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Not Quite Free and Clear

posted by Stephen Lubben

Beginning with Baird and Rasmussen's End of Bankruptcy, and including papers by Westbrook, LoPucki, and yours truly, much recent corporate bankruptcy scholarship has focused on the frequent exercise of pervasive control by secured lenders in chapter 11 cases.

A key aspect of this new reality is the prevalence of sales of "substantially all" (corporate speak for "all") of the debtor's assets under section 363, before formulation of a plan.  Lenders are willing to fund short cases leading to sales of the debtor as a going concern -- not "old fashion" reorganization plans.  Sale of the debtor's assets under section 363 importantly invokes § 363(f) of the Bankruptcy Code, which appears to allow the new buyer to acquire "clean" title to the debtor's assets.

But along comes Judge Markell, writing for the 9th Circuit Bankruptcy Appellate Panel in Clear Channel Outdoor, Inc. v. Knupfer (In re PW, LLC), to throw cold water on this reliance on section 363(f).  Judge Markell summarizes his opinion as follows:

outside a plan of reorganization, does § 363(f) of the Bankruptcy Code permit a secured creditor to credit bid its debt and purchase estate property, taking title free and clear of valid, nonconsenting junior liens? We hold that it does not.

I discuss this conclusion -- which many chapter 11 practitioners and scholars will find shocking -- after the jump.

The BAP's conclusion seems to be somewhat like the 7th Circuit's notorious K-Mart opinion:  an appellate court reigns in an accepted chapter 11 practice that has gotten too far in front of the actual language of the Bankruptcy Code.  And it is undoubtedly true that many 363 motions are drafted based on what we wish 363(f) said, rather than what the statute actually provides.  At best, these motions often make conclusory statements that the requirements of 363(f) have been met -- statements that don't count for much when viewed as part of an appellate record.

But I want to probe a bit deeper into Judge Markell's analysis of sections 363(f)(3) and (f)(5).  The case facts are simple:  The debtor owned a large parcel of land in Burbank, California.  The land was subject to a $40 million first lien held by a hedge fund, and second lien for $2.5 million held by another creditor.  Bankruptcy court affirms the sale of the property to the senior lender (who credit bid its claim as the "stalking horse"), free and clear of the second lien -- grumpy junior creditor appeals.

After holding that the appeal was not moot, the BAP held that neither section 363(f)(3) nor (f)(5) supported the bankruptcy court's decision to strip off the second lien.

First, Judge Markell rejected those cases that import a 506(a) type analysis into 363(f).  First, he noted that the language of 363(f)(3) was distinct from that used in 506(a), and if Congress had intended the same result why the distinct language?  Thus, he goes on to hold that 363(f)(3) is only implicated in cases where the sale price is more than the face amount of all liens on the asset.

He also notes that 363(f)(3) by it terms applies only when the sale price is "greater than" the value of all liens.  If a 506(a) analysis is used in the context of a credit bid, the sale price will always equal the value of the secured claim and never be greater than, as required by the statutory language.  Putting aside the assumed Congressional knowledge of algebra that this analysis implies, this point still seems rather persnickety.  Future creditors are advised to bid their claim plus $0.01 to ensure that 363(f)(3) applies.

Judge Markell's reading of the statutory language is somewhat more persuasive, but note that everyone (both the court and the parties) is assuming that the value of the real estate is $40 million.  But in a liquidating chapter 11 case that appears likely to offer no recovery to unsecured creditors, the lender likely had no reason not to bid the full amount of its claim at the auction (there is no mention of third-party guarantees).

If cash bidders uniformly valued the property at < $40 million, they wouldn't even show up at the auction -- as apparently happened in this case, where the stalking horse bid won the auction.  In short, would Judge Markell's analysis hold up if the lender had said "yeah, we bid our full claim amount but we're going to put on expert testimony to show that the property is really worth $30 million."  Assuming the expert was credible, the sale  "price at which such property is to be sold is greater than the aggregate value of all liens," albeit still lower than the face amount of the liens.

Sticking with Judge Markell's analysis under these facts forces us to confront the fact that this interpretation of the statue uses the term "value" in a way that means something other than economic value of the lien, and something more like "claim."  Of course, the term "claim" is also defined in the Code and if Congress had meant that, why didn't they use that term?    . . . and the interpretive wheel goes round again.

If you're still with me after all that, I'll say a few words about the court's analysis of 363(f)(5).

The court first rejected the idea that a cramdown under 1129(b) could be the relevant "legal or equitable" proceeding that could compel a junior creditor to accept a money satisfaction.  That seems reasonable, since the cramdown likely will never happen if the 363 sale occurs, and the entire analysis begins to resemble a particularly confusing time travel episode of Stargate.

Judge Markell than goes on to explain that

The question is thus whether there is an available type or form of legal or equitable proceeding in which a court could compel [the junior creditor] to release its lien for payment of an amount that was less than full value of [the junior creditor]'s claim.  Neither the Trustee nor [the senior creditor] has directed us to any such proceeding under nonbankruptcy law, and the bankruptcy court made no such finding.    2008 WL 2840659 at *15  (citations omitted).

Here the opinion again resembles Kmart, inasmuch as I view Kmart has having been driven by the tendency in chapter 11 practice to file motions that have little evidentiary support -- no, repeating the text of the motion in a declaration does not count, especially on an issue like this where the signer of the declaration probably does not have basis for knowing this information (if it is even a factual issue).  No doubt because of the increasingly transactional nature of chapter 11, it is all too easy to forget that what "works" in the bankruptcy court might not constitute an adequate record on appeal.

Future drafters of 363 motions would be well advised to point the bankruptcy court to the relevant state law citations that might support a finding that 363(f)(5) applies -- state foreclosure law would seem to be an obvious source.  As I'm sure my consumer colleagues on this blog can confirm, second liens get wiped out in foreclosure sales all the time, right?




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I just looked at the docket BAP docket sheet for the Clear Channel caase to see if it had been appealed to the 9th Circuit Court of Appeals, and see that the parties stipulated in the BAP to dismiss a motion for a rehearing and the appeal itself.

If so, the opinion may no longer be "precedent" (aside from the fact that the binding effect of a 9th Circuit BAP opinion on 9th Circuit bankruptcy judges is itself a murky issue).

-------- Herb Ross

I believe that under the analysis in U.S. Bancorp Mortg. Co. v. Bonner Mall P'ship, 513 U.S. 18 (1994), the opinion will remain binding, even if the parties have settled.

I had thought that part of the stipulation was an agreement that the opinion would somehow be "withdrawn." I agree with Stephen Lubben that, absent such a stipulation, the precedent stands.

I think I'm with Stephen on his analysis of 363(f)(3) -- the use of the word "value" makes a difference, because the economic value of the lien cannot be greater than the value of the property. Here is where it gets interesting then. The right of the first lien holder to "credit bid" is divorced from the right of the buyer to buy "free and clear" of the second lien. Outside of bankruptcy (at least in my state), that would not happen in a foreclosure of the first lien. Instead, the second lien holder would be "wiped out" and the buyer at foreclosure would take the property "free and clear" -- even if the buyer was the first lienholder who had credit bid.

So my question to Stephen is this -- why should the Code yield a diametrically different outcome in the credit bid situation?

If I'm understanding Judge Clark, he is rightly noting the tension between my 363(f)(3) and (f)(5) analysis -- the foreclosure sale law that I point to at the end of the 363(f)(5) analysis at least implicitly points to the senior creditor's claim as the "value" of the property to justify stripping off the junior creditor's lien. But my 363(f)(3) analysis kind of undercuts that, to the extent that I'm saying that credit bids don't always reflect "true" value.

I'm not saying that courts should routinely accept the notion that value is something other than what is bid -- my hypothetical turns on the intersection of limited liability and the absolute priority rule (and the lack of any third-party guarantees), so that the cost to the creditor of "overbiding" is essentially zero.

Even if you don't accept the notion that there is a value other than the auction value, I think my analysis forces us to probe exactly what the BAP is doing to the "word" value by its analysis.

The failure to word 363(f)(3) like 506(a) is an initially convincing point -- until we understand that Congress also did not word 363(f) like the section 101 definition of "claim," which is essentially what I see in the BAP's discussion. And, as I make clear in the post, I don't find the "greater than/less than" discussion particularly compelling, since it can be avoided by a simple "trick."

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