What happens when property that a trustee wants to sell in a section 363 sale is subject to unexpired leases that the trustee is empowered to reject under section 365(h)? The Ninth Circuit faced this conundrum in a recent case involving a luxury real estate development in Montana, Pinnacle Restaurant at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holdings II, LLC), 892 F.3d 892 (9th Cir. 2017).  Wrestling with a split between its sister circuits, the Ninth Circuit ultimately concluded that, “[w]here there is a sale, but no rejection (or a rejection, but no sale), there is no conflict,” and the trustee could properly proceed with the sale.

Spanish Peaks, a 5,700-acre resort in Big Sky, Montana, was financed by a $130 million loan secured by a mortgage and assignment of rents from Citigroup Global Markets Realty Corp. Citigroup assigned the note and mortgage to Spanish Peaks Acquisition Partners LLC (“SPAP”).

At issue on appeal were two leases at the resort. The first was a restaurant space that Spanish Peaks Holdings, LLC (“SPH”) leased for $1,000 per month to Spanish Peaks Development, LLC (“SPD”).  SPH and SPD later replaced the lease with a 99-year leasehold for $1,000 per year in rent.  SPD assigned its interest to The Pinnacle Restaurant at Big Sky, LLC (“Pinnacle”).  The second was a parcel of commercial real estate SPH leased to Montana Opticom, LLC (“Opticom”), for a term of 60 years and annual rent of $1,285.

SPH defaulted on its loan payments and filed, along with two related entities, Chapter 7 petitions in Delaware. SPAP, SPH’s largest creditor with a claim of $122 million secured by the mortgage, assigned its claim to CH SP Acquisitions, LLC (“CH SP”).  The trustee and SPAP agreed to a plan to liquidate “substantially” all of the debtors’ property through an auction with a minimum bid of $20 million.  The trustee sought approval for sale of the property “free and clear of all liens,” except for certain enumerated encumbrances and liens to be paid out of the sale proceeds or otherwise protected.

The Pinnacle and Opticom leases were mentioned neither on the list of surviving encumbrances nor on the list of protected liens.. Both entities thus objected to any sale “free and clear of [their] leasehold interests.” 872 F.3d at 895.  The bankruptcy court authorized the sale but did not rule on Pinnacle’s and Opticom’s objections.  The court instead deferred them until the hearing on the motion to approve the sale.

At the auction and approval hearing on June 3, 2013, CH SP won the auction with a bid of $26.1 million. Pinnacle and Opticom renewed their claim that their leases allowed them to retain possession and objected to the “free and clear” language in the proposed approval order.

The bankruptcy court approved the sale, holding that the sale was free and clear of any “Interests,” including any leases “except any right a lessee may have under 11 U.S.C. § 365(h), with respect to a valid and enforceable lease, all as determined through a motion brought before the Court by proper procedure.” Id. at 896.  After some procedural back-and-forth and another evidentiary hearing, the bankruptcy court found defects in Pinnacle’s and Opticom’s leases, and noted that they had neither requested adequate protection for their interests nor proven that they would suffer economic harm if their interests were terminated.  The bankruptcy court thus held the sale was free and clear of the Pinnacle and Opticom leases, and the district court affirmed.

On appeal, the Ninth Circuit considered whether the leases survived the sale to CH SP, which gave rise to an apparent conflict between the trustee’s ability to sell property of the estate under section 363 and authority to assume or reject unexpired leases under section 365(a) and (h). Section 365 gives a lessee in possession with two choices:  “treat the lease as terminated (and make a claim against the estate for any breach), or retain any rights—including a right of continued possession—to the extent those rights are enforceable outside of bankruptcy.” Id. at 898.

Other circuits had taken one of two approaches to the apparent conflict. The majority held that section 365 outweighed section 363 “under the canon of statutory construction that ‘the specific prevails over the general.’” Id. (internal citation omitted).

In contrast, the Seventh Circuit had held that “the statutory provisions themselves do not suggest that one supersedes or limits the other.” Id. (quoting Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537, 547 (7th Cir. 2003)).  In other words, section 363 confers a right to sell property free and clear of “any interest” without exempting leases protected under section 365, while section 365(h) focuses on the specific event of the rejection of an executory contract without reference to sales of estate property under section 363.  The Seventh Circuit explained:

Where estate property under lease is to be sold, section 363 permits the sale to occur free and clear of a lessee’s possessory interest—provided that the lessee (upon request) is granted adequate protection for its interest. Where the property is not sold, and the [estate] remains in possession thereof but chooses to reject the lease, section 365(h) comes into play and the lessee retains the right to possess the property.  So understood, both provisions may be given full effect without coming into conflict with one another and without disregarding the rights of lessees.

327 F.3d at 548.

The Ninth Circuit agreed with the Seventh Circuit’s approach as the best way to reconcile the two statutes, noting that while “[a] sale of property free and clear of a lease may be an effective rejection of the lease in some everyday sense, . . . it is not the same thing as the ‘rejection’ contemplated by section 365.” 872 F.3d at 899.

Here, then, the trustee had not rejected the Pinnacle and Opticom leases, so section 365 was not in play, and section 363(f)(1) authorized the sale of the property free and clear of the leases. The Ninth Circuit therefore affirmed the judgment of the district court.

The Third Circuit has affirmed the Delaware Bankruptcy Court’s approval of a section 363 sale and related settlement agreement over IRS’s objection to provisions in the sale and settlement agreements that provide payments to unsecured creditors and other administrative creditors while leaving the IRS with no recovery. While the IRS argued that the sale and settlement violated the absolute priority rule by favoring creditors with an equal or lesser priority under the Bankruptcy Code’s distribution scheme, the Third Circuit found that neither the funds set aside to make payments to unsecured creditors nor the funds set aside to pay other administrative creditors constitutes property of the debtor’s estate. As the Bankruptcy Code’s creditor-payment hierarchy is applicable only to property of the debtor, therefore, it was not implicated by the provisions in the sale and settlement agreements.

Prior to the petition date, and after failing to attract purchase offers that exceeded its debt obligations, LifeCare Holdings, Inc. entered into an asset purchase agreement with an acquisition vehicle made up of its secured lenders—who were undersecured due to the falling value of the company—whereby the secured lenders credited $320 million of the $355 million debt they were then owed in return for the cash and assets of LifeCare. In addition, the lenders agreed to pay the legal and accounting fees of LifeCare and the Committee of Unsecured Creditors, as well as the company’s wind-down costs, and to deposit funds into separate escrow accounts for the purpose of paying those amounts. The day after entering into the asset purchase agreement, LifeCare and its subsidiaries filed for bankruptcy and asked for permission to sell substantially all of its assets through a section 363 auction. Ultimately, the secured creditors’ “credit bid” remained the most attractive offer. After an objection to the sale by the Committee, the secured lenders’ group entered into a settlement agreement with the Committee whereby the secured lenders agreed to deposit $3.5 million in trust for the benefit of the general unsecured creditors.

The US Government, representing the IRS, objected to the sale and the settlement and sought a stay on the distribution of funds to creditors, arguing that the sale would result in a large capital-gains tax liability, thereby giving them an administrative claim, and that the proposed sale and settlement agreements therefore violated the absolute priority rule by providing for payments to be made to equally situated administrative creditors—primarily bankruptcy professionals—and to unsecured creditors.

In determining that the sale and settlement were properly approved by the Bankruptcy Court, the Third Circuit described the central issue as “whether certain payments by a section 363 purchaser . . . in connection with acquiring the debtors’ assets should be distributed according to the Code’s creditor-payment hierarchy.” The court focused on its view of the substance of the sale over form and found that the money in question was not paid at the debtors’ direction, consisted of the purchaser’s own funds, and never entered the estate.

The Third Circuit’s ruling may provide incentive for undersecured lenders to make similar credit bids, and for debtors to accept such bids. While potential purchasers, debtors, and creditors may be tempted to use the decision as a map to altering the Bankruptcy Code’s distribution scheme and a avoiding the tax implications of section 363 sales, the adoption of this approach by other circuits is not certain. For now, creditors should be warned that they risk being bypassed by such sale arrangements.

On Wednesday, January 14th, 2015, the Second Circuit declined to grant an en banc review of its holding requiring a full Section 363 review of a claims sale in a Chapter 15 proceeding in the case of In Re: Fairfield Sentry Ltd.  This decision left intact the Second Circuit’s earlier holding that dramatically expanded the ability of a bankruptcy court in a Chapter 15 proceeding to weigh in on issues related to the disposition of property within the United States and sharply curtailed the required deference to the foreign court in these proceedings.

The underlying dispute centered on the sale of a $230 million claim by the bankruptcy estate of Fairfield Sentry Limited to Baupost Group LLC, a hedge fund.  Fairfield was an investment fund that had invested 95% of their assets in the Madoff ponzi scheme that collapsed in 2008, and following the Madoff bankruptcy Fairfield entered into its own liquidation in the British Virgin Islands, which was recognized under Chapter 15 in 2010.  Subsequently, Fairfield sold its claims in the Madoff liquidation for approximately 32 cents on the dollar, but three days after the signature of the trade confirmation, the announcement of new recoveries in the Madoff liquidation increased the value of the claim to over 50 cents on the dollar.

Following approval of the sale in the British Virgin Islands over the objections of the Fairfield Trustee, the Bankruptcy Court denied an application for section 363 review on the basis that the SIPA claim was not property within the United States, and that comity dictated deferring to the British Virgin Islands court that had approved the sale.  The District Court, on appeal, affirmed the Bankruptcy Court.

The Second Circuit’s initial decision on September 26, 2014 held that the claim in the Madoff proceeding was property within the United States and subject to Chapter 15 review as the claim was subject to attachment or garnishment by US courts, and accordingly under Section 1502(8) constituted property within the jurisdiction of the United States.  Furthermore, the Second Circuit held that the Bankruptcy Code clearly required a section 363 review due to the language that stated that section 363 applied in a Chapter 15 proceeding “to the same extent” as a Chapter 7 or Chapter 11 proceeding.  Accordingly, the Second Circuit held that the principle of comity remained strongly applicable in Chapter 15 proceedings, it did not override the requirement for an independent section 363 review of the sale.

Furthermore, the Second Circuit noted that the section 363 review must include the significant increase in the value of the claim following the sale rather than merely analyzing the transaction at the moment of the sale.  This requirement, given the significant increase in the value of the claim, makes it significantly more difficult for the buyer, Baupost Group, to secure approval of the sale.

Following the original order, Baupost moved for reconsideration en banc or, in the alternative, a an amendment of the decision to preserve Baupost’s alternative arguments that no section 363 hearing was required.  Specifically, Baupost argued (i) that section 363 was discretionary rather than mandatory, (ii) that the bankruptcy court, in its recognition of the British Virgin Islands proceeding order, had entrusted to the Fairfield Trustee the “administration or realization of any property located in the United States” making review unnecessary, and (iii) that the sale of the SIPA claim was in the ordinary course of business.  The Second Circuit directed the Fairfield Trustee to respond to these three alternative arguments.  The response argued that each of these three arguments had been presented to the Bankruptcy Court or the District Court and either explicitly or implicitly rejected.  Following this response, the Second Circuit denied Baupost’s motion without further comment.

As a result of this decision, parties should be aware that their transactions with foreign bankruptcy companies will likely be subject to both a standard review in the foreign bankruptcy court, as well as a full section 363 review in the United States.  This will likely be most significant in cases where the foreign court’s review will not take into account subsequent developments, while the Second Circuit’s decision requires the US courts to take those developments into account when determining if approval should be granted.

In considering a Section 363 asset sale in In re Fisker Automotive Holdings, Inc., , the United States Bankruptcy Court for the District of Delaware used its “for cause” power under Section 363(k) to limit the proposed purchaser’s credit bid and trigger a competitive cash auction for the debtor’s assets.  2014 WL 210593 (Bankr. D. Del. Jan. 17, 2014).  The decision demonstrates that courts considering the limitation or denial of credit bidding will consider factors both intrinsic to the proposed credit bid (the validity of the secured status asserted had not yet been determined) and extrinsic (perceived unfair process by the proposed sale purchaser, and the potential benefits of a competitive auction).

Bankruptcy Code section 363(k) authorizes a creditor with a security interest in an asset being sold to discount its successful bid by the value of the lien.  So called “credit bidding” can give secured creditors a substantial advantage in section 363 asset sales, especially when the value of the lien approaches or exceeds the market value of the sale asset.  There is no absolute right to credit bid; section 363(k) provides that the court may, for good cause, limit or deny credit bidding.

The would-be purchaser in In re Fisker, Hybrid Tech Holdings, LLC, purchased its $168.5 million claim, the largest by far against Fisker, from the Department of Energy for $25 million.  Hybrid then offered to purchase substantially all of Fisker’s assets in a private sale for consideration including $75 million in the form of a credit bid.  The Official Committee of Unsecured Creditors objected to the private sale, arguing that a competitive auction would return more value to the estate, and objected to the size of the credit bid, arguing that Hybrid should be precluded from entering any credit bid, or at least, not greater than the $25 million Hybrid actually paid to obtain the claim.  The rival bidder, Wanxiang America Corporation, made clear that there should be no auction unless Hybrid’s credit bid were limited to $25 million.

Although it rejected Hybrid’s $75 million credit bid and limited it to a $25 million credit bid in the anticipated auction, the court did not hold that credit bidding by the purchaser of a claim should always be limited to the amount actually paid to obtain the claim.  Instead, the court imposed this limit because the extent to which Hybrid’s claim was secured by a perfected lien was still in dispute, and it appeared that Hybrid was trying to rush the sale, freeze out other buyers, and prevent an auction.  The amount of $25 million was the maximum possible without foreclosing the auction all together.

In re Fisker does not indicate whether each of these justifications would be independently sufficient to establish “good cause” under section 363(k).  What the court’s ruling does demonstrate is the scrutiny that proposed credit bids will face, particularly private sales premised on credit bidding, to ensure that they are in the best interest of the estate.