The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), analyzing a recent decision of interest:
The Fifth Circuit Court of Appeals (the Court) recently found that a lender to a developer which had accelerated its loan and then made a deal with the developer to transfer the property to the lender’s affiliate was entitled to make a credit bid for a sale free and clear of liens in the affiliate’s chapter 11 proceeding. Over a challenge from a junior lien holder, the Court determined that the lender was a good faith purchaser and therefore the appeal was statutorily moot under Bankruptcy Code § 363(m) since no stay had been obtained. Matter of RE Palm Springs II, L.L.C., 65 F.4th 752 (5th Cir. 2023).
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Palm Springs, LLC was the owner and developer of real property in Palm Springs, California, upon which it intended to construct a hotel. It contracted with SR Construction (SR) as general contractor on the project in 2015. In 2016 it financed the construction with a loan from Hall Palm Springs, LLC (the Lender), entering into a subordination under which the deed of trust from the Lender would be superior to any lien asserted by SR. In 2019 Palm Springs LLC terminated its contract with SR, owing it more than $14 million. Soon thereafter, it defaulted on the construction loan and the Lender accelerated the loan. SR then recorded a mechanic’s lien against the property. Soon thereafter, SR initiated a mechanic’s lien foreclosure action in California state court.
The Lender formed an affiliate, known here as RE Palm Springs II, LLC (RE Palm Springs), and worked out an arrangement in lieu of foreclosure with Palm Springs, LLC under which RE Palm Springs acquired title to the property in exchange for a release of Palm Springs, LLC of liability on the project as well as 50% of the net profits. In 2020 RE Palm Springs filed chapter 11 in the Northern District of Texas. The bankruptcy court approved the retention of r2 Advisors (r2) as a restructuring organization, approved bidding and sale procedures for a proposed sale of the property, and approved a debtor-in-possession loan from the Lender. Although there were many interested buyers, only the stalking horse presented a bid which was consistent with the sale procedures, but it backed out by failing to make the required deposit. At that time, the Lender requested permission from the bankruptcy court to make a credit bid on the property under § 363(k), which was granted, over the objection of SR. After further hearings, the bankruptcy found that the Lender was a good faith purchaser and approved the sale of the property, free and clear of all liens including that of SR. At the conclusion of the rulings, SR asked the bankruptcy court for a stay pending appeal, which was denied.
SR appealed to the district court, which affirmed that the Lender was a good faith purchaser and therefore the provisions of § 363(m) applied; the appeal was dismissed as moot. SR further appealed to the Court, which also concluded that the Lender was a good faith purchaser and affirmed the dismissal of the appeal.
Section 363(m) of the Bankruptcy Code provides, as relevant here, that unless an order approving a sale of estate property is stayed pending appeal, no reversal or modification of the order may affect the validity of the sale. Since SR’s attempt to obtain a stay pending appeal had been denied, the crucial issue before the Court was whether the bankruptcy court’s determination that the Lender was a good faith purchaser was error. The Fifth Circuit, recognizing that the Bankruptcy Code does not define “good faith,” has used two paths to determine good faith: (1) the notice-based definition, wherein a good faith purchaser is one who purchases the assets for value and without notice of adverse claims, and (2) a conduct-based definition, where the purchaser has not engaged in misconduct including fraud, collusion in the sale process, or taking gross advantage of other potential bidders. The Court concluded that the Lender met both definitions.
SR argued that the Lender had notice of adverse claims based on the state court action to foreclose it mechanic’s lien, which if successful would have removed the property from the bankruptcy estate. After reviewing relevant authorities on what constituted a sufficient adverse claim, the Court concluded that to qualify, the claim must be a dispute in ownership interest. At most, SR was asserting a lien, which was not an assertion of an ownership interest. Therefore, the Lender’s knowledge of the state court action was not notice of a qualifying adverse claim.
SR also asserted that the Lender had engaged in misconduct by creating an affiliate to own the property, making the deal with the original owner/developer to transfer the property to the affiliate, and influencing the bidding process in the bankruptcy court such that the only viable bid was its credit bid. The Court rejected that any of those actions was misconduct or fraud. The agreement with the original owner in lieu of foreclosure granted adequate consideration to the defaulting party by relieving it of future liability and promising it 50% of any future net profits. The bankruptcy court approved the bidding procedures after a contested hearing, which resulted in active interest in the property. That no bidder other than the stalking horse submitted a qualifying offer and that the stalking horse never made the required deposit were not evidence of any misconduct by the Lender but rather the realities of the marketplace. As a consequence, the Court concluded that the Lender passed the conduct-based test as well and was a good faith purchaser. It dismissed the appeal as statutorily moot.
This published opinion has ample merit. First, it is an excellent review of the definition of good faith purchaser, as determined by Fifth Circuit precedent, with reliance on authorities from other circuits and the Supreme Court. Second, it shows that not all parties affiliated with a debtor who participate in a sale process are conflicted from being the successful bidder on a sale free and clear. The key here was the Lender’s disclosure of what it was doing at every step of the way, plus its use of the third-party restructuring organization, r2, to provide objectivity to the direction of the chapter 11. This transparency caused the bankruptcy court to recognize that all other potential buyers of the property had ample opportunity to participate in the bidding. The outcome was fair, driven by the marketplace, not collusion or fraud.
This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.