Restructuring

Going, going, gone.  Most people might associate those words with fine art, not bankruptcy.  But in In re 388 Route 22 Readington Holdings, LLC, the question arose: is value reflected by an active, non-collusive auction, while not dispositive, strong evidence of fair value under section 363(b) of the Bankruptcy Code?  The United States Bankruptcy Court for the District of New Jersey (the “Bankruptcy Court”) answered this question affirmatively, the United States District Court for the District of New Jersey (the “District Court”) agreed, and so too did the United States Court of Appeals for the Third Circuit (the “Third Circuit”) in a recent unpublished decision No. 20-2629, 2021 WL 4811409 (3d Cir. Oct. 15, 2021).

Factual Background and Procedural History

The story goes like this.  The debtor, 388 Route 22 Readington Holdings, LLC (the “Debtor”), owned a parcel of real property.  In 2011, a creditor obtained a foreclosure judgement (“Creditor”) against the Debtor and the Debtor filed for chapter 11 to avoid foreclosure.  The Debtor and Creditor agreed to a payment plan, but that plan was short-lived.  In 2018, the Debtor again filed for chapter 11, and the Court converted the case to a chapter 7 liquidation, allowing the Creditor to foreclose on the Debtor’s property.  The Creditor stayed foreclosure until September 2019, requiring the chapter 7 trustee (“Trustee”) to sell the Debtor’s property by that time.

The Trustee marketed the property and received just one offer: $5 million, with strings attached.  Specifically, the buyer could cancel for any reason or none at all, and would have a diligence period that would push the sale until after the end of the creditor’s foreclosure stay.  The offer was further contingent upon (1) positive resolution of litigation to access the public sewer system; and (2) receipt of a zoning ordinance exemption to allow for non-conforming use of the property.

Finding the contingencies unworkable, the Trustee would have none of it.  Instead, in 2019, Trustee and Creditor held an active, competitive auction with twenty-two prospective buyers and fifteen bidders, resulting in one winner for a price of $3.2 million.  The winning bid was sufficient to pay the Creditor in full and cover all claims against the Debtor’s bankruptcy estate, while distributing over $100,000 to the Debtor’s sole owner (the “Shareholder Appellant”).  The Bankruptcy Court approved the sale.  

Preferring the greater distribution that could have resulted from the initial $5 million offer, the Shareholder Appellant maintained the $3.2 million auction sale price was inadequate and made multiple attempts to unwind the auction sale.  The Shareholder Appellant first requested a stay of the sale, but the Bankruptcy Court, District Court, and Third Circuit each rejected the request and the Bankruptcy Court entered a sale order.  The Shareholder Appellant then appealed the sale order to the District Court, which dismissed the appeal as moot under section 363(m) of the Bankruptcy Code.  Finally, the Shareholder Appellant appealed to the Third Circuit.

Legal Analysis

Section 363(b) of the Bankruptcy Code permits a trustee (or debtor in possession) to sell property of a bankruptcy estate.  Section 363(m) of the Bankruptcy Code, in turn, promotes finality of bankruptcy sales by mooting challenges to good faith sales under a two-part test.  In the Third Circuit, that’s if: “(1) the underlying sale … was not stayed pending the appeal, and (2) the court, if reversing or modifying the authorization to sell, … would be affecting the validity of such a sale or lease.”  However, before applying that test, the court must first determine whether the buyer purchased the property “in good faith,” for “appropriate value.”

The Third Circuit held that the results of a non-collusive auction do not conclusively establish fair value, but they can strongly evince it.  And in this instance, they did.  The Trustee’s auction was “properly advertised” and “actively participated in.”  The Third Circuit further noted the lack of irregularity, the high quantity of qualified bidders, and the property’s sale price approximately 40% above its previously assessed value.  It further noted the absence of any allegation of collusion.  The Third Circuit held such facts allowed the District Court to conclude that the auction was strong evidence the purchaser paid fair value.

The Shareholder Appellant did not identify any reason that this conclusion was incorrect.  Instead, it argued that the $5 million offer was a better one, and that the Bankruptcy Court should have heard further evidence.  The Third Circuit refocused the inquiry: it is not whether there is a better offer on the table, but whether the one under scrutiny is for fair value.  One offer can be useful to assessing the fairness of another, but only when that offer is itself fair; the $5 million offer was anything but.  It was illusory, and “contain[ed] two substantial, perhaps insurmountable, contingencies” (resolving litigation and obtaining an ordinance exemption).  The auction, on the other hand, accurately described the property’s sewer access and had adequate advertising.  There was sufficient evidence for the Bankruptcy Court to conclude that the property sold for fair value at auction without having to hear additional evidence.

Conclusion and Takeaways

Value maximization sits at the heart of the Bankruptcy Code.  Section 363(m) espouses this objective by protecting the finality of sales.  It does so by mooting any challenge to a section 363 sale so long as the purchaser acted in good faith and the appellant failed to obtain a stay.  This encourages the participation of buyers in bankruptcy auctions by assuring them that an appellate court will not modify a deal consummated with a debtor or bankruptcy trustee.  

Increased participation begets increased demand, giving way to higher offers and thereby maximizing value.  At bottom, In re: 388 Route 22 Readington Holdings LLC demonstrates the Third Circuit’s commitment to that end.  The lynchpin of a valid bankruptcy sale is fair value.  By holding that an active, non-collusive auction, while not dispositive, provides strong evidence of fair value under section 363(b) of the Bankruptcy Code, the Third Circuit confirmed its reluctance to set aside the results of bankruptcy sales, lest they deter would-be bidders from participating in bankruptcy auctions.  In strong endorsement of the auctioneer in a bankruptcy sale bringing down the hammer, the Third Circuit did so itself.            

This result, of course, should not be surprising to our readers – we have written often on the strong clear power of section 363(m) (statutory mootness of bankruptcy sales), including how buyers can best ensure they gain section 363 (m) protection (see here).