Adequate protection is one of the central protections provided to secured creditors by the Bankruptcy Code, and it is designed to protect against any diminution of the value of the secured creditor’s lien during the course of a debtor’s bankruptcy proceedings. Adequate protection must be provided when, among other circumstances, a debtor sells a secured creditor’s collateral pursuant to Bankruptcy Code § 363. Under § 363(e), the burden is on the secured creditor to request adequate protection in connection with a sale, including the burden of demonstrating that the value of its lien will diminish because of the sale.
In its recent decision in Ill. Dep't of Revenue v. Hanmi Bank, 895 F.3d 465 (7th Cir. 2018), the Seventh Circuit considered whether a junior creditor was entitled to adequate protection in connection with a § 363 sale where the senior lender was undersecured and therefore would not be paid in full. The Seventh Circuit assumed, without deciding, that the junior creditor’s ability to pursue the purchaser by way of a successor liability claim was an interest entitled to adequate protection, but held that adequate protection was not required due to the failure of the junior creditor to satisfy its burden of providing evidence on the value of its interest.
Although out-of-the-money junior creditors might see the decision as a ray of hope in bargaining for adequate protection in connection with a § 363 sale, the opinion opens a narrow door by making clear that those junior creditors would face difficulty in carrying their burden of demonstrating the value of any protectable interest.
By way of background, the genesis of the Seventh Circuit’s opinion was two consolidated appeals in which the senior secured lender was underwater. In each case, the bankruptcy court authorized the sale of the debtors’ principal assets free and clear of claims and interest pursuant to § 363(f). The sales qualified as bulk sales under Illinois statutes (i.e., the Bulk Sale Provisions), which, among other things, give the Illinois Department of Revenue (IDOR) the right to pursue the purchaser in a bulk sale for state taxes owed by the seller. However, because the sales were free and clear, IDOR’s right to impose successor liability on the purchasers for taxes owed by the sellers was cut off. IDOR argued that the elimination of that right required that IDOR be provided adequate protection under § 363(e).
The bankruptcy court in each case either agreed or assumed that IDOR’s right under the Bulk Sale Provisions to impose successor liability on the purchasers for the taxes owed by the sellers was an interest entitled to adequate protection under § 363. However, because the sale proceeds were insufficient to satisfy the senior-most creditor in each case, the bankruptcy court concluded that IDOR was not entitled to any portion of the sale proceeds. The bankruptcy court found that granting IDOR any share in those proceeds through adequate-protection payments would allow IDOR to impermissibly “jump the queue” of creditors. Because there were no other assets available for distribution to junior creditors, IDOR was not entitled to any compensation.
The Seventh Circuit affirmed the judgments from the bankruptcy court. The Seventh Circuit acknowledged that the Bulk Sales Provisions provided IDOR with a powerful means of securing payment that most other creditors lacked, and that removal of IDOR’s interest likely increased the price the purchasers were willing to pay for the debtors’ assets in each of the bankruptcy cases. Moreover, the court assumed, without deciding, that IDOR’s interest (i.e., the right to pursue the purchaser for successor liability) was an interest entitled to protection under § 363. However, IDOR failed to provide evidence on the issue of diminution in value of that interest due to the § 363 sales or what consideration, if any, the purchaser paid specifically to obtain the properties free and clear of IDOR’s interest under the Bulk Sales Provisions. IDOR did not dispute that it maintained the burden to establish the value of its successor-liability claim, and the Seventh Circuit affirmed the bankruptcy court on the narrow ground that IDOR’s claim was properly denied for want of evidence, enabling the bankruptcy court to assign a reasonable value to its interest for purposes of § 363(e).
Although the Seventh Circuit affirmed denial of any adequate protection, the decision raises the specter of out-of-the-money junior creditors making claims for adequate protection in connection with § 363 sales. IDOR argued that selling the property free and clear of IDOR’s interest made the property more attractive to purchasers and that therefore IDOR should receive payment of the unpaid taxes from the sale proceeds. In expressing doubts that IDOR would recover 100 percent of the tax delinquency from an informed and sophisticated purchaser with other options to disrupt IDOR’s rights (such as by foreclosure, through which successor lability would not attach), the court suggested that IDOR very well may have been able to strike a deal with the purchasers and the sellers’ senior creditors that gave it some lesser payment on the outstanding taxes, suggesting that the amount that could have been received through any such deal may have informed the value of adequate protection to which IDOR could have plausibly been entitled. Nevertheless, the opinion leaves open for another day whether a junior creditor could indeed prove up the value, if any, of a protectable interest for purposes of adequate protection when sale proceeds are insufficient to pay a senior creditor in full.