A trustee or debtor in bankruptcy may sell the bankrupt debtor's property with bankruptcy court approval under §363 of the Bankruptcy Code.  The purchaser might get a good deal because of the distress situation, but there are also other reasons that a purchaser might prefer to purchase from a seller in bankruptcy.

One of the advantages of dealing with a bankrupt seller is that it reduces or eliminates the possibility that the transaction will be set aside as a fraudulent transfer.  The Bankruptcy Code and Florida law allow sales of assets by an insolvent debtor to be set aside as a fraud if the purchase price was less than reasonably equivalent to the value of the property sold. 

Given the highly distressed real estate market, a lot of current sellers would be considered "insolvent."  Anyone purchasing property outside of bankruptcy from such a seller is taking a risk that the transaction may be avoided as a fraudulent transfer after the closing.  In addition, because of the magnitude of the risk, title companies now require a fraudulent transfer exception in title insurance policies, so the purchaser must simply absorb that risk.

On the other hand, if the seller is already in bankruptcy, then the risk is for all practical purposes eliminated.  The bankruptcy court provides a forum for creditors to challenge the fairness of the price in advance, and the Bankruptcy Code includes statutory protection for a court-approved sale.  Given the current market conditions and the distress that many real estate owners are now facing, this protection can be an important reason to purchase from a bankrupt seller.

Another reason it may be preferable to purchase from a bankrupt is that §363(f) allows the bankrupt seller to sell the property "free and clear" of encumbrances and interests.  The Bankruptcy Code only allows that, however, if protection is provided to persons whose interests will be cleared from the title.  For example, a sale may be made free and clear of a lien, but the lien must be paid from the proceeds or allowed to attach to the proceeds of the sale. 

At first glance, that limitation might seem to vitiate any benefit there may be to selling free and clear under the Bankruptcy Code.  However, there are circumstances where a sale free and clear is an advantage over a sale outside of bankruptcy.  For example, if there is a dispute as to the amount owed or to the right of the lienholder to be paid at all, the property can be sold free of the lien, with the lien attaching to the proceeds.  The parties then argue about who is entitled to the proceeds instead of clouding title to the real estate.

Also, §365 allows the bankrupt seller to transfer outstanding contracts to the purchaser, in some instances even though they may otherwise be nonassignable.  For example, a lease or a franchise agreement might be assigned in bankruptcy even though it is not assignable outside of bankruptcy.  The judicial nature of the sale enables the purchaser to cherry-pick assets without incurring the risk of successor liability for contracts and claims that it does not agree to assume.

Other advantages of a bankruptcy sale include the fact that the seller's officers and directors are effectively relieved of potential fiduciary liability for approving the sale, and the fact that the bankrupt seller itself may receive greater protection from potential liability arising out of warranties or representations. 

On the down side, the sale must be approved by the bankruptcy court after notice and a hearing, and that may cause some delay and expense.  However, §363(m) protects a purchaser who relies in good faith on a court order approving a sale that has not been stayed, even if it has been appealed.  The potential expense and delay of bankruptcy are often not so great that they offset the advantages of a sale under §363, particularly given the distress that is currently being experienced by many sellers in today's real estate market.

Please contact David Peterson or any member of the Distressed Real Estate Solutions Group if you have any questions concerning how you might benefit by using the bankruptcy court to assist in the sale or acquisition of property.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.