In a highly theoretical opinion, the Seventh Circuit said that an out-of-the-money creditor in a free and clear bankruptcy sale might be entitled to some sale proceeds, thus reducing the recovery by the senior lender even if the lender is not being paid in full.
How’s that possible? The Chicago-based appeals court theorized that the ability to sell free and clear might create an interest in property for which a subordinate creditor could be entitled to an adequate protection payment.
Before you panic and conclude that everything you know about bankruptcy sales is about to change, keep in mind that the Seventh Circuit based its July 9 opinion on an assumption that may prove to be wrong when the question arises again.
The Underwater Sales
The circuit court decided two consolidated appeals, both involving an Illinois bulk sale law designed to aid the state in collecting taxes. If state taxes are not paid, the bulk purchaser of a business becomes liable for the taxes under state law.
In parallel bankruptcies, the debtors owed $1.4 million and $600,000, respectively, in state taxes. In sales free and clear of liens and claims under Section 363(f), the properties fetched $5.2 million and $2 million, respectively. However, banks held first liens on the properties for $14 million and $4 million, respectively.
In other words, the first lien lenders would recover only a fraction of their secured claims even if they received all sale proceeds.
The state opposed distribution of the sale proceeds to the senior lenders, contending the state was entitled to be paid in full because the bulk sale law permits collection of the tax debts from purchasers. More cogently, the state argued that its successor liability claims under the bulk sale law amounted to an “interest” in property that was entitled to adequate protection under Section 363(e).
Because the senior lenders were underwater, the bankruptcy judges in Chicago both ruled that the state was entitled to no recovery from the sales.
On appeal, two different district judges remanded for the bankruptcy judges to develop the record by making two findings: (1) what the state would have recovered if the property had not been sold free and clear, and (2) how the state could be compensated for its “interest” given that the lenders had senior liens.
On remand, both bankruptcy judges again denied the state any recovery, ruling that the state’s realizable interest was effectively zero. The appeals court allowed direct appeals on both cases.
The Circuit Opinion, Based on an Assumption
Circuit Judge Ilana K. Rovner authored a 29-page opinion upholding the results in the bankruptcy courts, albeit on different grounds that some in the bankruptcy community may find unsettling.
Judge Rovner explained that the Illinois bulk sale law does not affect lien priorities. Indeed, the law does not apply in foreclosure, where the state cannot assert a successor liability claim against a purchaser.
In bankruptcy, however, the state contends that the ability to hold purchasers personally liable has “real value” that is entitled to adequate protection. More specifically, the state claims that a purchaser will pay a higher price because a bankruptcy sale relieves the purchaser of liability for state taxes. Developing the theory further, the state postulates that the purchaser would pay more to avoid the expense and loss of value to the business that would result from foreclosure, where the tax liability would disappear.
Judge Rovner therefore framed the question as whether the state was entitled to adequate protection when the properties were sold free and clear in bankruptcy court.
Significantly, Judge Rovner’s entire opinion rests on a critical assumption. Without deciding, she assumed that the state’s ability to impose successor liability was an “interest” in the debtor’s property that would invoke the concept of adequate protection under Sections 363(e) and 361(1). She made the assumption because the bankruptcy courts had made the same assumption, and the issue was litigated or decided below.
Judge Rovner’s own opinion contains language undercutting the assumption. She said that a buyer’s inclination to pay a premium for a sale free and clear “is attributable to [the state law] rather than any asset of the estate.” If that is true, a sale free and clear would be cutting off a state law right against a purchaser, not an interest in estate property deserving of adequate protection.
Judge Rovner said she was “dubious of the notion” that the state could have recovered all outstanding taxes. She also recognized that allowing the state to recover even a portion of the taxes “would, in a real sense, permit [the state] to jump the queue of creditors and grant [the state] monetary protection for its interest at the expense of other creditors.”
Judge Rovner therefore analyzed several hypotheticals to decide what the state “realistically could have recovered from the purchaser.” Even if a purchaser might pay more, the bank, she said, “surely would not be indifferent” if the state were to receive some of the proceeds when the secured lender was not being paid in full. The lender could foreclose, she said, to cut off the tax claims.
Nevertheless, “foreclosure comes with significant costs and can ultimately reduce the net recovery of a bank,” Judge Rovner said.
In a settlement to avoid foreclosure, a bank might accept somewhat less if the state were to take less than full payment. Judge Rovner said that compromises between the bank and the state “are more than an abstract possibility.” On the other hand, she quoted one of the district judges who said that an interest otherwise entitled to adequate protection “may be worth nothing, in practical terms, in which case the interest holder is entitled to no compensation pursuant to Section[s] 363(e) and 361(1).”
Focusing adequate protection “is where the wheels come off the wagon of [the state’s] argument,” Judge Rovner said, because “Section 361(1) directs us to consider how much the value of [the state’s] interest decreased as a result of the bankruptcy court’s free and clear orders.” In that regard, she said, “we are still faced with the problem of valuation.”
Regardless of whether the trustee or the state bore the burden of proof, she said there was “no evidence as to what [the state] likely would have collected from the purchaser but for the bankruptcy court’s Section 363(f) free-and-clear order.” In the absence of evidence about how much the state’s interest was diminished, Judge Rovner held that the “bankruptcy courts therefore did not err in valuing [the state’s] interest at zero for purposes of its right to adequate protection.”
What Does the Opinion Mean?
Judge Rovner’s opinion has set the stage for the next case where the state and the trustee will present expert witnesses about the incremental value in a bankruptcy sale as opposed to foreclosure.
It has always been this writer’s belief that a bankruptcy sale is more valuable than foreclosure for several reasons. Nonetheless, would the state be entitled to the incremental value, rather than the lender who is not being paid in full?
A lender’s ability to liquidate collateral in bankruptcy court could be viewed as a right held by a secured creditor, not value inherent in the collateral itself to which adequate protection rights might attach. Likewise, the bulk sale laws could be seen as creating only a claim against a purchaser, not an interest in the bankrupt seller’s property warranting adequate protection.
In a different context, the Ninth Circuit said in Pinnacle Restaurant at Big Sky LLC v. CH SP Acquisitions LLC (In re Spanish Peaks Holdings II LLC), 862 F.3d 1148 (9th Cir. July 13, 2017), that a bankruptcy sale can be the rough equivalent of mortgage foreclosure, in which case the state’s tax claims would be extinguished altogether. To read ABI’s discussion of Spanish Peaks, click here.
In any event, courts in the Seventh Circuit are now taxed with deciding whether the Illinois bulk sale law creates an interest in property entitled to adequate protection. It is by no means clear, however, that the outcome will affect only Illinois.
Most states have laws that confer rights on creditors to pursue claims against purchasers who do not follow procedures required by bulk sale laws. It is also not evident why the issue is confined to bulk sale laws, because subordinate secured creditors could argue that sales free and clear of their liens enhance the purchase price.
In a highly theoretical opinion, the Seventh Circuit said that an out-of-the-money creditor in a free and clear bankruptcy sale might be entitled to some sale proceeds, thus reducing the recovery by the senior lender even if the lender is not being paid in full.