This article was published in Law360 on February 13, 2014. © Copyright 2014, Portfolio Media, Inc., publisher of Law360.

In In re Scimeca Foundation Inc., 497 B.R. 783 (Bankr. E.D. Pa. 2013), a Chapter 7 trustee sought court approval for a sale of the debtor’s property and resolution of related issues over the objections of the debtor. In granting the trustee’s request, the court reviewed various issues that commonly come up in connection with bankruptcy sales, including the standard for review of the trustee’s proposed sale, bases for selling property “free and clear,” and the effect of a sale on leases.

The debtor owned a property in Philadelphia known as the Foremost Building. It was a mixed-use project with commercial tenants on two floors, office space on two floors, and apparently, an apartment on the fifth floor. The property was subject to a mortgage. The debtor filed for bankruptcy in order to stay a sheriff’s sale scheduled by the mortgagee. The debtor scheduled the property with a value of $9 million while the debt was approximately $3.2 million.

The case involved a long history of failed efforts on the debtor’s part. Although the debtor obtained confirmation of a plan of reorganization, it failed to make payments required under the plan. A motion to convert or dismiss the case was conditionally denied based on the debtor’s commitment to sell the property.

A couple of months later, the debtor filed a motion to approve a sale to a buyer for $6.1 million, but withdrew its motion without any explanation. A couple of months after that, the debtor filed a motion seeking approval of a refinancing, but was not successful in closing the loan. Eventually the case was converted and a Chapter 7 trustee was appointed.

In opposing the trustee’s request to retain a broker, the principle of the debtor (DeSeo) contended that a broker was not necessary since he had already negotiated a sale agreement. However, the court found a number of objectionable features in the proposed offer, including:

1. the fact that DeSeo had an interest in the buyer and would receive rent-free space
2. several conditions could result in a reduction of the $6.1 million purported sale price or allow the buyer to walk away
3. seller financing was required, and
4. a supposed cash capital contribution by the buyer was to be funded out of proceeds of the sale of the property.

So, the court rejected the proposed agreement and approved the trustee’s retention of a broker.

The trustee obtained an appraisal that valued the property at $3.8 million. The trustee then marketed the property, listing it for $4.5 million. Although about 80 people expressed some degree of interest, ultimately only two offers were received.

One was an offer for $4.377 million from an individual that had been involved in the debtor’s original proposed sale. However, it had various terms and conditions that were not acceptable to the trustee, and the potential buyer failed to respond to the trustee’s counterproposal.

Consequently, the trustee moved forward with the other offer. This offer proposed a purchase price of $4 million, with a $100,000 cash deposit, no financing contingency, and no further due diligence required. This second buyer was prepared to close if (1) an old oil tank was removed (which the trustee did) and (2) all leases for occupancy by DeSeo or his affiliates were terminated. The trustee accepted the offer conditioned on allowing third parties an opportunity to make higher offers.

The court noted that a trustee’s motion to sell should be approved if the trustee has “demonstrated sound business judgment” — which is shown by a fair and reasonable purchase price with the sale process conducted in good faith. “A trustee’s decision in executing a sale or accepting a bid ‘is entitled to respect and given deference from the court, so long as the burden of giving sound business reasons is met.’” Under the circumstances, the court concluded that the trustee made the appropriate showing.

With respect to claims relating to the property, Section 363(f) allows the sale of assets free and clear of interests if one of several tests is met. Typically “the effect of such a sale is to divest the property sold of all interests so that the purchaser holds no legal responsibility to honor those interests.” Generally the interests remain but are transferred to the proceeds.

In this case the three parties that held liens on the debtor’s real estate all consented, which met one of the tests under Section 363.

In addition, an entity created by DeSeo claimed to have a lien based on paying property taxes of the debtor, and it opposed the sale. However, the trustee contended that the claim was subject to a bona fide dispute, which would meet another test under Section 363.

The goal of that section is to allow prompt liquidation of the estate, as opposed to requiring a delay while the dispute is resolved. The court need only decide whether a dispute exists, and not whether the interest is actually invalid.

The court reviewed the circumstances and concluded that a genuine dispute existed. Consequently, the trustee was permitted to sell the property free and clear of the claim, although he was required to set aside the amount at issue from the proceeds pending resolution of the claim.

The debtor and DeSeo also objected on the basis that the purchase price was too low. They relied in large part on an appraisal they obtained showing a value of $6.3 million and the rejected offer for $4.377 million. To begin with, “an appraisal is not as persuasive as ‘[a] commercially reasonable sale of an asset [which conclusively] establishes the market value of that asset.’” Further, the court noted a number of deficiencies in the appraisal so that the $4 million bid was reasonable in the court’s opinion.

With respect to the competing offer, while it is true that normally, a higher offer should be accepted if the competing offers are on substantially the same terms, the “highest bid does not always equate to the best bid for the estate.” In light of the financing contingency and other conditions, the trustee’s choice to go with a somewhat lower all-cash offer with no contingencies was reasonable.

As for a criticism that the trustee did not aggressively develop the property, the court found that the trustee’s decision to address housing code violations, deal with deferred maintenance, and evict tenants who were not paying rent was a reasonable approach.

The debtor also contended that the sale should be rejected because it primarily benefited the secured creditor. The court agreed as a general rule that a trustee should not liquidate fully encumbered assets, since that doesn’t provide any benefit to unsecured creditors. However, in this case the trustee negotiated a carve-out with the secured creditor, which the trustee estimated would cover the costs of administration and provide an 18 percent dividend to nonadministrative creditors.

Consequently, the court approved the proposed sale.

With respect to the trustee’s request to sell free and clear of the purported leasehold interests of DeSeo and an affiliate, the court concluded that there was a bona fide dispute. It appears that both tenants were delinquent in paying rent. They contended that they had prepaid their rent, but there were a number of discrepancies in the evidence and it did not appear that rent was in fact prepaid.

Given the dispute, the court concluded that the property could be sold free and clear of the leasehold interests, with the claims to be resolved at a later date.

Although not raised by DeSeo, the court also addressed the impact of Section 365(h), which protects a tenant’s interests in the case of a landlord bankruptcy by allowing it to elect to retain possession under the lease. It noted that courts are divided on the interaction between the tenant protection in Section 365(h) and the ability to sell free and clear of a tenant’s interests under Section 365(f).

In this case, (1) the validity of the interests was very doubtful, (2) the lessees might not have paid any rents, (3) the leases were not disclosed by the debtor on its bankruptcy schedules, and (4) under the terms of the leases themselves, they could be terminated for nonpayment of rent.

Add the fact that these leases were with insiders — which meant they were subject to careful scrutiny — and the court concluded that the trustee could sell the property free and clear of the leasehold interests regardless of Section 365(h), with any value of the interests to be resolved in connection with disposition of the sale proceeds.

In negotiating a sale, a trustee will often justify positions based on an argument that they are required to obtain court approval. While these arguments may often go farther than necessary, it is true that the trustee will be called upon to defend any proposed sale. It doesn’t take much to create an issue that has to be dealt with and nuances can matter. In this case it seems likely that the debtor’s pattern of behavior helped influence the court to find in favor of the trustee.