Chapter 11

Working Group Proposal #7: Clarifying The Conditions for Sales Free & Clear Under

11 U.S.C. § 363(f)

Under certain circumstances, the Bankruptcy Code authorizes property of the estate to be sold free and clear of liens or security interests. Section 363(f) of the Bankruptcy Code delineates five conditions, any one of which independently justifies a sale free and clear. [ FN: Section 363(f) provides that "[t]he trustee may sell property under subsection (b) or (c) of this section free and clear of any interest in such property of an entity other than the estate, only if- (1) applicable nonbankruptcy law permits sale of such property free and clear of such interest; (2) such entity consents; (3) such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property; (4) such 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. " This list of conditions set forth in 11 U.S.C. §363(f) is disjunctive. 3 Collier on Bankruptcy ¶ 363.06[1]) (Rev. 15th ed. 1996).] The fact that the conditions are listed disjunctively means that none of the requirements independently can preclude a sale. These factors, particularly those in subsections (f)(3) and (f)(5), have been the source of continual confusion without offering any additional protection for the interest holder beyond what other Bankruptcy Code provisions already provide.

The Recommendation

Congress should clarify that bankruptcy courts may authorize sales of property of the estate free of creditors’ claims regardless of the relationship between the face amount of any liens and the value of the property sold.

Reasons for the Change

The ability to sell estate property free and clear is a longstanding component of the bankruptcy system that long precedes the enactment of the Bankruptcy Code of 1978. [ FN: See Michael H. Reed, "Successor Liability and Bankruptcy Sales, " 51 The Business Lawyer 653, 656 (1996), citing Van Huffel v. Harkelrode, 284 U.S. 225, 227 (1931) (bankruptcy courts inherently had power to permit assets to be sold free and clear).] Section 363(f), representing an effort to codify some parameters, has caused a great deal of confusion.

Section 363(f)(3) authorizes a sale free and clear if the property will be sold for a price greater than the aggregate value of all liens on such property. [ FN: Bankruptcy Amendment and Federal Judgeship Act of 1984, P.L. No. 98-353 §442(d)(1984). Initially under the Bankruptcy Code of 1978, section 363(f)(3) authorized a sale free and clear of a lien if the sale price was greater than the value of "such interest " in the property.] As is described in the following paragraphs, courts and commentators disagree on whether subsection (f)(3) requires the sales price to exceed the aggregate face amounts of the liens, or whether the provision merely recognizes that the sale price must be commercially reasonable such that the proceeds will coverthe actual economic value of the lienholders’s liens. This issue has not been resolved at the circuit court level.

Some courts have determined that "aggregate value" must refer to the face amount of indebtedness secured by a lien or liens. Instead of considering the estate’s potential liability for the deficiency, these courts argue that the estate will have little to gain from selling property free and clear of liens when the lienholders will be entitled to all proceeds. [ FN: "The theory is that the trustee should not need to sell a property free of liens if the proceeds of the sale will be earmarked for lienholders anyway, and the estate will receive no benefit from the sale, unless there is some other basis for such a sale under section 363(f). " 3 Collier on Bankruptcy 363.06[1]) (Rev. 15th ed. 1996), citingIn re Riverside Inv. Partnership, 674 F.2d 634. See also K.C. Machine, 816 F.2d at 243;In re Terrace Chalet Apts., 159 B.R. 821 (N.D. Ill. 1993);In re Heine, 141 B.R. 185(Bankr. S.D. 1992);In re Julien Co., 117 B.R. 910 (Bankr. W.D. Tenn. 1990);In re Stroud Wholesale Inc., 47 B.R. 999 (E.D.N.C. 1985), aff ’d without opinion, 983 F.2d 1057 (4th Cir. 1986).] Taking a cue from other Code provisions, they conclude that Congress would have continued to refer to "interest" had it intended to denote the concept of actual value rather than specifically departing from the use of that term in 1984. [ FN: For example, section 506(a) refers to "the extent of the value of such creditor ’s interest , " a concept that now is absent from section 363(f)(3).]

Other courts have concluded that subsection (f)(3) protects only the actual economic value of the liens and thus overencumbered property of the estate can be sold in bankrutpcy free and clear rather than abandoned to undersecured creditors. This approach is consistent with the conception of value underlying section 506(a) and other Bankruptcy Code provisions that deal with value, such as section 361. [ FN: SeeIn re Oneida Lake Development Inc., 114 B.R. 352, 356 (Bankr. N.D.N.Y. 1990) ( "Value " in subsection (f)(3) "must be defined by reference to Code section 506(a) which defines secured status as extending only to the ‘value of such creditor ’s interest in such property, ’ thus negating the contention that value is determined by looking solely to the face amount of the lien in analyzing Code section 363(f)(3) ");In re Collins, 180 B.R. 447 (Bankr. E.D. Va. 1994), citing United Savings Ass'n of Texas v. Timbers of Inwood Forest Assoc., 484 U.S. 365 (1988) (Section 506(a) definition of value has same meaning as in sections 361 and 362);In re Beker Industries Corp., 63 B.R. 474 (Bankr. S.D.N.Y. 1986);In re Milford Group Inc., 150 B.R. 904 (Bankr. M.D. Pa. 1992);In re WPRV-TV Inc. 143 B.R. 315, 320, rev ’d on other grounds, 983 F.2d 336 (1st Cir. 1993).] This approach also comports with the authorization of cramdown under section 1129(b)(2)(A), whether the property is retained or sold, with no express restrictions imposed by section 363. [ FN: Beker, 63 B.R. at 477.] By this reading, section 363(f)(3) authorizes the sale of property free and clear even if the fair market value of the property is less than the face amount of the liens.

The latter approach is well-supported by policy justifications. Although no proceeds revert directly to the estate if the property is overencumbered, the estate and other creditors benefit when a sale yields a higher price for the property and keeps the lienholder’s deficiencyjudgment to its minimum. State foreclosure sales typically yield lower prices than bankruptcy sales. The estate will be injured if an individual undersecured creditor can prevent a bankruptcy sale or extract a premium by holding out on this basis. If both an oversecured and an undersecured lien encumber a piece of property that is declining in value, one might not want to permit the second lienholder to hold out and prevent the bankruptcy sale, forcing the estate to abandon the property, which then will be sold in a state law foreclosure sale. At that sale, the holdout creditor can bid low on the property and then return to the bankruptcy court to collect its deficiency judgment, which nearly always will be greater than if the property had been sold in bankruptcy. The undersecured creditor not only will have obtained the property but is likely to get a good return in a distribution to unsecured creditors to the unnecessary detriment of all unsecured creditors. The undersecured lienholder that wants to hold onto its interest to speculate in the future on an appreciating market can bid on the property in the bankruptcy sale, where the value of the asset will be determined more properly.

If section 363(f)(3) protects only the actual economic value of the property, which many believe to be the more justifiable view, the condition imposed by this provision always will be satisfied in the context of a commercially reasonable bankruptcy sale. Thus, this subsection, which has served as a source of ambiguity, provides no real substantive benefit. Consideration of the value of the liens in relation to the property value should not be a factor in determining whether property can be sold free and clear of claims and interests.

Interrelation with subsection 363(f)(5)

Adding to the confusion is the presence and interpretation of section 363(f)(5), which has been used at times to interpret subsection (f)(3). Section 363(f)(5) permits a sale free and clear if "such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest." This subsection seems to provide merely that the estate can force the lienholder to exchange its lien for cash if no applicable law prohibits such monetary satisfaction, a relatively toothless restriction that seems to enable most, if not all, sales to be free and clear. Notwithstanding the clear language, a valuation component has been inserted on numerous occasions, albeit with varying results. [ FN: Heine, 141 B.R. at 189 (analyzing "equitable interests " in determining whether to permit sale free and clear under subsection (f)(5)).] According to some courts, the reference in subsection (f)(3) to "money satisfaction" means "full money satisfaction," [ FN:In re General Bearing Corp., 136 B.R. 361 (Bankr. S.D.N.Y. 1992) (requiring full money satisfaction for sale free and clear under both subsections (f)(5) and (f)(3) of 363).] unless equitable considerations support extinguishing the lien upon realization of less than the full amount of the secured debt. [ FN: Stroud Wholesale, 47 B.R. at 1003 (full money satisfaction required in liquidation cases, otherwise subsections (1) through (4) would be meaningless);In re Wing, 63 B.R. 83, 85 (Bankr. M.D. Fla. 1986).] Other courts believe that subsection (f)(5) is relevant only when a lien is worth less than faceamount if one takes the position that subsection (f)(3) already protects the face amount of a lien. [ FN:In re Healthco Int'l Inc., 174 B.R. 174, 176 (Bankr. D. Mass. 1994); Terrace Chalet, 159 B.R. at 827;In re Perroncello, 170 B.R. 189, 191 (Bankr. D. Mass. 1994).] Because a cramdown has been identified as a proceeding under which a lienholder can be compelled to accept less than full satisfaction of its interest, some courts have concluded that subsection (f)(5) authorizes a sale free and clear of an undersecured lien only if the requirements for cramdown under section 1129(b)(2) would be satisfied. [ FN: See Grand Slam, 178 B.R. 460; Terrace Chalet, 159 B.R. at 827, citingIn re Weyland, 63 B.R. 854, 860 - 61 (Bankr. E.D. Wis. 1986),In re Hunt Energy Co., 48 B.R. 472, 485 (Bankr. N.D. Ohio 1985), andIn re Red Oak Farms Inc., 36 B.R. 856, 858 (Bankr. W.D. Mo.1984); WPRV-TV, 143 B.R. 315.] In taking that approach, one court acknowledged that the Code did not quite support this result, but that it was better than the alternatives. [ FN: Healthco, 174 B.R. at 176.] As an interesting final twist, this conclusion on the interpretation of subsection (f)(5) has been used to support, in turn, the argument that (f)(3) must protect the full face amount of liens so as not to provide an end run around the imputed requirements of subsection (f)(5). [ FN: Perroncello, 170 B.R. at 191, citing Terrace Chalet, 159 B.R. at 827.]

This review of the case law reveals that subsection (f)(5) largely has been interpreted to address the same valuation issues as subsection (f)(3). The subsection’s purported guidelines are irrelevant if bankruptcy courts can permit sales of property of the estate free of creditors’ claims regardless of the relationship between the face amount of any liens and the value of the property sold.

All of the participants at the Working Group session who spoke on the subject supported clarification of section 363(f) to facilitate sales of property. They agreed that this provision causes a great deal of confusion without a readily identifiable purpose. When the sale is part of a chapter 11 plan, whether one of liquidation or reorganization, the sale will be subject to the greater protections in section 1129. One participant mentioned that a creditor might have an interest in having the property sold outside of bankruptcy, but then agreed that if bankruptcy sales typically bring higher revenues than foreclosure sales, this concern was vitiated.

Competing Considerations

Although the bankruptcy system has long recognized sales free and clear without the consent of the lienholder, some might believe that the elimination of these requirements is insufficiently restrictive on sales. However, even if the Commission took that view, it should develop more coherent criteria rather than the current (f)(3) and (f)(5).

It has been suggested that a corresponding change be made to section 506(c) to clarify that the costs of a section 363 sale are allocated to the secured creditors that benefit from the sale. This legitimate recommendation is affirmatively under discussion by the chapter 11 Working Group, which plans to address such a change separately because its application would be broader than that of this narrow proposal.