Bankruptcy Sales: “Free and Clear”… Or Not

In re Hassen Imports P’ship, 502 B.R. 851 (C.D. Cal. 2013) –

A chapter 7 trustee sought to sell real estate “free and clear” of certain prepetition contracts and covenants between the debtor and a city, as successor of a redevelopment agency.  The bankruptcy court ruled in favor of the trustee, and the city appealed to the district court.

In the early 1980s and 1990s the Redevelopment Agency of the City of West Covina conveyed several properties within the West Covina Auto Mall to the debtor.  The debtor and its affiliate operated the properties as auto dealerships.  In the mid-1990s and early 2000s the debtor entered into several financing and redevelopment agreements with the Redevelopment Agency.  In the context of these agreements, the debtor agreed to covenants (1) giving the Redevelopment Agency the right to approve any future owner of the properties, (2) giving it the right to approve any future operator of the dealerships, and (3) requiring that the properties be used solely for auto-related purposes.

After the debtor filed a voluntary chapter 11 bankruptcy that was converted to a chapter 7 liquidation case, the trustee sought court approval for the sale of some of the properties owned by the debtor free and clear of the covenants.  At the same time, the City of West Covina (as successor to the Redevelopment Agency) sought to enforce those covenants.  In particular, the City was concerned that the likely buyer was an entity controlled by the same person that owned and controlled the debtor and its affiliates.  Given past experience, the City objected to the continuing involvement of this individual.

The bankruptcy court concluded that the ownership covenant was not enforceable as a contractual interest, real property covenant, or equitable servitude under state law.  Although it found that the operating covenant was also not enforceable as a real property covenant, the court concluded that this covenant was enforceable as an equitable servitude.  However, the bankruptcy court also determined that the trustee could sell the properties free and clear of the equitable servitude under Section 363(f)(5) of the Bankruptcy Code.

On appeal, the district court considered first whether the operating covenant was enforceable, and then whether the trustee could sell free and clear of the covenant.

On the first issue, the question was whether the trustee could assert the rights of a bona fide purchaser and use its “strong arm” powers to avoid the covenant: Under Section 544 of the Bankruptcy Code, if a hypothetical bona fide purchaser as of the commencement of the bankruptcy could acquire the properties free of the covenants, then the trustee could avoid the covenants.

If a purchaser does not have notice of a claim, then usually a bona fide purchaser can acquire property free of that claim.  However, in most jurisdictions a purchaser is deemed to have constructive notice of prior recorded documents.  Consequently, if there is recorded notice of a claim, typically a bona fide purchaser will take title to the property subject to that claim.    Although a trustee exercising strong arm powers is not held accountable for actual knowledge, generally it is subject to constructive knowledge.  So, because the operating covenant was recorded prior to commencement of the bankruptcy case, the trustee had constructive notice and was not able to avoid the covenant using strong arm powers.

Turning to the second issue, Section 363(f) authorizes sale of property “free and clear of any interest in such property of an entity” if at least one of five conditions is met.  In particular, Section 363(f)(5) applies if “such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.”  The district court noted that the leading case in the 9th Circuit interpreting this section holds that it includes at least three elements:  “(1) a proceeding exists or could be brought, in which (2) the non-debtor could be compelled to accept a money satisfaction of (3) its interest.”

In this case the trustee contended that the foreclosure of a senior lien on the properties would satisfy the requirements.  The bankruptcy court agreed with the trustee that a foreclosure would qualify as an applicable proceeding, and noted that a senior lien foreclosure extinguishes junior covenants and equitable servitudes.  Since the operating covenant was junior to the lien held by one of the creditors, the bankruptcy court concluded that foreclosure of that lien would extinguish the covenant, and thus qualified under Section 363(f)(5).

The City objected on the basis that it would not receive a “money satisfaction” of its claim in connection with a foreclosure.  The district court agreed that it was not sufficient to merely extinguish the covenant, but rather there must be something given in exchange in order to constitute a “money satisfaction.”

The court distinguished another bankruptcy case that allowed a trustee to sell property free and clear of a covenant because that covenant was more in the nature of a potential construction contract where breach lent itself to monetary remedies.  In contrast it pointed to cases that held Section 363(f)(5) was not applicable where the only real remedy was to provide equitable relief in the form of an injunction.  In essence, the test is whether a restrictive covenant is “cash convertible.”  In other words, can the interest be reduced to dollars?

Although a foreclosure might be an appropriate proceeding with respect to a junior lien (since in that context junior liens are transferred to any surplus proceeds), it is not appropriate in the context of an equitable interest that is simply terminated.

While holding that the hypothetical foreclosure of the senior lien did not qualify, so that the trustee could not justify a sale free and clear of the covenants under Section 363(f)(5), the court emphasized that it did not find that the trustee was barred from selling the properties to the commonly controlled entity, nor that the trustee could never invoke Section 363(f)(5) to sell free and clear of the operating covenant.  Rather the court concluded only that the trustee had not identified a proceeding that would compel the City to accept a money satisfaction of the equitable servitude.

People sometimes take for granted that property can be sold free and clear of virtually any interest.  However, there must to be a specific basis in order to achieve this result.  It is also worth keeping in mind that a selling trustee or debtor in possession is not limited to the grounds listed in Section 363(f), but may also be able to use “strong arm” powers to avoid an interest.

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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