Free-and-Clear Bankruptcy Sales: There’s This Little Thing Called “Due Process”

After a bankruptcy case closed, a third party (CVC) sued the purchaser (ADM) of property acquired from the debtors in a bankruptcy sale. CVC claimed that it had a right of first refusal (ROFR) with respect to the property. In response, ADM contended that the ROFR did not survive the “free and clear” bankruptcy sale. At the request of ADM, the bankruptcy court reopened the bankruptcy case to consider the issue.[1]

The debtors’ chapter 11 plan of reorganization provided for an auction of their grain facility assets, including certain real estate. The court held confirmation and sale hearings, and approved the plan of reorganization and sale of assets to the purchaser (including the real estate in question). Although it appears that the ROFR was not explicitly addressed in the court hearings, it was a recorded document, and the debtors gave a title report to ADM showing the CVC right of first refusal before the sale closed.

The court emphasized that there were three important undisputed facts:

• CVC was not listed on the debtors’ mailing matrix and did not receive any formal notice of the bankruptcy case.
• None of the notices, documents and pleadings relating to the proposed sale free and clear of interests (including those of CVC) were served on CVC.
• Nobody gave CVC contractual notice as was required by its right of first refusal.

Instead, there were only limited informal communications regarding the bankruptcy. A couple of weeks before the confirmation hearing, CVC’s attorney sent a letter to the debtors and one of its attorneys indicating that CVC heard about a potential sale and wanted to advise that the property should not be packaged with any other real estate, since that would defeat the ROFR.

CVC did not learn of the confirmation hearing until, at the earliest, a week before the hearing. At that time, CVC’s attorney called one of the debtors’ attorneys. She claimed she told CVC’s attorney (1) the date of the confirmation hearing, (2) that the property was “subject to a potential sale, and [3] that if he or his clients wished to assert any rights, under the ROFR or otherwise, they should do so prior to or at the hearing.”

CVC did not appear in the bankruptcy case nor attend the confirmation hearing. Absent objections, the court approved the sale and confirmed the plan, and the sale closed shortly afterward. Subsequently, ADM proposed to resell the real estate that CVC claimed was subject to the ROFR.

The bankruptcy court looked to Rule 60 of the Federal Rules of Civil Procedure to analyze the CVC challenge. Under that rule, a court may provide relief from a final order only if the judgment is “void.” Finding this term unhelpful, the Seventh Circuit has applied a balancing test while acknowledging “‘[t]he strong policy of finality of bankruptcy sales embodied in section 363(m)’ and a ‘strict rule in favor of the bona fide purchaser at the bankruptcy sale.’”[2]

ADM argued that this meant CVC could not contest the orders given the finding that ADM was a good-faith purchaser entitled to protection under § 363(m). However, the bankruptcy court found that this did not preclude a challenge, and that any relief would be governed by Rule 60 with a balancing of competing interests.

In this case, the critical question was whether there was a violation of due process. The U.S. Supreme Court has held that due process requires “notice reasonably calculated, under all the circumstances, to apprise interested parties of the pendency of the action and afford them an opportunity to present their objections.”[3]

Although CVC was required to establish that there was a constitutional as opposed to merely a statutory violation, the bankruptcy court reviewed notice requirements in the Bankruptcy Code and rules for sales as an indicator of appropriate notice. Ordinarily, parties receive 21 days’ notice of a proposed sale outside the ordinary course of business. If property is to be sold “free and clear” of interests, the motion to sell must be served on parties with those interests in the same manner as service of a summons and complaint. The notice must include the date of the hearing on the sale motion and the deadline for filing objections. It also must give the time and place of a public sale and the terms and conditions of a private sale.

In this case, CVC never received any written notice that the property was going to be sold free and clear of its ROFR. “Ambiguous information in a telephone call about a potential sale at a confirmation hearing one week away did not provide CVC with the requisite information, time or opportunity to protect its interest.”

The court rejected ADM’s argument that it was sufficient that CVC was put on “inquiry notice” of the sale. ADM also argued that CVC had actual knowledge and was “not entitled to stick its head in the sand and pretend it would not lose any rights by not participating in the proceedings.” But in the court’s view, ADM was more aptly characterized as an ostrich. The ROFR was recorded, giving ADM constructive knowledge of CVC’s interest. In addition, the title report showing the interest was received by ADM prior to the sale, providing actual notice. Further, ADM received an email from someone with a reminder about the ROFR.

The court concluded that ADM was not a good-faith purchaser. However, even if it was, given the nature of CVC’s interest, ADM still would not prevail. Unlike the interests of a lienholder, which are limited to an interest in the sale proceeds that could be accommodated, CVC would lose its rights under the ROFR with no compensation.

It was also important to the court that the remedy requested by CVC was limited to exercising its ROFR in connection with ADM’s planned resale of the property to another potential buyer. CVC could be accommodated without affecting the entire sale and other innocent parties.

Accordingly, the court denied ADM’s motion to enforce the sale order. CVC was not given notice sufficient to satisfy due process, and ADM was not a bona fide purchaser since it had actual or constructive knowledge of CVC’s rights. Alternatively, even if ADM had been a bona fide purchaser, the balancing test favored CVC so that the plan and confirmation order was not effective to sell free and clear of CVC’s interests.

For most purchasers, a significant benefit of buying assets out of bankruptcy is the ability to obtain assets “free and clear” of interests. It behooves a purchaser to verify that the debtor has taken all necessary steps — specifically including providing notice to all potentially interested parties. In addition to compliance with § 363(f) of the Bankruptcy Code, it is important to keep in mind the underlying constitutional due process considerations that may allow a third party to trump a purchaser’s rights.