Sixth Circuit Underscores the Importance of Due Process in § 363(f) Sales

One of the primary purposes of chapter 11 is to maximize the value of a debtor’s assets. [2] Section 363(f), which allows a debtor to sell its assets free and clear of any liens, claims, interests or encumbrances, helps effectuate this purpose. [3] Indeed, § 363(f) has often been described as a “powerful tool.” [4] But with great power comes great responsibility: Among other things, in order to sell free and clear under § 363(f), creditors and parties in interest generally must be provided at least 21 days’ notice of the proposed sale. [5] Federal Rule of Bankruptcy Procedure 2002(l) provides that the bankruptcy court may allow notice by publication if it determines that notice by mail is impracticable. [6] Recently, however, in Alliance WOR Properties LLC v. Illinois Methane LLC (In re HNRC Dissolution Co.), the U.S. Court of Appeals for the Sixth Circuit held that notice by publication of a proposed § 363(f) sale violated a party’s due-process rights when the party had a known interest in the property subject to the sale. [7] Consequently, the court held that the party’s interest was not affected by the order approving the § 363(f) sale. Ordinarily, courts are reluctant to “unscramble the egg” like this due to the importance of the finality of orders approving complex transactions in bankruptcy cases. [8] But HNRC Dissolution shows that this policy takes a back seat to due process. The decision also serves as a stark reminder of the necessity of providing constitutionally sufficient notice of a proposed § 363(f) sale to all parties with interests in the property.

The dispute in HNRC Dissolution stems from a 1998 transaction between Old Ben Coal Company and Illinois Methane, LLC, under which Old Ben conveyed its rights to methane gas in various coal reserves to Illinois Methane. As part of that recorded transaction, the owner of the coal estate was required to pay rental fees to Illinois Methane while it mined coal in areas that Illinois Methane had not yet explored. This covenant was called the “Delay Rental Obligation,” and it ran with the land.

Four years later, Old Ben and its affiliates filed a chapter 11 petition. In bankruptcy court, Old Ben filed a motion to sell substantially all of its assets free and clear under § 363(f). Notice of the proposed sale was published in various newspapers, but Illinois Methane was never directly notified. The bankruptcy court granted the sale motion, and Old Ben’s assets, including the coal reserves, were conveyed free and clear to Lexington Coal Co.

The appellant, Alliance WOR Properties, LLC, was in privity with Lexington Coal. Several years after the sale, one of Alliance’s predecessors-in-title applied for a permit to mine coal from the reserves. Illinois Methane then filed an action against Alliance in state court seeking more than $11 million pursuant to the Delay Rental Obligation. In response, Alliance reopened Old Ben’s bankruptcy case and sought to enjoin Illinois Methane’s state court action, arguing that it violated the sale order. The bankruptcy court held that Old Ben’s notice of the sale by publication did not satisfy Illinois Methane’s rights under the Due Process Clause, thus the sale did not affect Illinois Methane’s interests with respect to the property. The district court affirmed.

The Sixth Circuit, reviewing the bankruptcy court directly, also affirmed. First, the court explained that due process requires that parties be provided “‘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.’” [9] Furthermore, reasonable efforts must be made to give property owners actual notice of an action before property can be subjected to a court’s judgment. [10] Constructive notice, including notice by publication, may be sufficient to contact unknown parties. [11] Publication notice, however, is generally not sufficient “‘with respect to an entity whose name and address are known or very easily ascertainable and whose legally protected interests are directly affected by the proceedings in question.’” [12]

Next, the court explained that under Illinois law, Illinois Methane was “a known party with a known, present, and vested interest in real property” that ran with the land. [13] Thus, Illinois Methane was entitled to more than just publication notice. The court also explained that Old Ben could have reasonably ascertained Illinois Methane’s interest after conducting due diligence. Because Old Ben never provided Illinois Methane with more than just publication notice, the court held that due process prevented Illinois Methane from being bound by the bankruptcy court’s orders related to the sale.

Conclusion

Section 363(f) generally makes a debtor’s assets more attractive in the open market by providing clear title to buyers. [14] However, the decision in HNRC Dissolution makes clear that a party’s interest in property is not affected by a free-and-clear sale if the party has a known interest in the property and is not afforded proper notice of the sale. The decision also supports the proposition that due process rights trump the policy interest in promoting the finality of bankruptcy sales. Thus, HNRC Dissolution is a cautionary tale for § 363(f) sale participants about the importance of providing constitutionally adequate notice of a proposed sale.