The Fifth Circuit wrote an opinion that can be cited for the proposition that a senior lender who uses economic leverage and asserts its legal rights to squeeze out a junior lender remains a good faith purchaser entitled to declare a sale moot under Section 363(m).

The April 17 opinion by Circuit Judge Patrick Higginbotham also says that facts disclosed to the bankruptcy court can’t be relied on later as evidence of the senior lender’s bad faith.

The developer of a hotel obtained construction financing from a secured lender. The general contractor agreed to subordinate its right to payment to the secured lender’s lien.

The project ran into trouble, with the developer unable to pay more than $14 million owing to the general contractor. The contractor filed a mechanic’s lien.

Around the same time, the developer defaulted on the loan. Basically, the lender took a deed in lieu of foreclosure, putting title in the name of an affiliate of the lender. Consequently, the lender also became the owner.

The contractor sued the owner and the lender in state court, seeking a declaration that its mechanic’s lien was senior to the lender’s mortgage.

To recover on the defaulted loan, the lender aimed to sell the unfinished property and hired the required professionals. There being no buyer outside of bankruptcy, the lender-owner put the property into chapter 11 before Chief Bankruptcy Judge Stacey G. C. Jernigan of Dallas. The lender became the DIP lender, with the usual controls over the case.

Judge Jernigan approved sale and bidding procedures. When a stalking horse bid fell though, the lender sought permission from Judge Jernigan to buy the property for a credit bid of more than $37 million. The credit bid was several million more than the stalking horse bid that never materialized.

The contractor objected to the allowance of the credit bid and claimed to have an “adverse claim” to the property, meaning that the lender would not be a good faith purchaser.

Judge Jernigan overruled the objections, approved the sale and declared that the lender was a good faith purchaser. The contractor appealed but failed to obtain a stay pending appeal.

The district judge dismissed the appeal as moot under Section 363(m) for lack of a stay pending appeal following a sale to a good faith purchaser. The contractor had no better success on a second appeal to the Fifth Circuit.

The Contours to an ‘Adverse Claim’

In the Fifth Circuit, the lender naturally contended that the appeal was moot under Section 363(m). The section provides that reversal or modification “of an authorization under subsection (b) or (c) of this section of a sale or lease of property does not affect the validity of a sale or lease [to a purchaser in good faith] . . . unless such authorization and such sale or lease were stayed pending appeal.”

The contractor contended that it had an adverse claim to the property by virtue of the dispute over the priority of its mechanic’s lien. Knowledge of the adverse claim, the contractor argued, meant that the lender was not in good faith.

The outcome of the appeal turned on the Fifth Circuit’s interpretation of Section 363(m) in In re TMT Procurement Corp., 764 F.3d 512, 520 (5th Cir. 2014). There, the appeals court said that knowledge of an objection to a transaction is not bad faith in itself. Judge Higginbotham quoted TMT for the idea that an adverse claim requires more than an objection to a transaction.

In TMT, the appeals court set aside a sale because the lender was not in good faith since it had knowledge about a third party’s claim of ownership. Judge Higginbotham also cited the Ninth Circuit Bankruptcy Appellate Panel for reversing a sale order when the title to the property was in dispute.

Summing up, Judge Higginbotham held “that, under the notice-definition of a good faith purchaser, the threshold for an ‘adverse claim’ is a dispute in ownership interest.” He said that the contractor had not contested ownership, only asserted a mechanic’s lien. Therefore, the contractor was not asserting an adverse claim to set aside the finding of good faith.

Other Considerations About Good Faith

Attempting to undercut the finding of good faith, the contractor argued that its lawsuit regarding priority of liens was an adverse claim. Judge Higginbotham disagreed, saying that the lien did not confer ownership rights and did not undercut the lender’s status as a good faith purchaser.

Next, the contractor argued that numerous actions by the lender-owner amounted to misconduct or fraud. For example, the contractor pointed to how the lender obtained ownership to control the bankruptcy and take over the property.

Judge Higginbotham said that becoming both the lender and owner “is not nefarious per se.” Instead, he said that it “reflects a market actor responding to market forces and exercising its contractual rights.”

As to myriad other facts, Judge Higginbotham said that “the lender disclosed each . . . to the bankruptcy court.” Disclosure, he said, “strongly favors a finding of good faith, as courts properly look to the transparency of the process as indicative of one’s intent.”

Holding that the “lender did not engage in fraud and was a ‘good faith purchaser,’” Judge Higginbotham affirmed the district court’s judgment dismissing the appeal as moot.