by approximately $70,000. Depending on what other unsecured claims existed against the estate, this could have represented a meaningful recovery to the Junior Lienholders. And as we all know, something is better than nothing—and nothing is exactly what would the Junior Lienholders received on account of the sale of their collateral when the court denied the Trustee’s 363(f) motion.
The obvious question to ask is why would Axis be willing to give up potentially $70,000 in value (certainly no less than $30,000) just to get the benefit of 363(f)? The answer becomes clear if we examine how the 363(f) sale would have been consummated if the court had approved the motion and compare that to the alternative options for disposition of the Assets. Upon the entry of the 363(f) order, the Junior Liens would have been transferred to the proceeds of sale. The $30,000 and the receivables (both now free of the junior liens) would simply become unencumbered estate assets, available for distribution to unsecured creditors. The Trustee, under the terms of the sale, would have received the benefit of Axis’ lien. At this point, Cornucopia could take the Assets and be on its merry way. For Axis to receive the proceeds of the sale, the Trustee would have to either object to the secured status of the Junior Lienholders’ claims, file an adversary proceeding to avoid the Junior Liens (given that they were fully unsecured on account of Axis’ senior lien), or pursue some combination thereof. Once the Junior Liens had been avoided, Axis would be free to take the sale proceeds. This process would have been fast, controlled, and relatively cheap. Yes, the burden would have been on the Trustee to shepherd the process to a conclusion—but that is precisely why Axis agreed to provide the estate with $70,000 in value for its troubles. The beauty of 363(f) becomes even more apparent when we take a closer look at the alternative (and far less beautiful) options available for disposition of the Assets.
The sale could simply have been consummated under section 363(b), without the benefit of 363(f). The junior liens, however, would have remained in place. For obvious reasons, this likely wasn’t an attractive option to a potential purchaser. Another possibility would have Axis seeking relief from the stay, after which it could foreclose on its liens, wipe out the Junior Lienholders, and then sell the assets, unburdened by the Junior Liens, to Cornucopia. This process would have taken considerable time and resources, and since Axis would be the party responsible to fund the process, as well as taking on the risk that the process might fail, the purchase price would have risen significantly for Cornucopia. Another similar option would have been for the Trustee to move under Section 554 of the Bankruptcy Code to abandon the Assets to the debtor, after which Axis could have foreclosed on the Assets, and sold them, lien-free, to Cornucopia. Again, this would have required Axis to take on considerable risk and expense in pursuing a state law foreclosure action. Moreover, none of these options would have yielded any return to the estate, meaning the Trustee would have had absolutely no incentive to cooperate, adding additional risk and uncertainty to these courses of action.
Without the safeguards of sections 363(f)(1)-(5), lienholders could have their liens unceremoniously stripped from their collateral (and reattached to the proceeds from the sale thereof) without the opportunity to question the terms of the sale, or at the least, without the protections they would be afforded under state law. In this case, because the Junior Lienholders were woefully undersecured, the value Axis was willing provide to the estate, in exchange for a sale process blessed by section 363(f), represented the only chance for the Junior Lienholders to receive a meaningful recovery on account of their (eventually) unsecured claims. The bankruptcy court was likely aware that by assiduously guarding access to section 363(f) and protecting the integrity of the statute, it was reducing potential recoveries to the very interest holders the statute was designed to protect. Sometimes, however, principle wins over pragmatism. Pracitioners should take note and make absolutely certain that they can satisfy at least one of the conditions of 363(f)(1)-(5) because courts will likely not tolerate any 363(f) deficiencies, regardless of how good a deal it represents for the estate.