Under § 363 of the Bankruptcy Code and subject to bankruptcy court approval, chapter 7 trustees have the power to sell the entire interest in property that the debtor owns with nondebtor co-owners. This unique power to sell the debtor’s and nondebtor’s interests can only be exercised by a trustee in certain circumstances and when the trustee is able to satisfy all the requirements of § 363(h) of the Bankruptcy Code. When undertaking such a sale, trustees must be strategic in their approach in order to bring about a transaction that will result in a meaningful recovery to the bankruptcy estate. A sale of the nondebtor’s interest co-owned with the debtor is commenced by an adversary proceeding against the co-owner. The requirements necessary to obtain an order selling the property out from under the nondebtor co-owner under § 363(h) are set forth below.
Ability to Partition the Property
One of the requirements for a sale of property subject to the interests of a nondebtor co-owner is that “partition in kind … is impracticable.” The trustee needs to evaluate whether or not the property can be subdivided in a way that is not “impracticable” and will net the same proceeds for the estate as the sale of the entire property, while weighing all the risks and costs. A simple example of a practical partition would be a 640-acre section of farmland. If the debtor owned one-fourth of the farmland and the trustee needed to partition a 160-acre quarter section, satisfying this component should be relatively easy to accomplish. But most real estate is not subject to partitioning, such as a house, commercial building, or even a piece of real estate with features that make it impossible to create multiple parcels of similar value and utility. And even with this example, one could argue that one discrete 160-acre quarter section is better than another, making what seems to be a simple property split a complicated partition.
Net Recovery Analysis
The trustee will need to make a decision regarding whether the sale of the estate’s undivided interest in the real estate would realize “significantly” less for the estate than if the entire property was sold in order to establish one of the statutory predicates for the entry of the § 363(h) sale order. An accurate valuation of the property is critical in all respects, but especially here given the fractional interest being sold. Based on that valuation, an analysis of the estimated net recovery from the fractional interest sale compared to an entirety sale is necessary in deciding whether to proceed in seeking entry of the sale order. Some of the trustee’s considerations in that analysis should include:
a. Access to the Property. If the trustee is going to attempt to sell the entire property, then the real estate broker needs access to the property so that prospective buyers can evaluate the opportunity. In some cases, the co-owners may not be cooperative, making access very difficult. For the trustee’s real estate broker, the effect of limited access or, worse yet, contentious access may make it practically impossible to find a buyer willing to be part of the transaction. In consultation with their real estate broker, trustees should assess the impact that limited access will have on the marketability of the property and consider seeking the bankruptcy court’s intervention if warranted.
b. Individual vs. Joint Debts. Many of the § 363(h) sales usually revolve around the sale of a residence owned by two spouses, but only one spouse files bankruptcy. If the jointly held residence is sold, the trustee is only permitted to use the proceeds to pay joint debts. The trustee should carefully evaluate all of the debts of the debtor and determine whether the scheduled debts are truly only the debts of the debtor or debts for which the debtor is jointly liable with the co-owner spouse.
c. Carrying Costs. If the property is being encumbered by secured debt and the co-owners are fighting an entirety sale, the trustee needs to account for the accruing carrying costs of the mortgage, assuming that the mortgage is not being paid. Other burdens of ownership such as real estate taxes and maintenance costs, and their impact on the property’s equity while the trustee is seeking the § 363(h) sale order, need to be taken into consideration. With significant pre-sale costs and accruals, the trustee runs the risk that a sale that started out with a significant recovery could end up with something else.
d. Break-Up Fee. A sophisticated buyer may require a break-up fee in exchange for waiting out a ruling in the adversary proceeding and entry of the sale order. Even if the buyer does not ask for one, the trustee should consider offering one so that the buyer has an incentive to not exit the contract. Otherwise, if the buyer exits the contract while the trustee is trying to get an offer approved over the objection of the co-owners, the trustee could end up having to re-litigate with the co-owners once another offer comes in. For the real estate broker working for the trustee, it can be a tough sale to convince a buyer to stay under contract for several months while the trustee deals with the co-owners unless an adequate incentive is provided. Since a § 363(h) adversary proceeding is a potentially long process in which the trustee runs the risk of co-owners challenging the sale, a break-up fee included as part of any offer will serve to keep the buyer in place.
e. Legal Fees. Legal fees associated with preparing and litigating an adversary proceeding against the co-owners will be paid from the sale proceeds. If the nondebtor co-owners are not in favor of their interests being sold by the trustee and are determined to defeat any § 363(h) sale efforts, the trustee must take the administrative costs into consideration. With the right facts, effective advocacy and cooperative nondebtor co-owners, the adversary proceeding is often resolved by entry of a consent order allowing the property to be sold.
After taking into consideration these factors, the trustee’s bright-line rule under § 363(h)(2) is whether or not a sale of the fractional interest would realize “significantly less” than the entirety sale. While there is no standard for what “significantly less” means, it’s important that the trustee carefully weigh the option of a lower-priced sale of the debtor’s fractional interest to the effort required to achieve an entirety sale.
Evaluating Co-Owner Impact
Another standard the trustee must consider under § 363(h) and establish to the satisfaction of the court is whether “the benefit to the estate of a sale of such property free of the interests of co-owners outweighs the detriment, if any, to such co-owners.” In some cases, this can be a clear-cut issue, and at other times, it is not. For instance, if the debtor jointly owns a residence that an estranged spouse is living in along with their minor children, the debtor could argue that the property is necessary for their family, so a sale would be detrimental. On the other hand, the trustee could argue that the property has substantial equity that can only be realized through a sale because neither the spouse nor the debtor has the funds to buy the equity from the trustee. The property in this example cannot be partitioned, and a sale of a 50 percent interest in the property would be substantially less than an entirety sale, satisfying this requirement of a § 363(h) sale.
Energy Impact
The final standard is very simple: The property “cannot be used in the production, transmission, or distribution, for sale, of electric energy or of natural or synthetic gas for heat, light, or power.” If it is, then the trustee should either sell the minority interest in the real estate to the highest bidder, or abandon the interest.
Once the trustee has made the decision to proceed with an entirety sale, the trustee may want to engage a real estate broker to solicit an offer first, and then file the adversary proceeding to compel the sale. Alternatively, the trustee can file the adversary proceeding first, and then engage their real estate broker. Commencing the adversary proceeding first may be the best course of action and has some material benefits. If the trustee needs to gain access to the property for the broker to adequately market the property, or if there is unique information about the real estate that the trustee and the real estate broker could use to enhance the marketability of the property, any issues concerning access to the property or the cooperation of the nondebtor co-owners (now defendants in the adversary proceeding) can brought to the court’s attention.
Once an offer has been received that satisfies the net recovery analysis, the trustee can use it as a means to negotiate a buyout from the co-owners. Many times the co-owners simply need some motivation and incentive to come to the negotiating table. That motivation and incentive is heightened when there is a real offer to buy the property and the trustee is prepared to commence the adversary proceeding.
For attorneys representing trustees, the adversary proceeding and litigation may seem like a routine and more expeditious way to get the co-owner’s attention. It is a good idea (and can be highly productive), however, to have a face-to-face meeting with the other co-owners after an acceptable offer has been received. Many times the co-owners may just be frustrated with the situation and need to vent. Once they realize the cost of fighting a sale, they will generally choose to avoid any litigation and decide to cooperate with a sale. The trustee should also use this meeting as a time to negotiate terms with the co-owners to help maximize the ultimate sales price. If the trustee can turn the co-owners from confrontational to supportive, then the overall result for all parties involved will be much improved.
With a § 363(h) sale, the hurdles to a significant net recovery of the debtor’s interest in real estate may take longer than a § 363(b) sale, but it can be worth it if there is meaningful equity for the benefit of the bankruptcy estate. But the trustee has to be strategic in the way that they deal with the co-owners and has to use an experienced real estate broker than can generate an acceptable offer with a patient, motivated buyer while also working with adversarial co-owners.