Bankruptcy Court was often seen as a venue for bargain hunters to obtain great deals. A recent decision by the Bankruptcy Appellate Panel, In re PW, LLC (Clear Channel v. Knupfer), 391 B.R. 25 (9th Cir. BAP 2008), appears to change that -- at least partially. In Clear Channel, the panel held that, contrary to popular belief, the Bankruptcy Code will not necessarily allow for the sale of real estate free and clear of junior encumbrances at bankruptcy court auctions.
The case involved an all-too-familiar scenario in today's troubled real estate market. A developer filed a Chapter 11 bankruptcy after appointment of a receiver in a last-ditch effort to avoid foreclosure. The project was encumbered by both a first deed of trust in favor of the lender and a junior lien. After the lender successfully moved for appointment of a trustee, the trustee auctioned the real property free and clear of all liens, at which auction the lender was allowed to credit bid. The junior lienholder objected to the sale.
The Bankruptcy Court approved the sale to the lender free and clear of the junior lien. No cash bids were received at the auction. The lender bid its secured claim, which was less than the total amount of all encumbrances against the property. In conjunction with the sale, the court denied the junior lienholder's request for a stay pending its appeal of the sale order. The sale order also included an express finding that, under Bankruptcy Code Section 363(m), a subsequent reversal would not affect the validity of the lender's title to the property. The lender then consummated the sale and declared victory, right? Not so fast.
In the ensuing appeal, the panel first ruled that the junior lienholder's appeal was not moot, despite the lack of a stay and Section 363(m) – the Bankruptcy Code's codification of a special mootness rule, which protects purchasers of property in bankruptcy. Section 363(m) is designed to facilitate and promote bankruptcy sales by protecting buyers from subsequent appeals where the objecting party fails to obtain a stay of the sale order. Bankruptcy courts will grant 363(m) protection to the buyer upon a certain evidentiary showing, including a showing that the buyer has purchased the property in good faith. Buyers often rely on the 363(m) protection to close their sales and obtain title, notwithstanding a potential appeal by objecting parties.
The panel agreed that the lender had obtained good title to the property that would not be disturbed on appeal in light of the Bankruptcy Court's 363(m) finding. Nevertheless, the panel determined that the junior lienholder's appeal was not moot because "stripping a lien is not a sale ... protected by the language of § 363(m), either directly or indirectly." Put another way, while the Bankruptcy Code seeks to protect the finality of sales, it does not provide the same level of protection to successful bidders to take title free and clear of nonconsenting liens. As such, the panel ruled that the junior lienholder's appeal could proceed to determine whether the lender had acquired the property free and clear of the junior lien.
The panel also held Section 363(f) of the Bankruptcy Code did not authorize a secured creditor to credit bid its debt and purchase the debtor's property free and clear of the nonconsenting junior lien. Carefully parsing the statute, the court determined that in cases where the sale price does not exceed the amount of all asserted liens or the junior lien is not the subject of a bona fide dispute, the Bankruptcy Court does not have the power to sell the property free and clear of a non-consenting junior lien. This determination was based on the panel's condition that the lender had failed to demonstrate that the junior lienholder could be compelled under state law to accept full satisfaction of its lien for less than full payment of the underlying debt. In so holding, the panel did leave open the possibility for secured creditors effectively to credit bid their claims in bankruptcy using other bankruptcy powers, including the so-called "cram-down" provisions of Chapter 11. However, the cram-down provisions are available only in connection with a plan of reorganization, which is a more expensive and lengthy process than a simple bankruptcy court auction.
Clear Channel is a wake-up call for secured lenders and others who might consider purchase of assets at a bankruptcy sale. When a debtor files bankruptcy to protect troubled real estate, lenders and other prospective purchasers must carefully consider all of their options, including moving for relief from stay to foreclose on the property, filing a motion to seek to value the property and to void any liens that exceed the value of the property pursuant to section 506(d) of the Bankruptcy Code, or proceeding with a sale of the property in conjunction with a plan of reorganization to strip off non-consenting junior liens via the cram-down provisions of the Bankruptcy Code. Given the current state of the law, even experienced lenders are advised to consult with bankruptcy counsel familiar with these intricacies before bidding at auction in bankruptcy court.
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