Section 363(h): An Oft-Forgotten, Yet Powerful Tool for Co-Owners of Commercial Real Estate

While lawyers and trustees in individual debtor bankruptcy cases are likely familiar with § 363(h) of the Bankruptcy Code, many commercial bankruptcy lawyers often forget its existence. Today, creative real estate investment structures, like tenant-in-common (TIC) structures, are used by individuals to own portions of significant income-producing commercial properties, including office buildings, nursing homes and apartment complexes. These ventures often involve numerous owners with divergent backgrounds, financial means and interests.

Although these investment structures can sometimes produce lucrative results, they also can cause chaos when the underlying investment becomes “distressed.” The distress often manifests itself through an impending maturity of a balloon note, poor management or lack of sufficient cash reserves to make capital improvements. In such circumstances, tensions among co-owners — both personal and financial — can lead to a paralysis of decision-making and, in some cases, cause one or more co-owners to file bankruptcy. A bankruptcy filing by some but not all of the co-owners can create significant further complications.

Fortunately, § 363(h) provides a useful and powerful tool to resolve such divisive situations. Under § 363(h), a debtor or trustee can sell an estate’s interest and the interests of any co-owner “free and clear” without the consent of the co-owner when:

(1) partition in kind of such property among the estate and such co-owners is impracticable; (2) sale of the estate’s undivided interest in such property would realize significantly less for the estate than sale of such property free of the interests of such co-owners; (3) 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; and (4) such property is not used in the production, transmission, or distribution, for sale, of electric energy or of natural or synthetic gas for heat, light, or power.[1]

Section 363(h) provides bankruptcy courts with jurisdiction to bind nondebtor co-owners to a potential sale. In so doing, the Bankruptcy Rules and courts impose certain procedural safeguards to protect the due process rights of nondebtor co-owners. For example, a debtor seeking to use § 363(h) must initiate an adversary proceeding to obtain declaratory relief against the nondebtor co-owners.[2] Thus, if there are significant disagreements among co-owners regarding issues like refinancing, future management and ownership, or the value of the underlying real estate investment is declining or in jeopardy, § 363(h) provides the co-owners with a single forum in which to resolve contentious disputes among, and dysfunctional relationships between, co-owners and asset managers.

Two cases illustrate the role § 363(h) can play in breaking logjams and returning value to investors.

In In re Nashville Senior Living LLC, two debtors owned a 60 percent undivided interest in seven assisted-living facilities located in North and South Carolina.[3] Thirty TICs acquired the other 40 percent of the interests.[4] The debtors obtained a secured loan on the properties, and the TICs had monetary obligations for a portion, but not all, of the debtors’ secured debt.[5] Following a payment default, the lender started foreclosure proceedings against the debtors’ interests, which precipitated their bankruptcy filing.[6]

Shortly after the filing, the debtors sought court authority to sell the seven properties free and clear of liens, claims and encumbrances under § 363(b).[7] The TICs, who were then organized as the unsecured creditors’ committee, objected to the sale.[8] As a result, the debtors filed seven adversary proceedings under § 363(h) against the TICs to allow the sale of each property to proceed without the TICs’ consents.[9]

At the sale hearing, the bankruptcy court approved the sale of the properties over the TICs’ objections, ultimately relying on testimony and documentary evidence sufficient to satisfy § 363(h).[10] The TICs believed the court had to issue a separate order under § 363(h), but the bankruptcy court disagreed.[11] Because the TICs failed to obtain a stay of the sale during appeals to the bankruptcy appellate panel and the Sixth Circuit, the appellate courts upheld the debtors’ sale under § 363(h), thus ending a contentious dispute where the properties’ value would have deteriorated further and likely would have ended in the secured lender foreclosing on the properties.

In a recent case in the Western District of Texas, 28 TIC co-owners of a student housing complex had substantial disagreements with the contractual asset manager, who also held the largest TIC ownership interest.[12] The asset manager demanded cash contributions from the TICs for maintenance and repairs and threatened to force the debtors to convey their TIC interests to the asset manager, all while the apartment complex was losing tenants and thus value.[13] Highly contentious litigation among the TICs and the asset manager was pending. As a result, 19 of the TICs filed for bankruptcy, while nine did not (including the asset manager).[14]

To overcome the disputes, the debtor TICs filed an adversary proceeding seeking the bankruptcy court’s authority to sell the property free and clear of the interests of the nondebtor TICs and asset manager.[15] The court ultimately issued a final order permitting the debtors to sell the interests of the nondebtor TICs pursuant to § 363(h).[16] Thereafter, the parties reached a consensual deal to sell the property to a third-party buyer (whom the author represented). But for the ability to sell the property free and clear of the nondebtor co-owners’ interests, the litigation and disputes among the parties would have persisted, and the property’s value would have declined more, thus further eroding the possibility of recovery for the TICs. As illustrated by UTSA Apartments, § 363(h) permits debtors to leverage holdout TICs and the asset manager to maximize value for all co-owners.

When confronting inevitably difficult relationships among co-owners in “distressed” situations, practitioners would be wise to remember they have a powerful arrow in their quiver. Section 363(h) can be used by debtors and nondebtors alike as a means to prevent warring parties from further engaging in value-destroying behavior. As the cases discussed above demonstrate, if no path to reconciliation is evident early in a co-owner’s bankruptcy case, parties should strongly consider filing a complaint under § 363(h) as leverage to force a resolution before potential value for the co-owners has eroded entirely.