On April 17, 2023, the Fifth Circuit Court of Appeals, in Matter of RE Palm Springs II, L.L.C., 2023 WL 2966520 (5th Cir. April 17, 2023), held that a senior lender who uses economic leverage and asserts its legal rights to squeeze out a junior lender remains a good faith purchaser entitled to declare an appeal moot based on a sale under section 363(m) of the Bankruptcy Code. Key to the Fifth Circuit’s opinion was the fact that the actions in question were disclosed to the bankruptcy court in advance of it making the section 363(m) finding.

Facts

Palm Springs, LLC (the “Developer”), a commercial real estate developer and the original owner of real property in Palm Springs, California, contracted with SR Construction (the “Contractor”) to develop its property and build a hotel, but the project ran into trouble almost immediately. Approximately a year later, the Developer financed the construction with Hall Palm Springs LLC (the “Secured Lender”), securing its loan with a deed of trust. At the same time, it entered into a separate Subordination Agreement with the Contractor, giving the Secured Lender priority of repayment over the Contractor.

The Developer later terminated the Contractor, owing it $14,151,000 for the work completed. Nine days later, the Developer defaulted on loan obligations owed to the Secured Lender, and the Secured Lender gave notice that it was accelerating the debt. The Contractor then filed a mechanic's lien on the property.

Thereafter, the Contractor filed suit in California state court against myriad parties, including both the Developer and the Secured Lender, seeking to foreclose on its mechanic's lien as superior to other liens and the Secured Lender’s deed of trust.

Approximately one month after the filing of the lawsuit, the Secured Lender’s president formed an affiliated corporate entity (the “Affiliate”) and became its sole manager and organizer. Following the Secured Lender’s acceleration of the debt, the Developer conveyed the property to the Affiliate pursuant to a conveyance agreement “as an alternative to foreclosure.” By its terms, the Developer would be “released from [its] obligations with respect to the [l]oan and [the Developer] shall be entitled to a net profits interest in the Property” in the amount of 50%. The Affiliate intended to finish construction and develop the hotel, but more trouble ensued: “with the impact of the novel coronavirus COVID-19 on the hospitality industry, coupled with the filing of numerous lawsuits ... [the Secured Lender] concluded that the sale of the Hotel to a strategic buyer would yield the maximum value for all parties.”

Within the ensuing six months, the Secured Lender and its Affiliate undertook several discrete actions to prepare for bankruptcy: the Affiliate changed its name, and around the same time, the Secured Lender retained a third-party with relevant experience, to oversee the Affiliate's restructuring (the “Restructuring Advisor”). To ensure arm's-length objectivity, as represented to the bankruptcy court, the Secured Lender “caused ... to convey ownership of [the Affiliate] to [the Restructuring Advisor]” such that “the entire sales process [wa]s under the control and supervision of [the Restructuring Advisor].”

The bankruptcy court approved the Secured Lender as the DIP lender for the Affiliate (i.e., the debtor) as well as sale and bidding procedures for the sale of the property. The stalking horse bidder, however, ultimately dropped out and the Secured Lender sought permission to buy the property for a credit bid of $37 million – several million more than the stalking horse bid that never materialized.

The Contractor objected to the allowance of the credit bid and claimed it to have an “adverse claim” to the property, meaning that the Secured Lender would not be a good faith purchaser.

The bankruptcy court overruled the objections, approved the sale and declared that the Secured Lender was a good faith purchaser. The Contractor appealed but failed to obtain a stay pending appeal.

The district judge dismissed the appeal as moot under section 363(m) for lack of a stay pending appeal following a sale to a good faith purchaser. The Contractor then appealed to the Fifth Circuit.

The Contractor’s “Adverse Claim”

In the Fifth Circuit, the Secured Lender contended that the appeal was moot under section 363(m), which provides that reversal or modification “of an authorization under subsection (b) or (c) of this section of a sale or lease of property does not affect the validity of a sale or lease [to a purchaser in good faith] . . . unless such authorization and such sale or lease were stayed pending appeal.”

The Contractor contended that it had an adverse claim to the property by virtue of the dispute over the priority of its mechanic’s lien. According to the Contractor, the Secured Lender’s knowledge of the adverse claim meant that the Secured Lender was not in good faith.

In rejecting this argument, the Fifth Circuit relief on its interpretation of section 363(m) in In re TMT Procurement Corp., 764 F.3d 512, 520 (5th Cir. 2014). There, court said that knowledge of an objection to a transaction is not bad faith in and of itself. Judge Higginbotham quoted TMT for the idea that an adverse claim requires more than an objection to a transaction: “an adverse claim ‘requires more’ than simply ‘some creditor ... objecting to the transaction and ... trying to get the district court or the court of appeals to reverse the bankruptcy judge.’ ” Id. at *4 (emphasis in original) (citing In re TMT, 764 F.3d at 522)).

In TMT, the Fifth Circuit set aside a sale because the lender was not in good faith based on its finding that the lender had knowledge about a third party’s claim of ownership of the property. By contrast, in Palm Springs, the Contractor was not asserting an adverse claim of ownership. The Fifth Circuit held “that, under the notice-definition of a good faith purchaser, the threshold for an ‘adverse claim’ is a dispute in ownership interest.” Id. As such, because the Contractor had not contested ownership, only asserted a mechanic’s lien, the Contractor did not assert an adverse claim to set aside the finding of good faith.

Misconduct and Fraud

The Contractor also argued that the Secured Lender was not entitled to “good faith purchaser” status because it engaged in misconduct and fraud. Specifically, the Contractor claimed that the Secured Lender, both “in preparation for and during the sale itself” engaged in conduct “specifically intended to affect the sale price or control the outcome of the sale.” The Contractor cited multiple data points: (1) the Secured Lender’s control over both the deed of trust and the property encumbered by the deed of trust; (2) the Affiliate's name change; (3) the arrangement between the Secured Lender and the Restructuring Advisor; (4) the Secured Lender’s engagement of an allegedly inadequate real estate broker; (5) the Secured Lender’s involvement in securing the stalking-horse bidder (who ultimately failed to make a bid); and, most importantly, (6) the bidding procedures themselves.

The Fifth Circuit disagreed. First, it held that becoming both the lender and owner “is not nefarious per se.” Id.at *6. Instead, the court held that it “reflects a market actor responding to market forces and exercising its contractual rights.” Id.

As to the myriad other facts, the court said that “the lender disclosed each . . . to the bankruptcy court.” Id. Disclosure, according to the court, “strongly favors a finding of good faith, as courts properly look to the transparency of the process as indicative of one’s intent.” Id.at *8.

Accordingly, the Fifth Circuit held that the “lender did not engage in fraud and was a ‘good faith purchaser,’” and affirmed the district court’s judgment dismissing the appeal as moot.