Bankruptcy Purchasers Beware: Do Not Take For Granted That Your Sale Will Be “Free and Clear”

In re Jaussi, 488 B.R. 456 (Bankr. D. Colo. 2013) –

A chapter 7 bankruptcy trustee requested court approval of a sale of vacant land to a bank that held a first lien on the property, with the sale to be “free and clear” of the junior liens of two judgment creditors.  Sounds reasonable, right?  The bankruptcy court did not agree.  It denied the request on the basis that the sale was not authorized under the Bankruptcy Code.

Under Section 363(f) of the Bankruptcy Code, property may be sold free and clear of an entity’s interests in the property “only if”:

(1)   applicable non-bankruptcy law permits sale of such property free and clear of such interests;

(2)  such entity consents;

(3)  the interest is a lien and the price at which the property is to be sold is greater than the aggregate value of all liens on such property;

(4)   the interest is in bona fide dispute; or

(5)   such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.

The trustee argued that the proposed sale was proper under either the first or third tests.

He offered the applicable state foreclosure statute as “applicable non-bankruptcy law,” arguing that foreclosure of the bank’s senior lien would extinguish the junior judgment liens.  The court disagreed, concluding that Section 363(f)(1) should be interpreted narrowly so that it applies only when the owner of the property could sell free and clear under non-bankruptcy law.

Examples the court gave of interests that would come within this test were (1) a restrictive covenant where a state law doctrine of “changed circumstances” applied, (2) an unrecorded mortgage in a jurisdiction where they have a “pure race” recording statute, and (3) the sale of a motor vehicle in a state with a title registration statute where a lender’s interest is not noted on the vehicle title.

The trustee also argued that the sale price was greater than the sum of all debts.  His argument was that the relevant value of debts secured by liens on the property was the amount that would be considered a secured claim under Section 506(a) of the Bankruptcy Code.  (See Chapter 11 Secured Loans: “Lien Stripping” Lives:  An undersecured claim is treated as a secured claim to the extent of the value of the collateral and an unsecured claim to the extent of any deficiency.)

While acknowledging that the courts are split on this issue, the bankruptcy court concluded that the better view is that “aggregate value of the liens” is the face amount of the debt secured by liens without regard to Section 506(a).  In addition, it commented that in a case where property is sold for less than the face amount of the liens it would always result in a sales price equal to the value of the liens, not greater (since, by definition, for purposes of Section 506(a) the secured claims would be set equal to the value of the property).

Consequently, the court held that the trustee failed to establish that Section 363 authorized sale of the property free and clear of the judgment liens.

People often take for granted that property can be sold free and clear of liens and other interests.  It is not unusual to see a motion for approval of a sale that simply asserts that a sale free and clear is justified under one or more of several subsections of Section 363(f) without undertaking any particular analysis.  As illustrated by this case, that may not be sufficient.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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