Fifth Circuit Holds Buyer Entitled to Exercise Contractual Economic Leverage Without Impairing Good Faith Purchaser Status

On April 17, 2023, the Fifth Circuit issued an opinion holding that a senior lender who uses economic leverage and exercises its statutory and contractual rights upon a borrower’s default, including the right to credit bid as part of a bankruptcy sale process—despite adverse impact on a junior lender—remains a “good faith” purchaser entitled to the protections under Section 363(m) of the Bankruptcy Code.  Specifically, the Fifth Circuit determined that neither an asserted lien nor a pending adversary proceeding rose to the level of an “adverse claim,” and, as such, the lender-purchaser was still a “good faith” purchaser under Section 363(m).  The Fifth Circuit also found nothing nefarious in the lender’s behavior, despite the lender exercising its contractual rights and exerting control over the sale and bidding process throughout the bankruptcy case.    

Factual Background

In November 2016, Palm Springs, LLC, (the “Developer”) a commercial real estate developer and the original owner of the real property at issue (the “Property”) contracted with SR Construction (the “Construction Company”) to develop the Property and build a hotel.  The project did not progress as planned.  Approximately one year later, the Developer financed the construction with Hall Palm Springs LLC (the “Lender”), securing its loan with a deed of trust.  At the same time, the Developer entered into a separate Subordination Agreement with the Construction Company, giving the Lender priority of repayment over the Construction Company.

On October 22, 2019, the Developer terminated the Construction Company, owing it in excess of $14 million for the work completed.  Nine days later, the Developer defaulted on the loan, and the Lender gave notice of acceleration.  On November 25, 2019, the Construction Company filed its mechanic’s lien on the property.  In January 2020, the Construction Company filed suit in state court against a number of parties, including the Developer and the Lender, seeking to foreclose on its mechanic’s lien and to declare its lien superior to the Lender’s deed of trust.  In February 2020, the Developer conveyed the Property to a newly formed affiliate (the “Debtor”) of the Lender.  In exchange for conveying the Property, the Developer was released of its obligations under the loan and received a “net profits interest” in the Debtor.

After receiving title to the Property, the Debtor intended to finish construction of the hotel, but was unable to do so due to market turmoil caused by the COVID-19 pandemic.  As such, the Lender concluded that selling the Property to a “strategic buyer” would yield the maximum value for all parties.  When the marketing efforts for the Property did not produce a buyer, the Lender and its affiliate, the Debtor, took several discrete actions to prepare for bankruptcy and ultimately the Debtor filed a voluntary Chapter 11 bankruptcy petition in the Northern District of Texas.

To finance the bankruptcy case, the Lender provided DIP financing to the Debtor.  In exchange, the Lender received the usual controls over the bankruptcy case, including the right to “veto” any proposed sale.  In addition, the Lender affiliate (the Debtor) filed motions to retain a real estate agent and other professionals as well as to approve specific bankruptcy sale and bidding procedures.

Judge Jernigan approved the sale and bidding procedures.  The marketing and sale of the Property garnered substantial interest.  However, when a stalking horse bid fell though, the Lender sought permission from Judge Jernigan to buy the Property for a credit bid of more than $37 million.  The credit bid was almost $2 million more than the floor set by the failed stalking horse bid. 

Judge Jernigan conducted an evidentiary hearing regarding the Lender’s ability to credit bid and the Lender’s ability to purchase the Property free and clear of liens, claims and encumbrances.  The Construction Company objected to the sale and argued that it should not proceed because: (1) the Lender was aware of adverse claims to the Property (namely the Construction Company’s mechanic’s lien and the pre-petition state court action); and (2) the Lender had fraudulently manipulated the bankruptcy court proceedings, including the sale process.

Judge Jernigan overruled the objections, approved the sale and declared that the Lender was a good faith purchaser.  The Construction Company appealed but failed to obtain a stay pending appeal.

The District Court 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 Lender).  The Fifth Circuit affirmed.

The Fifth Circuit’s Decision

In the Fifth Circuit, the Lender continued to argue that the appeal was moot under Section 363(m), which provides that “[t]he reversal or modification on appeal of an authorization ... of a sale or lease of property does not affect the validity of a sale or lease ... to an entity that purchased ... such property in good faith ... unless such authorization and such sale or lease were stayed pending appeal.”  The Bankruptcy Code, however, does not explicitly define “good faith.”

The Construction Company argued that the Lender was not a “good faith” purchaser because there were “adverse claims” to the Property of which the Lender was aware.  The Bankruptcy Code does not define “adverse claim.”  It only defines “claim.”  The Construction Company contended that it had an adverse claim to the Property by virtue of the dispute over the priority of its mechanic’s lien.  The Construction Company further argued that the Lender’s knowledge of its “adverse claim” meant that the Lender did not purchase the property “in good faith” and therefore was not entitled to the protections of Section 363(m).  Conversely, the Lender argued that “adverse claim” connotes an “element of hostility under a color or claim of title” such that neither the objection nor the state court action (nor the bankruptcy proceedings) raised to the level of an “adverse claim.”

The Fifth Circuit’s interpretation of Section 363(m) turned on its prior ruling in In re TMT Procurement Corp., 764 F.3d 512, 520 (5th Cir. 2014).  In that case, the Fifth Circuit determined that knowledge of an objection to a transaction is not bad faith in itself; rather, an adverse claim requires more than merely an objection to a transaction (here, the sale of the Property).

In TMT, the Fifth Circuit set aside a sale, finding that the lender was not purchasing the assets in good faith since it had knowledge about a third party’s claim of ownership.  In sum, the Fifth Circuit here noted “that, under the notice-definition of a good faith purchaser, the threshold for an ‘adverse claim’ is a dispute in ownership interest.”  Because the Construction Company was not disputing ownership of the Property, it did not rise to the level of an “adverse claim.”

Other Considerations

Attempting to undercut the finding of good faith, the Construction Company also pointed to two separate actions as “adverse claims.”  First, the Construction Company argued that the state court action filed prior to the bankruptcy proceeding created an “adverse claim.”  But the Fifth Circuit noted that, at the time it filed the state court action, the Construction Company only asserted that it had a lien against the Property (and a right to foreclose), but that a lien does not confer ownership rights. 

Second, the Construction Company argued that the adversary proceeding it filed in the bankruptcy proceeding asserting a fraudulent conveyance created an “adverse claim.”  Again, the Fifth Circuit noted that where a third party—here, the Construction Company—believes a conveyance between two other parties is fraudulent, it does not confer too that third party the right to avoid the transfer (or confer a right of ownership on the third party).  In sum, the Fifth Circuit held that neither a mechanic’s lien nor an adversary proceeding seeking to void the transfer constituted an “adverse claim” affecting the Lender’s good faith status in the bankruptcy proceeding.

The Construction Company also argued that the Lender was not entitled to “good faith purchaser” status because it engaged in misconduct and fraud.  The Fifth Circuit disagreed.  It noted that the circuit has previously stated that “misconduct” including “fraud, collusion between the purchaser and other bidders, or an attempt to take grossly unfair advantage of other bidders” could “destroy a purchaser’s good faith status.”  In re Bleaufontaine, 634 F.2d 1383, 1388 n.7 (5th Cir. 1981).  The Construction Company argued that the Lender did just that, citing multiple data points, including: (1) the Lender’s control over “both the deed of trust and the [P]roperty encumbered by the deed of trust”; (2) the Debtor’s name change; (3) the arrangement between the Lender and the party engaged to run the sale process; (4) the Lender’s engagement of an allegedly inadequate real estate broker; (5) the 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 again disagreed, finding that the Lender was entitled to exercise the leverage that it did as a result of the Developer defaulting on its loan.  Indeed, the Fifth Circuit stated that the Lender’s behavior reflected “a market actor responding to market forces and exercising its contractual rights” and “[i]ndeed, despite the [C]onstruction [C]ompany’s protests, the facts substantiate rather than undermine the [L]ender’s status as a ‘good faith purchaser.’”