Distressed asset purchasers should be aware of a recent decision, In re Marko, in which the bankruptcy court for the Western District of North Carolina called into question a trustee’s ability to sell estate assets free and clear of certain claims and interests, including claims and interests held against co-owners of the target assets.
The dispute in that case centered on a lake house property that was co-owned by the debtors, Bruce and Elizabeth Marko, and Mr. Marko’s parents by joint tenancy. At the petition date, the property was subject to a secured mortgage debt of approximately $1.4 million.
Prior to the commencement of the bankruptcy case, the property was offered for sale through a South Carolina auction house. It was unclear whether the sale was authorized by all of the owners and whether an absolute sale was authorized. The auction, however, proceeded, and a successful bidder was selected with a winning bid of $650,000, significantly less than the outstanding mortgage debt. When the owners failed to appear at the closing to convey title, the putative purchaser commenced a suit against the co-owners, the auctioneer, and the mortgage lender in South Carolina state court seeking a variety of relief, including specific performance of his auction contract. To complicate matters, a short time later, the mortgage lender commenced a foreclosure action against the property.
The debtors, thereafter, commenced their chapter 7 bankruptcy case, staying both the foreclosure and the putative purchaser’s state court action. All parties agreed that there was no equity in the property to benefit creditors or the debtors.
After a number of previous attempts failed to recognize any value for the estate on account of the property, the trustee filed a motion seeking authority, pursuant to sections 363(b), (f), and (h), to sell the property to a third party for $1.0 million, free and clear of all liens and interests, including the putative purchaser’s specific performance and equitable lien claims. In addition, the secured lender that now held the mortgage debt agreed to carve out $75,000 from the closing proceeds for the benefit of the estate. As an alternative to the sale, the trustee also filed a motion seeking authority to abandon the estate’s interest in the property on the basis of a lack of equity and a desire to avoid continuing expense and liability for the same.
In the sale motion, the trustee proposed to sell not just the debtors’ one-half interest in the property but also the interests of the parents, pursuant to sections 363(f)(2) and 363(h) of the Bankruptcy Code, both of whom had consented to the sale. With respect to other claim or lien holders, the trustee had the consent of the secured lender as required by section 363(f)(2). With respect to the putative purchaser, however, the trustee asserted that his interests in the property were in “bona fide dispute” and, therefore, the trustee was permitted, pursuant to section 363(f)(4), to sell the property, including the non-debtors’ ownership interests, free and clear of the putative purchaser’s alleged interests. The putative purchaser objected arguing, among other things, that the sale would deny him the relief he was seeking in the South Carolina state court action, namely the right to have the property deeded to him by specific performance.
Section 363(b) permits a trustee, after notice and a hearing, to use, sell, or lease property of the estate outside the ordinary course of the debtor’s business. Section 363(f)(4) provides that the trustee may sell property “free and clear of any interest in such property” if “such interest is in bona fide dispute. . . .” Section 363(h) allows a trustee, in certain circumstances, to sell both the estate’s interests and “the interests of any co-owner in property in which the debtor had, at the time of the commencement of the case, an undivided interests as a tenant in common, joint tenant, or tenant by the entirety. . . .”
Although the court conceded that the putative purchaser’s interests were in bona fide dispute, the court ultimately denied the sale motion, focusing instead on, and calling into question, the trustee’s ability to use section 363(f)(4) in connection with the provisions of section 363(h) to sell the non-debtor, co-owners’ interests free and clear of the putative purchaser’s claims.
After briefly examining the limited and conflicting case authority on point, the court, citing the Eighth Circuit opinion in Missouri v. Bankr. E.D. Ark. held that courts should “use the free and clear power with caution — meaning they should carefully consider their jurisdictional limitations — when the bona fide dispute concerns only the rights of third parties vis à vis one another and is not a dispute with the debtor.”
The court held that because the parent co-owners could not have effectuated a sale free and clear of the putative purchaser’s claims under state law, a ruling in favor of the trustee would, effectively, extend bankruptcy relief to those non-debtor parties. Accordingly, the court found the trustee’s ability to use section 363(f)(4) in conjunction with section 363(h) to sell property free of disputed liens on co-owners’ interests questionable.
The court then went on to state that, even if such a power did exist, it should not be exercised based on the facts presented. In support of its decision to deny the trustee’s motion, the court first took note of the fact that there was no equity in the property and the Bankruptcy Code generally contemplates that over encumbered property should not be sold. The court also dismissed the argument that the sale proponents had manufactured $75,000 of equity via the carve-out in light of the legal quandaries and the parties’ demonstrated propensities to litigate. The court then went on to state that a ruling in favor of the trustee would interfere with and change the course of the South Carolina state court action and, with no equity and multiple non-debtor parties, the state court action had the greater interest. The court further noted that a sale would eliminate the putative purchaser’s prospective remedy of specific performance and limit his potential recovery in that action. Finally, the court held that judicial economy dictated that it deny the sale motion and defer to the state court action. Accordingly, the court denied the sale motion and granted the trustee’s abandonment motion.
Although the outcome may have been different if there had been equity in the property for creditors, the decision does cloud the ability of parties to purchase distressed assets in bankruptcy free and clear of all interests, including claims and interests against co-owners. Potential purchasers of distressed assets should take care to identify all potential claims that may impact their target assets, including those held against non-debtor co-owners, before proceeding with any distressed asset sale.
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