In a recent decision,1 the Bankruptcy Court for the Northern District of New York broadly interpreted the meaning of “interest” in the context of determining the scope of a sale free and clear of “liens, claims, encumbrances, and interests” under section 363(f) of the Bankruptcy Code. “Interest” is an undefined term under the Bankruptcy Code. By adopting an expansive scope of the term “interest,” the court’s interpretation provides better protections to asset purchasers in bankruptcy sales and indirectly, will likely result in higher sale prices for sales under section 363 and therefore maximize the value of the bankruptcy estate for the benefit of creditors.
In re Tougher Industries, Inc., involved the sale of substantially all of the assets of two debtors, whose cases were jointly administered by the bankruptcy court. The purchasers continued to conduct the business operated by the debtors prior to the sale. The sale of the assets was authorized by the court, and the sale order included an express finding that the assets were being sold free and clear of all liens, claims, encumbrances, and interests as allowed under section 363(f). The sale order specified that this included interests “relating to taxes arising under or out of, in connection with, or in any way relating to the operation of the Assets prior to the Closing . . . .”
After the sale, the New York Department of Labor (the “DOL”) asserted that the debtors’ experience ratings – which were used to calculate unemployment insurance tax premiums – will be used to calculate the premiums due from the purchasers. The purchasers filed a motion in the bankruptcy court seeking a clarification that under the sale order the DOL is barred from using the debtors’ experience rating in calculating the premiums due from the purchasers.
The purchasers argued that “interests” included the experience rating calculated by the DOL to assess the debtors’ tax liabilities. The DOL does not appear to have directly challenged the purchasers on this front, rather, relying on the Victory Markets2 opinion and the Tax Injunction Act, the DOL challenged the bankruptcy court’s subject matter jurisdiction, arguing that the court did not have jurisdiction to determine the tax liability of the non-debtor purchasers.3
The Bankruptcy Court framed the issue as dependent on the meaning of “interest” in section 363(f) and proceeded to adopt an expansive definition of the term “interest” to include the debtors’ experience rating as calculated by the DOL. The court first noted that in contrast to other courts that have limited the meaning of “interest” to in rem property interests,4 the Second Circuit has interpreted the term more broadly to reach obligations that “arise from the property being sold.”5
In reaching its decision, the court in Tougher Industries followed the Second Circuit’s expansive reading of “interest,” as well as a recent decision by the First Circuit Bankruptcy Appellate Panel. In In re PBBPC, Inc., the question presented was whether “interest” under section 363(f) included the experience and contribution rate for taxes owed to the Massachusetts Department of Unemployment Assistance (the “DUA”).6 As in Tougher Industries, the purchaser in PBBPC challenged the DUA’s assertion that it could tax the purchaser using tax rates calculated according to the debtor’s experience rating. The bankruptcy court concluded that the contribution rate was an interest, and the First Circuit Bankruptcy Appellate Panel affirmed.7
Both the Tougher Industries and PBBPC courts rejected the reasoning of an older case, In re Wolverine Radio Co., where the Sixth Circuit held that an employer’s contribution rate was not an interest under section 363(f) because it did not “attach to property ownership so as to cloud its title.”8
Finally, the court in Tougher Industries also explained that its interpretation of “interest” was appropriate because it was consistent with the policy of maximizing the value of the asset and the return to creditors. The court reasoned, “[i]f the sale had not been free and clear, [the purchasers] would presumably have paid less for the assets.”
This decision reflects a recent trend, both in the Second Circuit and elsewhere, towards an expansive interpretation of “interest” when determining the scope of a “free and clear” sale.9 The Tougher Industries court emphasized the fact that its interpretation would maximize the purchase price for asset sales, for the benefit of the bankruptcy estate and ultimately the creditors. In addition, a narrower interpretation of “interest” could interfere with the relative priorities of creditors: if concerns about potential liability to junior creditors depressed the sale price, this would essentially elevate the junior claims at the expense of senior creditors, who would see a smaller recovery. A clear rule that provides for a broad interpretation of “interest” ensures that concerns about potential liability will not lower the sale price in future sales and will provide certainty to asset purchasers.