Bankruptcy Sales: Buyers Are Not the Only Ones Who Should Beware

In Re Vista Marketing Group LTD., 557 B.R. 630 (Bankr. N.D. Ill. 2016)

The purchaser of property from a chapter 11 debtor was surcharged by a sanitary district for a connection fee that arose because the initial connection fee was based on estimated water use and actual use exceeded the estimate. The purchaser contested the surcharge on the grounds that it bought the property “free and clear” of the sanitary district’s claims.

In connection with construction of a gas station convenience store, the debtor applied to the sanitary district for a sewer construction permit. The application included the debtor’s estimated usage, which was used as the basis for a connection fee of ~$2000 assessed in connection with the issuance of the construction permit. Upon completion the debtor owned and operated the store. By the time it filed bankruptcy the facility included a car wash, which apparently caused the actual use to significantly exceed the estimated use.

A few months after filing bankruptcy the debtor obtained court approval of a sale of the property “free and clear of all liens with all liens to attach to the proceeds pursuant to 11 U.S.C. §363.” The sale order provided that proceeds were to be used to pay all normal and customary closing costs, including past due real estate taxes, with the net proceeds to be applied to a first mortgage, then to a second mortgage, with the balance of the proceeds to be held subject to further court order.

The district was aware of the sale. It provided its final bill to the title company for all amounts due through the closing date. The billed charges were paid from the debtor’s sale proceeds at closing. The district also updated its records to reflect the new owner. Two years later the district sent the purchaser an assessment of ~$6000 for a “connection fee surcharge” because “‘recent billing records” revealed that actual average flow exceeded the estimate.

The purchaser contested the surcharge on the grounds that as to the purchaser the surcharge claim was disposed of by the sale order. The district’s response was that:

[T]he connection charge is specific to the property and touches and concerns the land and therefore runs with the land. Because it runs with the land and in [sic] specific to the property, it cannot be discharged in bankruptcy. Real property cannot be sold free and clear of a connection charge.

After the district threatened to shut off its water, the purchaser brought an action in bankruptcy court seeking to enforce the sale order.

The bankruptcy court first addressed application of section 365(f) of the Bankruptcy Code, which authorizes sale of property free and clear of interests if at least one of several criteria is met. In particular, subsection (5) authorizes a sale free and clear of any interest if the entity holding the interest “could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.”

The district’s response was that the connection charge was not the sort of “interest” covered by section 363. Rather it was a covenant running with the land, and like a restrictive covenant could not be eliminated in a bankruptcy sale. However, the district was not asserting a non-monetary interest, but the right to receive a liquidated sum which originated at the time of the original sewer connection. “Indeed, one would be hard pressed to present a clearer example of the situation where the interest-holder could be compelled to accept a money satisfaction of its interest under subsection (f)(5) than the calculable monetary obligation asserted by the District in its surcharge bill and disconnection notice.”

In addition, the district had notice of the sale “free and clear” and failed to object. Under 7th Circuit precedent, failure to object when there is notice counts as consent – which is another basis for selling free and clear of an interest.

Further the district did not appeal or seek a stay of the sale order and did not allege the property was purchased in bad faith. Consequently, the purchaser was protected: even if an interest should not have been stripped from the sold property, section 363(m) of the Bankruptcy Code prevents a court from later resurrecting the interest.

The district next argued that the surcharge was more akin to a tax on the purchaser’s increased usage following the sale rather than a fee for the original connection. However, although the statute authorizing the surcharge originally allowed ongoing additional surcharges on an annual basis, the statute was amended so that by the time the purchaser was assessed the annual adjustment had been replaced by a single adjustment based on the initial 3 years of actual use. Loss, the surcharge was assessable based on pre-sale, pre-petition usage by the debtor and not post-sale usage by the purchaser.

Finally the district argued that the surcharge was a tax that was subject to the Tax Injunction Act. This act provides that federal courts “shall not enjoin, suspend or restrain the assessment, levy or collection of any tax under State law where a plain, speedy and efficient remedy may be had in the courts of such State.”

The court noted that the 7th Circuit uses a functional test that distinguishes between charges designed to generate revenue (which are taxes) and charges designed to punish or to compensate for services provided by the government (which are not). The court was inclined to view the surcharge as a fee rather than a tax. However it did not need to decide this issue since the purchaser was not requesting imposition of any new injunction and the district could not use the Tax Injunction Act to collaterally attack the original sale order.

Consequently, the court determined that the district violated the sale order by attempting to enforce a terminated obligation of the debtor against the purchaser.

The bankruptcy court order selling property “free and clear” of interests can have a surprisingly broad effect. Anyone who may have a continuing interest of any kind in property post-sale should carefully consider whether it would be prudent to negotiate a provision in the order explicitly recognizing that 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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