Even prior to the COVID-19 pandemic, most retail bankruptcy cases involved at least some effort to maximize value by selling real estate holdings. The Bon Ton Stores, Forever 21, Sears, and Toys ‘R’ Us cases, among others, are perfect examples. These cases have, for the most part, achieved such sales under section 363(f) of the Bankruptcy Code with minimal resistance, typically on expedited time-frames. The lingering impact of the pandemic will likely continue to cause more distress to retail real estate owners who have seen dwindling revenues as a result of shut downs, capacity restrictions as well as government-mandated rent deferrals. Indeed retail real estate has been one of the hardest hit markets by the COVID pandemic. This unprecedented revenue depletion will undoubtedly pose new and significant challenges to debtors seeking approval of real property sales free and clear of liens under section 363(f); decreased revenues often correlate directly with decreases in collateral value, which often falls below that of the secured debt. Therefore, depending on a particular court’s interpretation of section 363(f), the ability to sell property free and clear may become more challenging.
Starting with the accepted premise that debtors are bound by their fiduciary duties to maximum the return to the estate, questions arise as to how this applies where the estate’s most valuable asset, its real property, is over encumbered by pre-petition liens. The answer seems to vary based on what hat you are wearing, be it estate fiduciary or secured creditor.
Section 363(f) contains five separate grounds for a trustee to sell property free and clear of interests. Because the grounds are listed disjunctively, a debtor need only satisfy one ground with respect to each interest to sell the property free and clear of that interest. For security interests on depreciated property, section 363(f)(3) is usually the biggest hurdle.
Section 363(f)(3) permits a sale free and clear only if “such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property.” This begs the question: what does “aggregate value of all liens” actually mean? One position is that the phrase refers to the economic value of the liens, meaning that the collateral value dictates the value of the liens. This position is followed by several courts, including, but not limited to, the 11th Circuit in In re Atlanta Retail Inc., 456 F.3d 1277 (11th Cir. 2006) and the 2nd Circuit in In re Beker Industries Corp., 63 B.R. 474 (Bankr. S.D.N.Y. 1986). The countervailing view is that the phrase refers to the face amount of all liens, that is, the amount owed to the lienholder without reference to value of the underlying collateral. This view is maintained by the 7th Circuit in In re Riverside Inv. Partnership, 674 F.2d 634 (7th Cir. 1982) and, most notably, the 9th Circuit in Clear Channel Outdoor Inc. v. Knupfer (In re PW, LLC), 391 B.R. 25 (9th Cir. B.A.P. 2008).
The Economic Value Approach
Proponents of the economic value approach note that the Bankruptcy Code classifies a debtor’s obligations in terms of “claims” rather than “debts.” This generally means that a creditor who is owed money on the basis of a pre-bankruptcy transaction is treated as holding either an unsecured prepetition claim or a secured prepetition claim. This camp further notes that whether a claim is secured or unsecured is determined by section 506(a) of the Bankruptcy Code. Section 506(a)(1) provides that a secured creditor’s claim is “a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property . . . and is an unsecured claim to the extent that the value of such creditor’s interest . . . is less than the amount of such allowed claim.” The provision goes on to mandate that “[s]uch value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property.”
In short, section 506 allows a secured lender’s claim to be bifurcated into two separate claims: a secured claim up to the value of the collateral and an unsecured claim to the extent the debt exceeds the collateral value. This bifurcation typically occurs in the plan confirmation process. Yet, economic value proponents suggest that such bifurcation should apply equally in the 363 sale process, arguing that “value” of a secured creditor’s lien as used in section 363(f)(3) should be defined as it is in section 506(a), that is, only to the extent of the value of the collateral, and not the face amount of the claim.
The Face Amount Approach
Those following the face amount approach suggest that their reading of section 363(f) adheres best to the plain, unambiguous language of the statute, and argue that their interpretation is supported by two grounds. First, such interpretation does not rely on valuation concepts inapplicable to section 363(f)(3). Specifically, reliance on section 506(a) is misguided because section 363(f)(3) refers not to “secured claims,” a term of art in section 506(a), but to liens, which is defined in section 101(37) as “charges against or interests in property to secure payment of a debt or performance of an obligation.” Proponents suggest that this makes it clear that a lien is distinct from a claim under section 506(a). Further, these proponents argue that the plain language of section 363(f)(3) gives no indication that Congress intended the word “value” to relate to collateral by reference to section 506(a). They support this argument by pointing to the 1984 amendment to section 363(f)(3), which replaced the language, “aggregate value of such interests” with “aggregate value of such liens.” The substitution of “lien” for “interests” signified that Congress intended 363(f)(3) to protect more than merely the economic value of liens.
Second, face amount proponents argue that requiring that a purchase price exceed the aggregate face amount of the liens encumbering the property is consistent with the plain language of the statute because it assures that the purchase price is “greater than” the aggregate value of all liens on the property. By contrast, the economic value proponents would write “greater than” completely out of the statute. Under the economic approach, when property is sold for less than the face amount of liens by application of section 506, the purchase price can only be, at best, equal to the economic value of the liens; it can never be greater than the value, as is clearly required by section 363(f)(3). Moreover, such sales would result in nothing more than handing over the sales proceeds to the lienholder.
Indeed, those in the face amount camp are quick to point out that their application comports with the concept that trustees should only pursue sales that will result in a clear benefit to the estate. In short, there must be equity in the property. As noted in Colliers and by several courts, absent consent of the lienholder or a bona fide dispute concerning the validity of the lien, the well-established rule is that a sale should not be held if it would not fully compensate the lender and produce a return for the benefit of the estate. Accordingly, if property is to be sold for less than the face amount of the liens, proponents argue that a trustee must use a provision other than section 363(f)(3) to accomplish the sale.
All is not necessarily lost for over-encumbered debtors in face amount jurisdictions. A debtor who cannot sell the property under section 363 can consensually grant stay relief to allow the lender to foreclose, preserving the parties’ arguments on what claim remains. The lender will either credit bid at foreclosure or the property will be sold to a third party. In either event, a properly conducted foreclosure sale will establish the existence or non-existence of equity. This is logically what would happen under the economic value approach as well. Ultimately, the dispute may come down to whether the lender thinks it can do better in a 363 sale with its free and clear incentives and the estate bearing the costs, or a state law foreclosure, both options having their potential pitfalls.
In light of the lingering impact the COVID pandemic will continue to have on a real estate borrower’s ability to service secured debt, as well as the impairment of collateral values, these issues will soon become front and center. Certainly, sales outside of a plan confirmation context will only increase in frequency. Thus, borrowers and lenders alike should be well attuned to which jurisdictions apply the foregoing tests to determine and protect their (often times) competing interests.
 11 U.S.C. § 363(f)(3).
 11 U.S.C. § 506(a)(1).
 11 U.S.C. § 101(f)(3).
 Collier on Bankruptcy, ¶ 363.06 (Matthew Bender 2017); see, e.g., Criim Mae Servs. Ltd. P’Ship (In re Hurley), 298 B.R. 527, 532 (Bankr. D. N.J. 2002).