When might a bankruptcy court's "free and clear"
order not be the last word in a Section 363 sale? Mid-City Bank
v. Skyline Woods Homeowners Association,1 a recent
case out of the 8th Circuit, highlights the interplay between
federal and state court decisions interpreting bankruptcy laws, the
"full faith and credit" mandated by 28 U.S.C. §
1738, and bankruptcy sales free and clear of real estate interests
created under state law. This intersection of legal principles,
addressing the sale of a golf course in bankruptcy, suggests that
the answer to this question can be complex and, in some respects,
unpredictable.
An "Interest"ing Journey from Bankruptcy Court
to State Court
Skyline Woods Country Club, L.L.C. filed for bankruptcy
in late 2004 and, in early 2005, sold property that had been
operated as a golf course for 40 years free and clear of all
"mortgages, liens, pledges . . . encumbrances, easements,
options, rights of first refusal, restrictions, judgments, claims,
demands . . . interests or liabilities of any kind or nature
(whether known or unknown, accrued, absolute, contingent, or
otherwise)"2 through a sale order in the bankruptcy
proceeding under 11 U.S.C. § 363 ("Sale Order") to
Liberty Building Corporation ("Liberty"). When Liberty
stopped operating the property as a golf course a year later,
homeowners in the surrounding neighborhood
("Homeowners")3 brought an action in Nebraska
state court to enforce an implied restrictive covenant requiring
that the property be used as a golf course. Liberty contended that,
because of the prior free and clear sale order issued by the
Bankruptcy Court, Liberty was not required to operate the property
as a golf course. The state district court held for the Homeowners,
and Liberty appealed to the Nebraska Supreme Court.
In its analysis, the Nebraska Supreme Court considered that when
the original owner of the golf course developed the Skyline Woods
neighborhood surrounding the golf course, he used the proximity and
existence of the golf course as an enticement to purchasers of the
housing lots, claiming that the golf course was the "center
and heart" of the residential development.4 Because
the real estate records were replete with evidence supporting the
existence of this common scheme of development and the Homeowners
had relied on this scheme, there was an "implied"
restrictive covenant requiring that the property be used only as a
golf course, and this covenant ran with the golf course property,
despite the covenant itself being unrecorded. This
"implied" restrictive covenant was found to exist as a
matter of Nebraska state law, even though no "express"
restrictive covenant had been set forth in the property deeds
themselves.
Once the Nebraska Supreme Court determined that such an implied
restrictive covenant existed, it turned to consider whether the
bankruptcy sale eliminated the covenant. Pursuant to Section 363(f)
of the Bankruptcy Code, a trustee or debtor can sell property of an
estate free and clear of any interest only if one of five
statutory requirements is satisfied: (1) applicable nonbankruptcy
law permits the sale of such property free and clear of such
interest; (2) the entity holding the interest consents; (3) such
interest is a lien and the price at which such property is to be
sold is greater than the aggregate value of all liens on such
property; (4) such interest is in bona fide dispute; or (5) such
entity could be compelled, in a legal or equitable proceeding, to
accept a money satisfaction of such interest.5 While
"interest" is not defined in the Bankruptcy Code, the
Nebraska Supreme Court found that applicable case law had held that
"interest" does not encompass implied restrictive
covenants such as the one encumbering the golf course.6
Therefore, the court did not reach an analysis of whether any of
the five requirements for selling the property free and clear of an
"interest" were satisfied.
In finding that the implied restrictive
covenant—evidenced in large part by documents in the real
estate records—was not an "interest" in
property, the Nebraska Supreme Court provided an interesting
contrast to federal court decisions that extend the definition of
"interest" to contract claims (and authorize a sale
"free and clear" of those interests). For example, in
In re Trans World Airlines, Inc. ("TWA"), the
3rd Circuit discussed what constitutes an "interest" in
determining whether Trans World Airlines could sell its assets free
and clear of travel vouchers held by flight attendants. In that
case, the court noted that the trend is toward an expansive reading
of the term "interests," and held that the debtors could
sell free and clear of the vouchers under Section 363(f)(5) since
they were subject to monetary valuation.7 The more
recent In re Chrysler LLC decision from the Southern
District of New York used TWA's broad construction of
"interest" to hold that tort claims are
"interests" of which the debtor can sell free and
clear.8
In holding that the restrictive covenant did not constitute an
"interest," the Nebraska Supreme Court affirmed the state
district court's order that the implied covenant required the
property to be used as a golf course.9 Liberty therefore
remained obligated to maintain the course.
"Reopening" the Debate in Bankruptcy Court
After the Nebraska Supreme Court's decision, Liberty defaulted
on its secured loan to Mid-City Bank (the "Bank"). When
the Bank recorded an election to sell the golf course, the
Homeowners commenced a second state court action, seeking to
subordinate the Bank's deed of trust to the Homeowners'
equitable lien for the costs of maintaining the golf course. At
that point, Liberty filed a motion to reopen the bankruptcy case
and enforce the Sale Order. The Bankruptcy Court denied the motion.
It determined that: (1) the Nebraska Supreme Court had concurrent
jurisdiction to interpret the Sale Order; (2) the dispute the Bank
and Liberty sought to adjudicate if the case were
reopened—whether the Sale Order eliminated the covenants
requiring the operation of a golf course on the
property—had been decided by the Nebraska Supreme Court;
and (3) the movants had "no right to another bite at the apple
in the bankruptcy court."10
Appealing to the Federal BAP and Circuit Courts
Liberty appealed the decision to the Bankruptcy Appellate Panel for
the 8th Circuit ("8th Circuit BAP"), which affirmed the
Bankruptcy Court's decision. The 8th Circuit BAP focused on the
fact that the Nebraska Supreme Court had concurrent jurisdiction to
interpret the Sale Order, distinguishing between a bankruptcy
court's jurisdiction to enter a sale order which is
original and exclusive, and a bankruptcy court's jurisdiction
to interpret a sale order that was previously entered,
which is concurrent with other federal and state
courts.11
Still unsatisfied with the result, the Bank and Liberty appealed
the 8th Circuit BAP's decision to the U.S. Court of Appeals for
the Eighth Circuit ("8th Circuit").
There, the 8th Circuit identified as the critical question the
following: whether the Nebraska Supreme Court's judgment was
entitled to "full faith and credit" under 28 U.S.C.
§ 1738. If it was, then a federal court in a reopened
bankruptcy case would have to give it the same preclusive effect as
it would be given under the state laws of Nebraska.12 In
this case, such a preclusive effect would mean defeat for the Bank
and Liberty.
The 8th Circuit initially looked to the United States Supreme
Court's decision in Durfee v. Duke, in which the
Supreme Court had adopted a broad principle of jurisdictional
finality: "a judgment is entitled to full faith and
credit—even as to questions of
jurisdiction—when the second court's inquiry
discloses that those questions have been fully and fairly litigated
and finally decided in the court which rendered the original
judgment."13 The Bank and Liberty argued that the
instant case came within an exception to Durfee because
the matter was within the exclusive jurisdiction of the federal
bankruptcy courts, and thus the original Nebraska state court
action was void from its inception. But the 8th Circuit rejected
the contention that the Bankruptcy Court had maintained exclusive
jurisdiction over the Homeowners' claims at the time of the
first state court action. Although a bankruptcy court has exclusive
in rem jurisdiction over the property of the estate
granted by 28 U.S.C. § 1334(e)(1), the 8th Circuit's view
is that this exclusive jurisdiction exists only so long as the
property is part of the bankruptcy estate, and not after the
property is sold. The Bankruptcy Court's jurisdiction over the
post-sale dispute would more properly fall under 28 U.S.C.
§ 1334(b), the portion of the federal bankruptcy jurisdiction
statute that provides non-exclusive jurisdiction, concurrent with
state courts.
The Bank and Liberty also argued that Section
363(m)—which provides that the appeal of a Section 363
sale order does not affect the validity of a sale unless the sale
order was stayed pending appeal—prevented the Nebraska
state courts from modifying Liberty's "free and
clear" title. In rejecting that argument, the 8th Circuit
noted that Section 363(m) applies, by its terms, to
appeals of sales orders, but took this point no farther,
leaving the implication that Section 363(m) applies only
to direct appeals of bankruptcy court orders to higher federal
courts and not to collateral challenges of bankruptcy court orders
in state courts. The 8th Circuit conceded that the Sale Order was
itself entitled to full faith and credit in the Nebraska state
court proceedings.14 But, the court said, the Nebraska
courts had given full faith and credit to the Sale Order
and Section 363(f)—the state courts had merely
interpreted the scope of the Sale Order's free and clear
provision—and ruled against Liberty's claim "on
the merits."
Notably, the 8th Circuit did not explore the line between
permitting an "on the merits" interpretation of a free
and clear sale order and prohibiting a challenge to the order under
Section 363(m). Based on the broad "free and clear"
language in the Skyline Sale Order and the state court's
decision, it is difficult to imagine what "on the merits"
interpretation of a sale order by a state court would not be
permitted under the 8th Circuit's analysis.
It is interesting to consider that the 8th Circuit's approach
to this issue reaches a similar result to the decision of the 9th
Circuit Bankruptcy Appellate Panel in the much-discussed Clear
Channel case of several years ago.15 In Clear
Channel, the 9th Circuit BAP held that an aggrieved junior
lienholder could challenge the effect of the "free and
clear" provisions of a sale order, notwithstanding Section
363(m), because a challenge to the "free and clear"
provisions was not an attack on the sale order itself. In
Skyline Woods, the 8th Circuit seems to be saying that a
party may obtain a state court judgment that "free and
clear" provisions of a sale order are not applicable to it,
because such a judgment is not the result of an appeal of the sale
order, but rather an interpretation of the sale order. These two
decisions arise in different procedural contexts, with the 9th
Circuit BAP allowing a challenge to "free and clear"
language on appeal because the language is not integral to the sale
order, and with the 8th Circuit allowing a challenge to the
application of the "free and clear" language because the
challenge goes to the "merits" of the sale order. But in
each case the "free and clear" language was successfully
challenged notwithstanding Section 363(m)'s apparent
finality.
The Bottom Line
Purchasers rely on a bankruptcy court's "free and
clear" order when purchasing property. Many purchasers may
anticipate that, if the sale order is later challenged, they can
return to the bankruptcy court and resolve the dispute in a
favorable forum. Mid-City Bank v. Skyline Woods Homeowners
Association illustrates that when purchasers buy free and
clear under Section 363 of the Bankruptcy Code, they should
consider, among other risks, the risk that a non-bankruptcy court
will decide issues of whether the sale was "free and
clear," and that its decision will be adverse to and binding
on the purchasers. Purchasers may be able to mitigate this risk in
part by providing notice of the pending sale and "free and
clear" terms to all parties holding potential claims, and by
insisting that the sale order address those claims specifically and
clearly, reducing the likelihood that a state court will find the
need to "interpret" the sale order. However, even after
taking these actions, some risk and unpredictability may
remain.
Endnotes
1 In re Skyline Woods Country Club, 2011 WL 589912 (8th Cir. 2011).
2 Order Under 11 U.S.C. §§ 105(a), 363 and 365 and Federal Bankruptcy Rules 2042, 6004 and 6006 Authorizing and Approving (A) the Sale of Substantially all of the Debtor's Assets Free and Clear of Liens, Claims, and Encumbrances, (B) the Assumption and Assignment of Executory Contracts and Unexpired Leases; and (C) Granting Related Relief, In re Skyline Woods Country Club, L.L.C., No. 04-84218 (Bankr. Neb. Feb. 9, 2005) [Docket No. 75].
3 The Homeowners had not been given notice of the sale. This was noted by the courts in stating the factual background but was not the expressed basis of any court's decision.
4 Skyline Woods Homeowners v. Broekemeier, 758 N.W. 2d 376, 381 (Neb. S. Ct. 2008).
5 11 U.S.C. § 363(f)(1)-(5) (2011).
6 Skyline Woods Homeowners, 758 N.W. 2d. at 392 (citing
Gouveia v. Tazbir, 37 F.3d 295 (7th Cir. 1994); In re
WBQ P'ship, 189 B.R. 97 (Bankr. E.D. Va. 1995); In re
Oyster Bay Cove, Ltd., 161 B.R. 338 (Bankr. E.D.N.Y. 1993);
and In re 523 E. Fifth St. Housing Pres. Dev. Fund, 79
B.R. 568 (Bankr. S.D.N.Y. 1987)). These cases do not hold that
restrictive covenants do not constitute "interests" as
the Nebraska Supreme Court suggests. Other than Oyster
Bay, they uniformly agree that the trustee or debtor could not
sell free and clear of the "interest" of the beneficiary
of a restrictive covenant because the sale did not satisfy any of
the provisions in Section 363(f) of the Bankruptcy
Code–including Section 363(f)(5). Gouveia, 37
F.3d at 299; In re WBQ, 189 B.R. at 105-107; and In re
523 E. Fifth St., 79 B.R. at 570-71. Oyster Bay did
not go through the analysis of Section 363(f)(1)-(5), but held that
the language of the sale order at issue in that case did not imply
that the land was to be sold free and clear of non-monetary
restrictions of record which ran with the land. Oyster
Bay, 161 B.R. at 343.
7 In re Trans World Airlines, Inc., 322 F.3d 283, 288-91
(3d Cir. 2003).
8 In re Chrysler LLC, 405 B.R. 84 (Bankr. S.D.N.Y.
2009).
9 Skyline Woods Homeowners, 758 N.W. 2d at 395.
10 Order regarding Motion by Liberty Building Corporation, Mid-City
Bank, David Broekemeier and Robin Broekemeier to Reopen Chapter 7
Case, In re Skyline Woods Country Club, L.L.C., No.
04-84218 (Bankr. Neb. Nov. 13, 2009) [Docket No. 180].
11 In re Skyline Woods Country Club, 431 B.R. 830, 835
(B.A.P. 8th Cir. 2010).
12 Mid-City Bank v. Skyline Woods Homeowners Association
(In re Skyline Woods Country Club), 2011 WL 589912, *2
(8th Cir. 2011).
13 375 US 106, 111 (1963).
14 The 8th Circuit cited its own decision in Regions Bank v.
J.R. Oil Co., LLC for this principle. Notably, in Regions
Bank, the 8th Circuit held that a "free and clear"
sale order was binding on a non-party to the bankruptcy proceeding
because a bankruptcy sale order "free and clear of all liens,
is a judgment that is good as against the world, not merely as
against parties to the proceedings." 387 F.3d 721, 732 (8th
Cir. 2004).
15 Clear Channel Outdoor, Inc. v. Knupfer, 391 B.R. 25
(B.A.P. 9th Cir. 2008).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.