Introduction
A recent decision from the U.S. Court of Appeals for the Seventh Circuit provides insight into the pitfalls that can befall a buyer of assets in a bankruptcy if it is not found to be a “good faith” purchaser under section 363(m) of the Bankruptcy Code. On April 4, 2022, many years after a bankruptcy sale closed, the Seventh Circuit ruled that a buyer who purchased assets of a debtor in bankruptcy under section 363 of the Bankruptcy Code did not purchase in good faith because it had actual and constructive knowledge of a competing interest in the property held by a party that did not receive proper notice of the bankruptcy or the sale and that the buyer nevertheless allowed the sale to proceed without ensuring that the bankruptcy judge was aware of the competing interest held by a party excluded from the bankruptcy case. As a result, the buyer was not entitled to the protections of section 363(m) when it sought to resell the property and the bankruptcy court refused to intervene and stop the state court litigation commenced by the holder of the competing interest against the buyer. The Seventh Circuit opinion underscores the importance of proper due diligence, adherence to the notice requirements under the Bankruptcy Code, and disclosure to the bankruptcy court of any known competing interests of which the buyer seeks to take title free and clear.
Significance of Section 363(m) of the Bankruptcy Code
Section 363(m) of the Bankruptcy Code provides that a sale to a “good faith” purchaser authorized under section 363(b) or (c) of the Bankruptcy Code cannot be reversed or modified on appeal, unless such sale was stayed pending appeal. A finding by a bankruptcy court that a buyer is a good faith purchaser under section 363(m) provides a strong protection and certainty for buyers of assets in a bankruptcy because it effectively renders most challenges to a sale after it closes as statutorily moot.
Seventh Circuit Decision
On April 4, 2022, the Seventh Circuit affirmed a bankruptcy court and district court ruling that a buyer was not a good faith purchaser of certain assets purchased in a bankruptcy sale. The decision relates back to the buyer’s purchase of property in a bankruptcy sale consummated in August 2011. The 2011 order approving that sale provided that the buyer took title to the property free and clear of any encumbrances not specified in the sale order and that the buyer was a good faith purchaser under section 363(m). The buyer then owned and operated the property for more than four years, until October 2015, when it entered into discussions to sell the property. Upon learning of the sale discussions, a third party filed a state court action seeking to challenge the buyer’s sale of the property by asserting a right of first refusal that predated the 2011 sale of the property to the buyer. The buyer responded by filing a motion in the bankruptcy court asking the court to enforce the free and clear nature of the sale and stop the third party’s state court litigation on the grounds that the buyer was a good faith purchaser entitled to the protections of section 363(m) of the Bankruptcy Code. The bankruptcy court denied the request even though the third party never filed an objection to the sale years earlier when the sale was first approved by the bankruptcy court. On appeal, the district court affirmed the bankruptcy court decision. The Seventh Circuit also affirmed the prior rulings. Why? First, the Seventh Circuit found that the buyer had constructive knowledge of the third party’s right of first refusal because the right was recorded in the relevant real estate records and had actual knowledge of the right because it had received a title search report showing the right. Second, upon a close review of the record, the bankruptcy court learned that the third party did not have sufficient notice of the sale for its right to be extinguished – indeed it did not receive formal notice of the bankruptcy or the sale and thus could not have been expected to appeal the bankruptcy court’s order purporting to sell free and clear of all interests, including the right of first refusal. And, third, notwithstanding the buyer’s knowledge of the third party’s right of first refusal, the buyer did not take steps to ensure that the bankruptcy court was made aware of the right of first refusal and that it was held by a party that had been excluded from the bankruptcy case. The Seventh Circuit agreed with the bankruptcy court that this was unacceptable. Consequently, the buyer was no longer considered a good faith purchaser and was not protected by section 363(m) of the Bankruptcy Code. As a result, even though more than a decade had passed since the sale, the Seventh Circuit ruled that the buyer must defend its right to the property acquired through the sale against the third party’s claims.
Key Takeaways
The Seventh Circuit’s decision serves as a warning to buyers on the importance of being proactive to ensure that parties with known competing interests in the sale assets receive proper notice of the sale or, at a minimum, that the court is made aware that the buyer seeks to buy free and clear of a known interest held by a party who did not receive formal notice of the bankruptcy. Staying quiet and hoping nobody notices can come back to haunt the buyer – sometimes years later – and may result in the bankruptcy court revisiting its original finding that the buyer was a good faith purchaser under section 363(m). Below are a few additional takeaways.
- First, buyers should conduct comprehensive due diligence so they are informed of any interests existing in the property being purchased.
- Second, buyers should ensure that any party holding such an interest receives proper notice in accordance with the Bankruptcy Code and relevant bankruptcy rules. While the debtor is usually the party tasked with providing creditors and parties in interest with notice of the bankruptcy and sale, it is critical for the buyer to be proactive and involved in the notice process so as to ensure that the right parties received the proper notice – as the buyer is likely to be the party that bears the consequences of improper notice, which can sometimes rear its ugly head years after the sale is consummated as evidenced by the Seventh Circuit’s recent decision. While this case focused on the buyer’s ability to rely on being a good faith purchaser under section 363(m), as a practical matter, proper notice to parties holding interests in the property is required to ensure that the buyer acquires the property free and clear of any such interests and that the holder of the competing interest received due process.
- Buyers should also ensure that any known interests in the property being purchased have been disclosed to the court – especially if the known party with such an interest did not receive notice of the bankruptcy and sale for some reason. If the debtor has not disclosed this to the court, then the buyer has a responsibility to do so itself. If the court is made aware of such an interest by some other party, the court may find that the failure to disclose precludes the buyer from being found to be a good faith purchaser in the first instance or may lead a court to revisit a previous finding of good faith.
- Finally, while the buyer’s failure to disclose would likely have been fatal to its good faith finding regardless of how extensive the findings in the sale order were, it should be noted that the original findings were not particularly robust or detailed in this instance. Having robust and detailed factual findings on the buyer’s good faith conduct to support the good faith finding is recommended as it can often be a powerful weapon against any future challenge to the buyer’s status as a good faith purchaser.
