Bankruptcy Code section 363(f) allows a debtor to sell an asset free and clear of interests (such as liens and leases) under certain conditions − for example, if the interest is subject to a bona fide dispute, the interest holder consents, or the debt secured by the lien is fully satisfied. Selling an asset free and clear benefits both the buyer (who is able to acquire the asset debt free and leave behind all disputes relating to the allowance and treatment of claims in the bankruptcy case) and the seller (who can attract more buyers, at higher prices, than if the asset were sold subject to the existing interests and any disputes that accompany them).
Does a sale free and clear under the Bankruptcy Code necessarily increase the sale price? Would a junior interest holder be entitled to adequate protection for the loss of its interest? Is an underwater first lienholder entitled to all of the increase in value?
According to Illinois Department of Revenue v Hanmi Bank, 895 F.3d 465, 467 (7th Cir. 2018), the answer to the first question is likely yes; the answer to the second question is likely yes; and the answer to the third is not necessarily. Hanmi Bank supports junior lienholders, in that a sale free and clear of their interests increases the value of the asset sold and that junior interest holders may be entitled to some or all of that increase in value.
Overview of Hanmi Bank
In Hanmi Bank, the Seventh Circuit heard two consolidated appeals addressing whether a sale free and clear of certain interests, in and of itself, creates value, and whether that value should be available to junior creditors who would otherwise be out of the money.
In Hanmi Bank, the bankruptcy courts authorized the sale of the debtors' primary assets (gas stations, a movie theater and a cafe). Those sales qualified as bulk sales under an Illinois statute that gave the Illinois Department of Revenue (IDOR) the right to pursue the buyer for taxes owed by the sellers (the debtors). The bankruptcy courts authorized the sale “free and clear of the interests in those properties held by any entity other than the bankruptcy estates, including IDOR’s interest under the Bulk Sales Provisions” (id. at 467). While the bankruptcy courts assumed that IDOR was entitled to adequate protection for the sale free and clear of its rights against the purchaser, they concluded that IDOR was out of the money, because the sale price was not high enough to satisfy the claims of senior lienholders. The bankruptcy courts reasoned that if IDOR were allowed to share in the proceeds of the 363 sale, it would impermissibly "jump the queue" of creditors. IDOR received nothing from the bankruptcy estates.
IDOR appealed, contending that “the final sale price for the properties necessarily included consideration for the removal of IDOR’s interest, and it is entitled to a share of the sale proceeds pursuant to sections 361 and 363(e) to compensate it accordingly” (id. at 467–68). The Seventh Circuit agreed with this principle: “In short, an entity whose lien or other interest is removed from property in order to facilitate its sale is entitled to compensation for whatever loss the removal causes the entity” (id. at 474). While IDOR may have had a “cognizable interest,” the Seventh Circuit found that IDOR had not given the panel a realistic assessment of the value of its interest (id. at 468).
The Hanmi Bank decision is important for several reasons. First, senior lenders/lienholders need to be cautious: no matter the breadth of their security interests, they may not be entitled to all proceeds from a 363 sale. In light of this decision, senior lenders should be prepared to justify why the value of the sale is just the value of the property and to show that there is no premium being paid for the sale being free and clear. Senior lenders should focus on whether the junior interest holders have recourse against the purchaser and, if they do, seek to minimize the value of such interests to a purchaser.
Second, and most novel, under Hanmi Bank junior interest holders can now argue that the mere fact that a 363 sale resulted in freeing the purchaser from potential liability itself has value and that they are entitled to share in that portion of the value. However, just as IDOR failed to provide a realistic value of its avoided interest in Hanmi Bank, there may be practical difficulties in valuing an asset subject to a junior interest versus valuing the same asset free and clear of such interest. As the law on this issue develops, there should be more guidance on how to value junior interests.
Hanmi Bank left some key questions unanswered.
First, is a junior interest holder entitled to share in sale proceeds only if it has some recourse against the purchaser, like IDOR did under the Bulk Sale Provisions? A junior interest holder’s ability to look to a purchaser for satisfaction of its interest is a matter likely to be heavily disputed in future cases. Though there is broad language in the decision, Hanmi Bank may be limited to its narrow facts.
Second, how much of the free and clear premium is the junior interest holder entitled to? The Seventh Circuit was extremely skeptical that IDOR should be entitled to all it could conceivably claim against a purchaser, even if it could prove such value. This issue will likely be factual and require expert valuation testimony.
The importance of Hanmi Bank is clear: junior interest holders can now credibly argue that they are entitled to share in the proceeds of a sale free and clear of their interest, even where senior lienholders are not being paid in full. While there are unanswered questions regarding the scope of interests encompassed by this ruling and how best to value such interests, expect junior interest holders to rely on Hanmi Bank during sale negotiations in an effort to lay claim to some portion of the free and clear premium.