What happens in a bankruptcy Section 363 sale when the sale is subject to an existing lien and the existing lien has a due-on-sale clause? Is there a basis to eliminate the due-on-sale clause under state law? Does the fact that the sale occurred pursuant to Section 363 somehow eliminate the due-on-sale clause? Buyers beware: At least two courts have held that a due-on-sale clause is enforceable in a bankruptcy “363″ sale.

Section 363 of the Bankruptcy Code is a very useful provision that enables debtors (and trustees) to quickly monetize assets. Purchasers like to acquire assets via a 363 sale for the perceived, if not actual, benefit of obtaining assets “on the cheap.” Oftentimes the sale is “free and clear” of all liens, claims, and encumbrances; but on occasion, the sale will be subject to an existing lien.

When the sale is subject to an existing lien, any potential buyer who hopes to acquire the assets subject to an existing lien with the intent of simply continuing to make regular payments must carefully review the existing loan documents. In particular, the potential buyer should confirm, among other things, whether the loan documents provide that the transfer of the collateral to another without the lender’s consent would be a default, or upon default the balance due on each note could be accelerated, or on the occasion of a default and a failure to pay the accelerated balance, the lender could utilize its repossession remedies. If the existing loan documents contain these provisions, known as a “due-on-sale clause,” and the issues are not addressed pre-closing, the potential buyer could acquire the assets only to find out that the full balance owed under the loan is immediately due once the sale on the assets occurs.

— Outside of bankruptcy it is clear that, as a general rule, due-on-sale clauses are enforceable. As noted by Hogan, Pitfalls in Default Procedure, 2 U.C.C.L.J. 244 (1970), and followed as black letter law by the courts:

Some people have suggested that Section [9-311] prohibits you from using a transfer of the collateral as the basis of a default. I think that thus far neither the statute nor the cases (footnote omitted) support that conclusion. Section 9-311 merely preserves the interest of the transferee. [For example] [i]f the debtor sells the car, the transferee gets whatever the debtor had. Yet the sale can still be a default. * * *.

— As a general proposition, nonbankruptcy rights are to be honored unless a specific bankruptcy provision or policy requires differently. As noted by the U.S. Supreme Court in the Stern v. Marshall, “Property interests are created and defined by state law” and “unless some federal interest requires a different result there is no reason why such interest should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding.” The burden to show that applicable state law is overridden by bankruptcy law or policy is on the one who asserts that position.

— In In re Anthony’s Restaurant, Inc. (a bankruptcy case from the Eastern District of Pennsylvania) the debtor sought to convey its assets to a proposed purchaser in a 363 sale “under and subject to the first mortgage,” rather than free and clear of liens as originally proposed. The first mortgagee objected to the sale “subject to the first mortgage” on the basis that the due-on-sale clause contained in its mortgage authorized the mortgagee to immediately declare due and payable all sums due under the mortgage if the debtor sold the assets without the mortgagee’s consent.

In support of the proposition that there was no identifiable federal interest that would override state law enforcing due-on-sale clauses, the bankruptcy court in Anthony’s Restaurant found that (1) the 363 sale would not further the debtor’s reorganization; (2) the debtor would not be receiving any of the sale proceeds so the sale did not implicate the debtor’s “fresh start,” and (3) the due-on-sale clause was distinctly different from a forfeiture or bankruptcy default clause.

— The bankruptcy court in In re Evans Oil, LLC (a bankruptcy case from the Middle District of Florida) agreed with the analysis in Anthony’s Restaurant, holding that there was no identifiable federal interest that would require the court to treat the lien any differently in the bankruptcy context than under state law, and therefore, the due-on-sale clause was enforceable.

If a prospective buyer of a bankruptcy debtor’s assets desires to assume the debtor’s liability and continue under the terms of the existing note and security agreement (or mortgage), it should first negotiate for such concessions with the lienholder.

If it does not, it proceeds at its own peril.