Corinne Ball
Corinne Ball ()

The U.S. Court of Appeals for the Sixth Circuit recently reviewed the scope of and standard for applying §363(m) of the Bankruptcy Code, which is the statutory mootness rule protecting §363 sales. The Sixth Circuit’s analysis began with the following principles: (1) the “mootness rule” applies “regardless of the merits of legal arguments raised against” the bankruptcy court’s order and (2) functions to “encourage participation in bankruptcy asset sales and increase the value of the property of the estate by protecting good faith purchasers from modification by an appeals court of the bargain struck with the [bankrupt].” Brown v. Ellmann (In re Brown), 851 F. 3d 619 (6th Cir. 2017) (quoting In re Nashville Senior Living, 620 F. 3d 548, 591(6th Cir. 2010)).

Asset sales pursuant to §363 of the Bankruptcy Code are prevalent in bankruptcy proceedings whether to fund the reorganization by disposing of undesired assets or to sell substantially all of the assets on a going concern basis outside of a plan, often on a notably faster schedule. In addition to speed, §363 sales are attractive because they are insulated from appeal by the statutory mootness rule, which essentially establishes finality for such sale orders. In contrast, bankruptcy court orders confirming a plan may be protected from appeal only by equitable mootness, which can be more complicated. In the absence of a stay pending appeal, §363(m) prohibits reversal or modification of a sale so long as the purchaser acted in good faith. Indeed, most circuits construe §363(m) as creating a “per se” rule automatically mooting appeals. In contrast, in Brown the Sixth Circuit joins the Third and Tenth Circuits in requiring, as an additional element for statutory mootness, a determination that the reviewing court is unable to “grant effective relief without impacting the validity of the sale.” The inquiry then focuses on whether it is possible to fashion relief in a manner that would not disturb the bargain struck with the good faith purchaser.

In a related decision coming out of the U.S. Court of Appeals for the Second Circuit last week, the court vacated an order dismissing an action brought against debtor’s counsel by unsuccessful bidders at a §363 sale, rejecting the defendants’ arguments of mootness and res judicata, both of which were premised, in part, on the need for finality in bankruptcy court orders, especially sale orders. Brown Media v. K&L Gates, No. 15-4185-cv, 2017 U.S. App. LEXIS 6481, at *6 (2d Cir. Apr. 14, 2017).

‘In re Brown’

Brown involved an objection by an individual Chapter 7 debtor to the sale of her residence by her bankruptcy trustee. Although the property was subject to liens in excess of the sales price, the individual debtor objected seeking to exempt the value of her redemption rights. Initially, Brown intended to surrender her residence to the bankruptcy estate, and thus she did not claim any exemptions for the value of her redemption rights under Michigan law. She received a bankruptcy discharge in August 2014. When the trustee sought to sell the property, however, Brown objected, seeking to take advantage of the exemptions. The bankruptcy court approved the sale and the district court affirmed. Brown subsequently appealed to the Sixth Circuit, but she did not obtain a stay of the sale of the property pending the appellate review.

The Chapter 7 trustee argued, in part, that the court lacked jurisdiction to consider the appeal, because the case was moot on statutory grounds. The various provisions of the Bankruptcy Code have built in mootness mechanisms that extend beyond the customary mootness analysis under Article III’s “case or controversy” requirement. Section 363(m) of the Bankruptcy Code provides:

The reversal or modification on appeal of an authorization of a sale or lease of property does not affect the validity of a sale or lease under such authorization to an entity that purchased or leased such property in good faith, whether or not such entity knew of the pendency of the appeal, unless such authorization and such sale or lease were stayed pending appeal.

Sixth Circuit’s Decision

Until Brown’s appeal, the Sixth Circuit had not yet committed to either the “per se” approach to statutory mootness or the approach adopted by the Third and Tenth Circuits. Considering the issue in Brown’s case, however, the Sixth Circuit court adopted the latter approach, requiring parties alleging statutory mootness under §363(m) to prove that the reviewing court is unable to grant effective relief without affecting the validity of the sale. The court deemed it a superior interpretation of §363(m) as “it accommodates the provision’s clear preference in favor of upholding the validity of bankruptcy sales without unduly restricting the appellant’s right to contest errors of law made by the bankruptcy court.” In the court’s view the plain reading of §363(m) did not permit a reviewing court to modify or set aside a sale of property, but did not prevent redistribution of the proceeds from the sale. Thus, the court believed that it could issue relief in compliance with the Bankruptcy Code that would not disturb the bargain struck with the good faith purchaser—whether by redistributing money still in escrow or by imposing a constructive trust on the proceeds of the sale.

‘Brown Media’

In Brown Media, the plaintiffs were the managers of a debtor, Brown Publishing, and an entity, Brown Media, formed for the managers to buy the assets of Brown Publishing. The managers had sought pre-bankruptcy counseling from defendants K&L Gates, discussing among other things, their ability to buy the assets of Brown Publishing in a §363 sale. Subsequently, defendants K&L Gates represented the debtor, Brown Publishing and pursued a §363 sale.

The plaintiffs arranged for financing and submitted a bid. Certain lenders, with whom K&L Gates purportedly also had a client relationship, submitted a competing credit bid. One of the lenders in the credit bid group was a mortgagee on the premises Brown Publishing leased from an affiliate of the plaintiffs. This lender, also allegedly a client of defendant K&L Gates, started a foreclosure action against the landlord Brown Media affiliate. The managers urged the debtor to enforce the automatic stay and stop the foreclosure before the auction. Nevertheless, allegedly upon the advice of defendants, the debtors went ahead with the auction, and selected the lenders’ proposal as the winning bid. Brown Media was the unsuccessful bidder in part because its financing failed due to the foreclosure action. Thereafter, the debtors enforced the automatic stay and stopped the foreclosure.

Following the sale and subsequent confirmation of Brown Publishing’s liquidation plan, Brown Media and its managers, as the unsuccessful bidders, sued K&L Gates in a separate action in the district court, alleging breach of fiduciary duty in (1) failing to secure a waiver of the conflict presented by their dual representation of plaintiffs and the debtors, (2) failure to disclose their client relationship with members of the lender group, including the lead lender and the bank foreclosing on the debtors’ premises, and (3) the misuse of confidential information obtained from managers during the K&L Gates’ representation of the managers to manipulate the bidding process to favor the lenders. In addition, the complaint alleged tortious interference with prospective economic advantage and fraud based on the defendants’ breach of duty to disclose potential conflicts of interest. The district court dismissed the action reasoning that the plaintiffs’ action was “so inextricably linked” to the underlying bankruptcy proceeding that the relief sought would require the court to “effectively overrule” the bankruptcy court and that any policy interest in allowing the plaintiffs to proceed with their action was “outweighed by the longstanding policy favoring the finality of sale orders issued by bankruptcy courts.” Plaintiffs appealed.

Second Circuit’s Decision

The Second Circuit reviewed elements of res judicata, noting at the outset, that the standard res judicata analysis can be an “awkward fit” when applied to bankruptcy proceedings. The court reasoned that unlike a typical lawsuit, where one party brings an action against another, a bankruptcy proceeding is a forum for multiple parties, to sort out how to allocate a debtor’s assets or value, confirming that the bankruptcy court’s foremost concern is maximizing the value of the debtor’s estate. The court determined that in a bankruptcy context, the court must assess “whether an independent judgment in a separate proceeding would impair, destroy, challenge or invalidate the enforceability or effectiveness of the reorganization plan” or the sale. The court further reasoned that it must also assess whether a new action seeks to bring claims that could have been raised and litigated within the scope of the bankruptcy proceeding. Although the plaintiff sought damages described as economic benefits attributable to the lost sale, the court concluded that because the complaint only alleged misconduct on the part of counsel, did not allege collusion among the debtor and the successful lender bidders, and did not seek relief against any parties in the bankruptcy, it was not incumbent on the plaintiffs to challenge the “good faith purchaser” status of the lender bidders in the bankruptcy court. In making that determination, the court rejected the argument that the plaintiffs’ claims are so “inextricably linked to the underlying bankruptcy proceeding that the relief … would require [the district court] to effectively overrule the bankruptcy orders.” The court concluded that a judgment against K&L Gates would have no effect on the continuing validity of the bankruptcy court’s order approving the sale … .”

Conclusion

Significantly, both decisions start with the dual premise that bankruptcy proceedings are “a forum where finality of court orders is particularly important,” In re Lawrence, 293 F. 3d. 615, 621 (2d Cir. 2002), and that a §363 sale “protects the reasonable expectations of good faith third-party purchasers by preventing the overturning of a completed sale,” Farmland Indus., 408 B.R. 497, 508-09 (B.A.P. 8th Cir. 2009). Nevertheless, the Sixth Circuit joins the Third and Tenth Circuits in adding a review element to the statutory mootness analysis—examining whether there is relief that does not disturb the sale to a good faith purchaser. For the Second Circuit, it means reviewing whether the subject action poses a threat to the finality of the bankruptcy court’s orders. The common thread is that the sale to the good faith purchaser is undisturbed and protected. Others, including counsel, are not.

The importance of finality of bankruptcy court orders has been confirmed once again. Statutory mootness protecting §363 sales may not prevent or preclude an appeal or subsequent lawsuit, but the good faith purchaser and the transfer nevertheless continue to be insulated from appellate relief or collateral attack. The extent of that protection to other parties is unclear. Finally, it is refreshing to see the understanding of the difference between a typical lawsuit and a bankruptcy as it applies to finality, preclusive effect and res judicata, admonishing courts to take into account and scrutinize the “totality of the circumstances.” Had the defendant in the Brown Media case been the successful bidder, there may have been a different result.