The finality of asset sales and other transactions in bankruptcy is an indispensable feature of U.S. bankruptcy law designed to maximize the value of a bankruptcy estate as expeditiously as possible for the benefit of all stakeholders. To promote such finality, section 363(m) of the Bankruptcy Code prohibits reversal or modification on appeal of an order authorizing a sale or lease to a "good-faith" purchaser or lessee unless the party challenging the sale obtains a stay pending appeal. What constitutes "good faith" has sometimes been disputed by the courts.

The U.S. Court of Appeals for the Fifth Circuit recently revisited this issue in SR Construction Inc. v. Hall Palm Springs LLC (In re RE Palm Springs II LLC), 65 F.4th 752 (5th Cir. 2023). The court reaffirmed its earlier decisions that a buyer's or lessee's good faith under section 363(m) is not defeated merely because it is aware of objections to the proposed sale or lease. Instead, the claims of the party challenging the sale or lease must rise to the level of an "adverse interest" in the ownership of the property. The Fifth Circuit also held that transparency in the sale or lease process is of paramount importance in establishing good faith.

Mootness of Appeals Under Section 363(m)

"Mootness" is a doctrine that precludes a reviewing court from reaching the underlying merits of a controversy. An appeal can be either constitutionally, equitably, or statutorily moot. Constitutional mootness is derived from Article III of the U.S. Constitution, which limits the jurisdiction of federal courts to actual cases or controversies and, in furtherance of the goal of conserving judicial resources, precludes adjudication of cases that are hypothetical or merely advisory.

The court-fashioned remedy of "equitable mootness" bars adjudication of an appeal when a comprehensive change of circumstances has occurred such that it would be inequitable for a reviewing court to address the merits of the appeal. In bankruptcy cases, appellees often invoke equitable mootness as a basis for precluding appellate review of an order confirming a chapter 11 plan that has been "substantially consummated."

An appeal can also be rendered moot (or otherwise foreclosed) by statute. For example, section 363(m) of the Bankruptcy Code provides as follows:

The reversal or modification on appeal of an authorization [of a sale or lease of property in bankruptcy] 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.

11 U.S.C. § 363(m). Section 363(m) of the Bankruptcy Code is a powerful protection for good-faith purchasers because it limits appellate review of a consummated sale irrespective of the legal merits of the appeal. See Made in Detroit, Inc. v. Official Comm. of Unsecured Creditors of Made in Detroit, Inc. (In re Made in Detroit, Inc.), 414 F.3d 576 (6th Cir. 2005); see also In re Palmer Equip., LLC, 623 B.R. 804, 808 (Bankr. D. Utah 2020) (section 363(m)'s protection is vital to encouraging buyers to purchase the debtor's property and thus insuring that adequate sources of financing are available).

Statutory mootness under section 363(m) can preclude appellate review not only of an unstayed sale order, but also orders approving transactions that are an integral part of the sale. See, e.g., In re Pursuit Holdings (NY), LLC, 845 Fed. App'x 60, 62-63 (2d Cir. 2021) (the statutory mootness rule indisputably applies to challenges to any integral provision of an order approving a sale, such as a settlement); In re Trism, Inc., 328 F.3d 1003, 1007 (8th Cir. 2003) (mooting under section 363(m) "a challenge to a related provision of an order authorizing the sale of the debtor's assets" because the related provision was integral to the sale of the assets and reversing the provision would alter the parties' bargained-for exchange); see also Matter of Alabama-Mississippi Farm, Inc., 791 F. App'x 466, 470 (5th Cir. 2019) (section 363(m) does not preclude an appeal seeking a security interest in sale proceeds because "nothing in the record suggests that the sale … was dependent on how the proceeds of that sale were to be distributed").

Section 363(m) has also been read to go further than simply limiting appellate review and to protect broadly the interests of any good-faith purchaser by subjecting any collateral attack made against a section 363 sale to a good-faith purchaser to the requirements of Rule 60(b) of the Federal Rules of Civil Procedure, which governs motions for reconsideration of or relief from prior court judgments or orders. See In re Edwards, 962 F.2d 641 (7th Cir. 1992) (holding that a collateral attack on sale to a good-faith purchaser must be made pursuant to Fed. R. Civ. Proc. 60(b)); In re Veg Liquidation, Inc., 572 B.R. 725, 737 (Bankr. W.D. Ark. 2017) ("To the extent the trustee is alleging that fraud was involved, his remedy is under Rule 60, not [section] 363(m)."), aff'd, 583 B.R. 203 (B.A.P. 8th Cir. 2018), aff'd, 931 F.3d 730 (8th Cir. 2019); see also In re Alan Gable Oil Dev. Co., 978 F.2d 1254 (4th Cir. 1992) ("[T]hough section 363(m) does not in the strictest sense apply to [a movant's] 60(b) motion, the policy favoring protection of good faith purchasers of estate property does. Not only does [the movant] bear the burden of establishing that the district court abused its discretion, he must do so in light of the strong policy favoring good faith purchasers of bankruptcy assets."); In re Nilhan Devs., LLC, 631 B.R. 507, 534 (Bankr. N.D. Ga. 2021) ("Sale orders in bankruptcy cases are accorded a high level of finality and, accordingly 'collateral attacks on sale orders should generally be prohibited.'") (quoting In re CHC Indus., Inc., 389 B.R. 767, 774 (Bankr. M.D. Fla. 2007)).

Bankruptcy and appellate courts have long disagreed as to whether section 363(m) is jurisdictional—meaning that the issue can never be waived and an appellate court lacks jurisdiction to hear any appeal of an unstayed sale or lease authorization order other than on the ground that the purchaser or lessee did not act in good faith—or instead a defense that can be invoked by the proponents of the sale (e.g., the debtor, the bankruptcy trustee, or the purchaser) in connection with the appeal. The U.S. Supreme Court definitively settled this question in MOAC Mall Holdings LLC v. Transform Holdco LLC, 143 S. Ct. 927 (2023). A unanimous Court held that section 363(m) is not jurisdictional and that an appeal of a bankruptcy court order approving the sale and assignment of a lease was not moot. The Court also expressed skepticism about mootness in general as a bar to appellate review of bankruptcy court decisions, despite the importance of finality in bankruptcy sales.

Good Faith

The Bankruptcy Code does not define "good faith." Courts have adopted various definitions, many of which are substantially similar. See generally Collier on Bankruptcy ("Collier") ¶ 363.11 (16th ed. 2023). For example, the Fifth Circuit has defined a "good-faith purchaser" for purposes of section 363(m) as "'one who purchases the assets for value, in good faith, and without notice of adverse claims.'" Hsin Chi Su v. C Whale Corp. (In re C Whale Corp.), 2022 WL 135125, *3 (5th Cir. Jan. 13, 2022) (quoting In re TMT Procurement Corp., 764 F.3d 512, 521 (5th Cir. 2014)); accord Licensing by Paolo, Inc. v. Sinatra (In re Gucci), 126 F.3d 380, 390 (2d Cir. 1997); In re Mark Bell Furniture Warehouse, Inc., 992 F.2d 7, 8 (1st Cir. 1993). Lack of good faith is commonly manifested by "fraud, collusion between the purchaser and other bidders or the trustee, or an attempt to take grossly unfair advantage of the other bidders." TMT Procurement, 764 F.3d at 521; accord In re Ewell, 958 F.2d 276, 279 (9th Cir. 1992); In re Abbotts Dairies, Inc., 788 F.2d 143, 147 (3d Cir. 1986); Hoese Corp. v. Vetter Corp. (In re Vetter Corp.), 724 F.2d 52, 56 (7th Cir. 1983); Badami v. Burgess (In re Burgess), 246 B.R. 352, 356 (B.A.P. 8th Cir. 2000); In re General Motors Corp., 407 B.R. 463, 494 (Bankr S.D.N.Y. 2009).

Some courts—principally in the Third Circuit—require a finding of good faith at the time the bankruptcy court approves a sale or lease of property under section 363. See Abbotts Dairies, Inc., 788 F.2d at 149–50; In re Perona Bros., Inc., 186 B.R. 833, 839 (D.N.J. 1995); In re Primel, 629 B.R. 790, 799 (Bankr. W.D. Pa. 2021); In re Hereford Biofuels, L.P., 466 B.R. 841, 860 (Bankr. N.D. Tex. 2012). Other courts do not. See, e.g., In re Zinke, 97 B.R. 155, 156 (E.D.N.Y. 1989) (declining to adopt the Abbotts Dairies rule); In re M Cap. Corp., 290 B.R. 743, 748 (B.A.P. 9th Cir. 2003) ("Because findings of 'good faith' made at the time of the sale may be premature because they are made before the really interesting facts emerge, the Ninth Circuit does not require that a finding of 'good faith' be made at the time of sale and has rejected the Third Circuit's contrary rule.").

Courts also disagree as to whether any entity asserting a lien on, or other interest in, property to be sold free and clear under section 363(f) of the Bankruptcy Code must be provided with advance notice of the sale for the purchaser of the property to be entitled to the protection of section 363(m). See generally Collier at ¶ 363.11 ("The protection afforded by section 363(m) has been held [by some courts] not to protect even an otherwise good faith purchaser when no notice was given to the lienholder, resulting in the purchaser taking the property subject to the lien."). Compare Archer-Daniels-Midland Co. v. Country Visions Cooperative, 29 F.4th 956 (7th Cir. 2022) (affirming lower court rulings denying a motion to bar an entity holding a right of first refusal on property purchased from a debtor "free and clear" pursuant to section 363(f) from continuing state court litigation seeking to enforce its right and holding that, because the buyer had actual and constructive knowledge of the right of first refusal, yet never informed the bankruptcy court, the buyer had not acted in good faith and was not entitled to the protections of section 363(m)); United States v. Moberg Trucking, Inc. (In re Moberg Trucking, Inc.), 112 B.R. 362 (B.A.P. 9th Cir. 1990) (section 363(m) requires that a sale be authorized under section 363(b), which specifically requires notice and a hearing; thus, section 363(m) mootness is not applicable when the appellant seeks to attack the section 363 sale of estate property on the grounds of improper notice), with In re Edwards, 962 F.2d 641 (7th Cir. 1992) (a purchaser at a section 363(b) sale took clear title even though the lienholder did not receive notice at the time of the sale); In re Motors Liquidation Co., 529 B.R. 510 (Bankr. S.D.N.Y. 2015) (lack of notice will not invalidate a sale, unless party can show prejudice).

A purchaser or lessee bears the burden of establishing good faith under section 363(m). TMT Procurement, 764 F.3d at 520.

RE Palm Springs

In November 2016, commercial real-estate developer Palm Springs, LLC ("Palm Springs") contracted with SR Construction, Inc. ("SR") to develop a hotel property located in Palm Springs, California. In 2017, Hall Palm Springs LLC ("Hall")—which was not a Palm Springs affiliate—agreed to provide Palm Springs with up to $50 million in construction financing secured by a deed of trust on the unfinished hotel. At the same time, SR entered into a subordination agreement with Hall in which SR agreed that Hall's loan would have priority of repayment over any claims asserted by SR in connection with the project.

Palm Springs terminated its construction contract with SR in October 2019, at the time owing SR more than $14 million for completed work. Shortly afterward, Palm Springs defaulted on the Hall loan, and Hall notified Palm Springs that it was accelerating the debt. On November 25, 2019, SR filed a mechanic's lien on the property to secure its $14 million claim.

In January 2020, SR sued Palm Springs, Hall, and various related parties in California state court seeking to foreclose on its mechanic's lien (the "state court action"), which SR alleged was superior in priority to Hall's deed of trust.

In February 2020, in lieu of foreclosure, Palm Springs agreed to convey the hotel property to a newly formed affiliate of Hall—RE Palm Springs II, L.L.C. (the "debtor")—under an agreement that would release Palm Springs from all liability for the loan and give Palm Springs a 50% interest in any net profits generated by the still-unfinished hotel property. After the beginning of the COVID-19 pandemic derailed the debtor's plans to complete the hotel project, Hall and the debtor determined that they would attempt to find a strategic buyer for the property in bankruptcy.

As part of pre-bankruptcy planning, Hall retained an unrelated restructuring advisory firm—r2—to oversee the affiliate's restructuring. In an effort to ensure arm's-length objectivity, Hall conveyed ownership of the debtor to r2.

On July 22, 2020, the debtor filed for chapter 11 protection in the Northern District of Texas. It immediately sought court approval of debtor-in-possession ("DIP") financing to be provided by Hall, bidding and sale procedures, and the retention of r2 as a real estate agent to market the property. The bankruptcy court approved all the requested relief, finding that Hall's DIP loan "was the only game in town" and that r2 was well qualified and without any conflicts of interest.

The auction procedures required that the stalking-horse bidder for the property—an unrelated company named McWhinney Real Estate Services, Inc. ("McWhinney")—submit its bid as well as a nonrefundable $2.5 million deposit on or before August 28, 2020. Other bids were due no later than October 5, 2020, 11 days before the scheduled sale hearing.

The marketing of the property initially garnered substantial interest. Although McWhinney informally proposed a bid of $35,450,000 for the hotel, it ultimately declined to submit a bid or a deposit. The stalking horse having bowed out, Hall filed a motion seeking court approval to submit a credit bid for the property in the amount of its outstanding secured debt—$37,279,365.74—or nearly $2 million more than the amount of McWhinney's proposal. SR objected to the motion and commenced an adversary proceeding (the "adversary proceeding") against Hall, the debtor, and Palm Springs challenging Hall's lien and seeking a determination that the conveyance of the hotel property to the debtor was voidable.

In opposing the credit-bid sale, SR argued that it should not proceed because: (i) Hall (the intended purchaser) was aware of adverse claims to the property (i.e., the claims asserted in the state court action and the adversary proceeding); and (ii) Hall fraudulently manipulated the bankruptcy case by rigging the auction sale to acquire the hotel property free and clear of all interests, including SR's mechanic's lien.

In November 2020, with no other bidders expressing interest, the bankruptcy court entered orders approving the credit-bid sale of the hotel property to Hall free and clear of all interests under sections 363(b), 363(f), and 363(k) of the Bankruptcy Code. The bankruptcy court denied SR's motion for a stay pending its appeal of the sale order to the district court.

On appeal, the district court affirmed the bankruptcy court's orders, as well as the court's finding that Hall was a good-faith purchaser, and dismissed the appeal as moot under section 363(m). SR appealed to the Fifth Circuit.

The Fifth Circuit's Ruling

A three-judge panel of the Fifth Circuit affirmed the rulings below.

Writing for the panel, U.S. Circuit Judge Patrick E. Higginbotham explained that the outcome of the appeal hinged on the Fifth Circuit's interpretation of the meaning of "good faith" under section 363(m) in TMT, where the court had previously defined the term in two ways: (i) a "notice-based definition," according to which a "good faith purchaser" is "one who purchases the assets for value, in good faith, and without notice of adverse claims"; and (ii) a "conduct-based definition," according to which a buyer or lessor acts in good faith unless it engages in misconduct, including fraud, collusion "or an attempt to take grossly unfair advantage of other bidders"). RE Palm Springs, 65 F.4th at 759 (footnotes and internal quotation marks omitted). According to Judge Higginbotham, although the Bankruptcy Code does not define the term "adverse claim" (section 101(5) does broadly define the term "claim"), the Fifth Circuit in TMT determined that such a 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 760 (quoting TMT, 764 F.3d at 522). Therefore, he noted, knowledge of an objection to a transaction is not bad faith by itself.

Instead, Judge Higginbotham concluded, TMT and other similar rulings, including the U.S. Supreme Court's long-standing precedent in Boone v. Chiles, 35 U.S. 177, 210 (1836), "make clear that, under the notice-definition of a good faith purchaser, the threshold for an 'adverse claim' is a dispute in ownership interest." Id. at 760-61. Because the lower courts found that the parties did not dispute the ownership of the hotel property—SR merely asserted a mechanic's lien, rather than an ownership interest—the Fifth Circuit held that SR's claims "do not rise to the level of an 'adverse claim' so as to vitiate the lender's status as a 'good faith purchaser.'" Id. at 761.

The Fifth Circuit rejected SR's argument that the state court action and the adversary proceeding alleging that the transfer of the property to the debtor was voidable and challenging the priority of SR's liens was an adverse claim. According to Judge Higginbotham, the contractual subordination agreement between SR and Hall "neuters [SR's] claim to equitable relief" in the state court action, and the adversary proceeding seeking a determination that the property transfer was voidable (as distinguished from void) passed the "notice-of-adverse claims test." Id. at 752.

The Fifth Circuit also rejected SR's argument that Hall was not entitled to good-faith purchaser status because it engaged in fraud and misconduct, including Hall's actions to control the bankruptcy case (by, among other things, controlling the real estate broker r2 and the stalking-horse bidder McWhinney) and obtain ownership of the hotel property at a depressed price free and clear of any competing interests (e.g., SR's mechanic's lien). According to Judge Higginbotham, Hall's actions in connection with the events surrounding Palm Springs's default on the construction loan and the transfer of a deed in lieu of foreclosure on the hotel did not constitute misconduct, but instead "reflects a market actor responding to market forces and exercising its contractual rights." Id. at 763. Those market forces included the pandemic, the unfinished state of the hotel property, the absence of alternative sources of financing, and evidence that the property was a "wasting asset" with substantial monthly carrying costs.

Moreover, Judge Higginbotham explained, the other "data points" cited by SR as evidence of Hall's "fraud or misconduct" were disclosed by Hall to the bankruptcy court, which approved the auction sale transaction with full knowledge of the relevant facts. Disclosure, Judge Higginbotham wrote, "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 765.

Holding that the "lender did not engage in fraud and was a 'good faith purchaser,'" the Fifth Circuit affirmed the district court's judgment dismissing the appeal as moot.

Outlook

There are several key takeaways from the Fifth Circuit's ruling in RE Palm Springs.

First, the Fifth Circuit reinforced its previous rulings that the finality of orders authorizing bankruptcy asset sales is an indispensable part of U.S. bankruptcy law, without which it would be far more difficult to monetize estate assets for the benefit of all stakeholders. Statutory mootness of unstayed sale or lease orders is the gatekeeper to finality and, at least in the Fifth Circuit, section 363(m) categorically bars appeals of such orders on any ground other than that the purchaser or lessee did not act in good faith. See In re Walker County Hospital Corp., 3 F.4th 229, 236 (5th Cir. 2021).

Second, the good-faith status of a buyer or lessee of estate property in bankruptcy is not impugned merely because the buyer or lessee is aware of objections to the proposed sale or lease. Instead, such claims must rise to the level of an "adverse interest" in the ownership of the property to defeat good-faith status under section 363(m).

Third, a proposed buyer or lessee may generally exercise its legal and bargained-for contractual rights to safeguard its interests without jeopardizing its good-faith status under section 363(m). In RE Palm Springs, the courts appeared to be skeptical of the contractor's objections because it had expressly agreed to the subordination of its mechanic's lien and appeared to believe that the hotel property should have fetched significantly more at auction than it did.

Finally, RE Palm Springs illustrates the importance of transparency in establishing good faith in connection with a proposed asset sale or lease in bankruptcy. The bankruptcy court was made aware of all of the alleged conduct complained of by the contractor and had approved the auction procedures for the sale with full knowledge of the relevant facts.

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