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  • Writer's picturePaul Peter Nicolai

Bankruptcy Shield - Important Section 363 Protections

Updated: May 10, 2022

A Delaware bankruptcy judge reminded potential buyers or acquirers of assets from a distressed entity they have important protections. The judge highlighted the protection afforded to buyers who purchase assets under Section 363(f) of the Bankruptcy Code.

Before the debtor filed for bankruptcy in late 2020, it negotiated and accepted a purchase and sale agreement to sell its leasehold interest to a historic hotel and event space. Under the agreement, the buyer would purchase the 50-year leasehold interest for $5.25 million. The agreement was subject to the consent of the debtor’s secured lender. While the property owner consented, the buyer could not obtain permission from Goldman Sachs. Before the deal between could close, the debtor filed for bankruptcy.

The buyer tried to buy the leasehold interest at an auction conducted under the Bankruptcy Code with a $5.3 million bid. It was unsuccessful when the debtors canceled the auction after deciding the buyer was not qualified under the bidding procedures order. The buyer later objected to the debtor’s reorganization plan, saying the secured lender was interested in acquiring the leasehold interest before withholding their consent to the purchase and sale agreement. Ultimately, the secured lender acquired the leasehold interest under the confirmed plan.

The rejected buyer filed suit in state court, alleging it improperly used its position as a secured lender to withhold its consent to the purchase and sale agreement and prevented the buyer from acquiring the leasehold interest before the bankruptcy filing. The lender sought relief from the bankruptcy court by filing a motion that said the Tennessee suit was an impermissible collateral attack on the confirmation order.

The bankruptcy court disagreed, pointing out that, while the plan contemplated a sale under Section 363 could occur, the debtor never conducted one. Thus, the lender was not protected from lawsuits that arose prepetition related to the asset.

This highlights the critical protections given to a purchaser in a Section 363 sale, namely the freedom from prepetition claims that come with purchasing assets “free and clear” under Section 363 of the Bankruptcy Code.

Under Section 363(f), the trustee or debtor-in-possession may sell property free and clear of interests, liens, and encumbrances if one of a series of conditions is met. A Section 363 sale benefits both a debtor and a buyer. The debtor benefits from the expedited pace of Section 363 sales. This accelerated timeline allows debtors to quickly dispose of assets that may otherwise sit idle, depreciate, or require expensive upkeep. Section 363 sales benefit debtors by encouraging a higher price for assets that may be less marketable due to unknown or unasserted claims against the support by allowing the debtor to sell such assets free and clear.

It is also beneficial to a purchaser to acquire an asset free and clear of any interests and the risk of legacy obligations. Bankruptcy courts have held that a wide range of situations qualifies as an interest within Section 363(f). After the sale, if a third party attempts to enforce its lien, encumbrance, or claim against the buyer, the buyer can use the shield of Section 363 and seek relief in the bankruptcy court that issued the sale order.

A Section 363 sale effectively puts the entire world on notice, including nonparties, while a sale or transfer under a confirmation order does not give the world the same information and does not have the same shield. By transferring its interest under the confirmation order instead of conducting a Section 363 sale, the lender took the interest subject to liens and encumbrances and was vulnerable to suit.

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