Sale “Free and Clear”: Adequate Protection of Nothing is Nothing

In re Elk Grove Village Petroleum, 510 B.R. 594 (Bankr. N.D. Ill. 2014)

After substantially all of the debtors’ assets were sold in a bankruptcy sale, a secured lender and a state tax authority made competing claims for turnover of sale proceeds. The bankruptcy court addressed first the relative priority of their claims and then the right of the state tax authority to collect unpaid seller taxes from the purchaser of the assets.

The debtors owned and operated five gas stations. The lender (UCD) made loans totaling ~$14 million secured by all of the real and personal property of the debtors. The state tax authority (IDOR) claimed that the debtors owed prepetition taxes of ~$1.8 million, which it asserted consisted of ~$1.38 million secured debt, ~$420,000 priority unsecured debt, and ~$75,000 general unsecured debt.

As the first order of business the court addressed the UCD claims. Although UCD did not file a proof of claim, the court found that secured creditors are not required to do so to assert a claim. In addition, the UCD claim was scheduled by the debtors as secured claims that were not disputed, contingent, or unliquidated. As a result, the schedules constituted prima facie evidence of the validity and amount of the claim; and since there was no objection to UCD’s claims, they were deemed allowed. UCD also established that it had liens on all of the assets that were sold.

IDOR asserted that it had priority under state law. Since there were recorded liens for certain of the claims, the court concluded that it had valid liens on the proceeds of the sale for ~$1.4 million. However, since the UCD liens were recorded first, it had priority over IDOR. And since the UCD claims were greater than the proceeds, that meant that IDOR was “out of the money” and not entitled to receive any of the proceeds.

IDOR also contended that under state law it was entitled to assert a claim against the buyer for the secured portion of its claim. The applicable statute provides that “any person who shall acquire any property or rights thereto which, at the time of such acquisition, is subject to a valid lien in favor of the Department, shall be personally liable to the Department for a sum equal to the amount of taxes secured by such lien but not to exceed the reasonable value of such property acquired by him.”

However, the property was sold free and clear of “interests” under Section 363(f) of the Bankruptcy Code. The court determined that IDOR’s ability to assert claims against a buyer for unpaid seller taxes constituted an interest in property, since the buyer’s liability arises from ownership of the acquired property. Thus, the sale was free and clear of IDOR’s right to collect taxes from the buyer.

This led to the question of whether IDOR was entitled to adequate protection of its interest. Under Section 363(e) of the Code, if a party has an interest in property that is being sold, the court is required to prohibit or condition the sale “as is necessary to provide adequate protection” of the interest. The court concluded that if the right to collect from the buyer was an interest for purposes of Section 363(f) authorizing a sale free and clear, it was also an interest for purposes of eligibility for adequate protection under Section 363(e).

The purpose of adequate protection is to prevent a loss in the value of a secured creditor’s interest in property of the bankruptcy estate. Under Section 361, adequate protection may take various forms, including a cash payment, a replacement lien, or “the indubitable equivalent of such entity’s interest” in the property. IDOR argued that it was entitled to sale proceeds as the indubitable equivalent of its interest in the sold assets. However, since UCD had a senior interest in all of the proceeds, IDOR’s claim was treated as an unsecured claim. Although it lost an avenue of pursuing its claim, that avenue was without value. So it did not experience a loss that entitled it to adequate protection.

Consequently IDOR was neither entitled to any portion of the sale proceeds nor was it entitled to pursue collection of the unpaid seller taxes from the buyer.

Not all courts would agree that a tax authority’s ability to collect unpaid seller taxes from a buyer of property constitutes an interest such that the property can be sold free and clear of that right. A buyer has an incentive to make sure that property taxes are paid at closing to provide certainty that it will not be subject to claims for unpaid taxes down the road.

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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