On July 9, 2018, the U.S. Court of Appeals for the Seventh Circuit issued an important opinion raising the possibility that out-of-the-money junior creditors might be entitled to share in the proceeds of a free-and-clear bankruptcy sale under 11 U.S.C. § 363(f), even where the senior secured party is underwater. In Illinois Department of Revenue v. Hanmi Bank, while the court ultimately held in favor of the senior secured lenders on the evidence presented (finding a failure of proof by the junior creditors of the value of the interest supposedly lost in the sale), the court’s reasoning opened the door to giving juniors a share of the sale proceeds. Before the Hanmi Bank case, the prevailing view was that an underwater senior creditor always could keep all of the proceeds of a free-and-clear sale as a matter of law. Junior creditors would get nothing.
The court’s theory, while far from crystalline, rested on the idea that the free-and-clear sale itself creates a premium in value—by eliminating junior interests that otherwise might be difficult to shed—that at least partially should be allocated to the eliminated junior interest, rather than going entirely to the underwater senior creditor. If that premise holds, then otherwise out-of-the-money junior creditors will enjoy nontrivial leverage to pressure senior creditors into agreeing to share some of the proceeds of a free-and-clear sale, or to face a contested evidentiary hearing as to either the value of the interest lost by the juniors or the amount of the premium paid by the sale purchaser because of the enhanced protections of the free-and-clear sale vis-à-vis the eliminated junior interests.
It is possible that the Hanmi Bank decision will be narrowly limited to its facts, based on the fact that the junior interest implicated and eliminated by the free-and-clear sale in that case gave the state taxing agency a successor liability claim against the purchasers personally, rather than solely a claim against the selling debtor. The Seventh Circuit speculated that the purchasers at the sale accordingly may have paid a premium specifically to be insulated from that successor liability, and perhaps a court would find no such corollary premium to exist in favor of out-of-the-money junior creditors who lack the right to pursue the purchasers. But such a narrow reading is not inevitable; even with regard to junior creditors who lack a right of recourse against purchasers, there are aspects of the legal operation of a § 363(f) free-and-clear sale that generate a prospective premium in the sale price with respect to any eliminated junior interest.
The case involved two consolidated appeals, both involving the Illinois Bulk Sales law, which gives the Illinois Department of Revenue (IDOR) the right to pursue the purchaser in a bulk sale for state taxes owed by the seller. However, with regard to the priority of claims against the debtors, IDOR ranked behind the senior secured creditors. In a foreclosure sale, IDOR would not be entitled to recover its taxes as against the foreclosing senior creditor. The intriguing question, then, is what happens to the IDOR successor liability claim when a debtor’s property is sold in bankruptcy in a free-and-clear sale under § 363(f), when the sales price is not enough to pay off the claim of the senior secured creditor.
In one case (Elk Grove), the debtors owed $14 million to the senior secured creditor (Hanmi Bank) and owed IDOR $1.8 million in taxes. In the other case (Naperville), the debtor owed $4 million to the senior secured party (First Community Financial Bank) and $600,000 in taxes to IDOR. In each case, the debtor’s property was sold in a free-and-clear sale under § 363(f), with the sale price yielding far less than owed the senior creditor—$5.2 million in Elk Grove (where the bank was owed $14 million), and $2 million in Naperville (where the bank was owed $4 million). Thus, if all sales proceeds were distributed to the senior secured creditor in accordance with the priority ranking the creditors had against the debtors, nothing would be left for the IDOR tax claims.
In each case, IDOR argued that the Illinois Bulk Sales Provisions that imposed successor liability against the purchasers entitled it to recover the full amount of the taxes owed by the selling debtors from the proceeds of the bankruptcy sale. Technically, IDOR’s argument was that the successor liability claim was an “interest” in property that was entitled to “adequate protection” in the bankruptcy sale. The bankruptcy judges, though, ruled against IDOR, concluding that even if its successor liability claim were found to be an “interest” in property entitled to adequate protection, the measure of IDOR’s adequate protection was $0, since it ranked behind the underwater senior creditors. That is, IDOR’s interest had not declined in value due to the free-and-clear sale order, since the senior banks already were entitled to everything and ranked ahead of IDOR. The district judges in each case reversed and remanded, concluding that IDOR’s right to pursue the purchaser might have had value, and asked the bankruptcy judges to assess what IDOR might have recovered if there had not been a free-and-clear sale, and how IDOR might be compensated for that value. Again, though, the bankruptcy judges ruled against IDOR, reasoning that the realizable value of the successor liability claim again was zero, given the priority of the underwater senior lenders.
The Seventh Circuit first explained that it would assume without deciding that IDOR’s authority to impose successor liability on bulk sale purchasers was an “interest” in the debtor’s property which would be covered by § 363. It did so because no party had seriously contested the issue in the lower courts. Note, though, that it is far from clear that a successor liability right is in fact such an “interest”; the case law runs both ways.
Therefore, the bankruptcy courts were required to determine the extent of the reduction of the value of IDOR’s interest as a result of the free-and-clear sale of the properties. Under the Bulk Sales Provisions, IDOR is entitled to demand that funds from a bulk sale be set aside to satisfy the delinquent tax obligations of the seller. In the event the purchaser does not comply with this demand, IDOR is also empowered to seek recovery of the seller’s unpaid tax liabilities from the purchaser of the bulk assets. However, even though the Seventh Circuit agreed that IDOR had some right to recover for giving up its interest (i.e., its right to assert successor liability against the purchaser) in the free-and-clear sale, the question before the court was how to value that interest and its concomitant decrease due to the free-and-clear sale.
The Seventh Circuit was also sensitive to the issues that were presented by IDOR’s asserted claim on a portion of the sale proceeds when its claim as to the debtors’ assets was subordinate to the claim of other creditors, particularly where, as here, the senior secured creditor was underwater. However, and most significantly, the court nevertheless determined that IDOR’s right to look beyond the debtors’ assets and seek payment from the purchaser via successor liability potentially entitled it to some recovery, even at the expense of more senior creditors. That reasoning seems dubious, though, given that the issue is the relative entitlement inter se of the creditors of the debtor to receive proceeds from the sale of the debtor’s assets.
In order to determine what this recovery would be, the Seventh Circuit looked to the reality of bulk sale transactions, particularly in situations where the senior secured creditor was undersecured. The court acknowledged that there are a myriad of ways a purchaser might protect itself from tax liability to IDOR, including seeking indemnity from the seller for the taxes, demanding a lower purchase price to account for the liability, or creating an earmarked portion of the purchase price to be used for tax payments. But all of those methods reduce the payout to the senior creditor, and give a share to IDOR. Yet, the parties also acknowledged that if an underwater secured creditor foreclosed on the property, the Bulk Sales Provisions would not apply, and IDOR would get nothing. But in a foreclosure, the proceeds likely would be less for the senior creditor than in a free-and-clear bankruptcy sale. The court thus surmised that each side—the senior secured party, on the one hand, and IDOR, on the other—would have a means of leverage to reduce the payout to the other. In a sense, it is almost like the old game of chicken; another analogy would be to the prisoner’s dilemma game theory conundrum.
Given the respective rights of all parties, the Seventh Circuit determined that the most likely outcome was that the IDOR and the purchaser would settle: that is, they would negotiate for some portion of the sale proceeds to be paid for the taxes, but likely for less than 100 percent of the total tax liability owed to IDOR. Here, and fatally, IDOR had failed to present any evidence supporting the value of its interest that should have been protected. Because it did not provide adequate evidence, the Seventh Circuit affirmed the judgment of the bankruptcy court that the interest had no value. But it opened a Pandora’s box in speculating that a junior creditor, such as IDOR, even had a potentially valuable and protectable interest in a free-and-clear sale, even when the senior creditor was underwater.
The critical point of the Hanmi Bank decision is that it creates the specter of new and unprecedented leverage for out-of-the-money junior creditors to demand a share of the proceeds of a free-and-clear bankruptcy sale under § 363(f), even where the senior creditor is underwater. The court’s opinion could be read to apply narrowly only in situations where the junior creditor enjoys a successor liability claim against the purchaser at the sale. But such a narrow reading may not carry the day. Parts of the court’s reasoning suggest, firstly, that the § 363(f) free-and-clear sale itself generates an enhanced value, and, secondly—and this is the critical leap—that the senior creditor is not necessarily entitled to enjoy all of the enhanced value until its claim is paid in full. The baseline assumptions of the court are that a purchaser might pay more in a § 363(f) sale, and that the extra money should perhaps be allocated at least in part to junior parties.
So, for example, assume that a junior creditor (even one not enjoying a right to successor liability) offers credible expert testimony that the purchaser at a § 363(f) sale would pay $500,000 to acquire the debtor’s assets free and clear of all claims and interests, but that the same property would fetch only $400,000 in a foreclosure. In the real world, such an assumption is not farfetched; there are many aspects of a bankruptcy free-and-clear sale that are extremely attractive to purchasers. Assume that the senior creditor’s claim is $600,000 (and thus is underwater). Who should get the $100,000 incremental value? While the senior creditor could have foreclosed and eliminated the junior claims, it would have only gotten $400,000 had it done so. The larger $500,000 payout is possible only because of the legal operation of § 363(f). The Hanmi Bank decision offers junior creditors an opening to argue that they, too, should share in the incremental bounty attributable to the free-and-clear bankruptcy sale.
At the very least, the Hanmi Bank decision makes § 363 sales more uncertain and costly, which draws out the bankruptcy process and may reduce recoveries to other classes of creditors. Certainly in cases where a junior creditor has successor liability rights against the purchaser, such as where there are significant tax liabilities, a bankruptcy sale becomes much more problematic. It is also likely that the Seventh Circuit’s decision may discourage prospective debtors from filing a bankruptcy case in the Seventh Circuit in cases where the senior lender is underwater and a sale is potentially contemplated. In the final analysis, Hanmi Bank is very unwelcome news for senior secured creditors, but offers an unexpected ray of hope to junior creditors.