Exploring the Outer Limits of ' 363(f) Clearance

Clearing Successor Liability Claims: Leckie and TWA

Two of the most oft-cited cases on the issue of interest clearance under
' 363(f) are the Fourth Circuit's Leckie decision and the Third Circuit's decision in In re Trans World Airlines, Inc., 322 F.3d 283 (3d Cir. 2003). Both cases examine the extent to which ' 363(f) permits successor liability claims to be stripped from bankruptcy sale assets. Moreover, the latter case's reliance upon the former in its application of ' 363(f) to employment discrimination claims demonstrates the expansive scope of rights and interests that can potentially be cleared from bankruptcy sale assets. Indeed, TWA probably represents the most visible high tide marker of interest clearance under ' 363(f).

In Leckie, the Fourth Circuit dealt with consolidated appeals in which certain debtor coal operators had obtained ' 363(f) orders permitting the sale of their assets free and clear of any potential successor liability arising under the Coal Industry Retiree Health Benefit Act of 1992, 26 U.S.C. ” 9701-9722. Leckie, 99 F.3d at 575-76. Under the Coal Act, successors in interest to applicable coal operators acquire joint and several liability for the operators' Coal Act premium funding obligations. See 26 U.S.C. ” 9701(c)(2), 9704(a).

In assessing whether successor liability under the Coal Act fell within the scope of interests that could be cleared in a ' 363(f) sale, the Fourth Circuit acknowledged the difficulty in settling upon a precise definition of the operative phrase 'interest
in such property' as it appears in ' 363(f). See Leckie, 99 F.3d at 581-82. On the one hand, the Fourth Circuit rejected 'an unduly broad interpretation' that would encompass all general unsecured claims. Id. However, it also noted that 'Congress did not expressly indicate that, by employing such language, it intended to limit the scope of section 363(f) to in rem interests, strictly defined, and we decline to adopt such a restricted reading of the statute here.' Id at 582. The Fourth Circuit consequently determined that a sufficient relationship existed between the debtors' Coal Act liabilities and their sale assets such that the liabilities constituted interests in those assets that were subject to clearance under ' 363(f). Id. It stated that the Coal Act liabilities were 'grounded, at least in part, in the fact that those very assets had been employed for coal-mining purposes.' Id.

In the TWA case, the Third Circuit followed the reasoning of Leckie and applied it to prospective successor liability claims against TWA's buyer, American Airlines. See TWA, 322 F.3d 289-90. The bankruptcy court below had entered a sale order that extinguished successor liability on the part of American for certain employment discrimination claims against TWA as well as claims under a travel voucher program awarded to TWA's flight attendants in settlement of a sex discrimination class action. Id. at 285-87. Noting that 'the trend seems to be toward a more expansive reading of 'interests in property” as that phrase appears in ' 363(f), the Third Circuit examined and adopted the Fourth Circuit's Leckie rationale. Id. at 289. It consequently determined that a requisite 'relationship' existed between the employment claims against TWA and TWA's assets so as to find that the claims constituted 'interests in property within the meaning of ' 363(f) in the sense that they arise from the property being sold.' Id. at 289-290. As the court specifically stated:

Had TWA not invested in airline assets, which required the employment of the EEOC claimants, those successor liability claims would not have arisen. Furthermore, TWA's investment in commercial aviation is inextricably linked to its employment of the [class action] claimants as flight attendants, and its ability to distribute travel vouchers as part of the settlement agreement. Id. at 290.

Though Leckie and TWA both reflect express attempts to circumscribe the scope of general unsecured claims that should be considered interests for purposes of ' 363(f), it is difficult, as a practical matter, to find any clear dividing line. Virtually all claims against a Chapter 11 debtor will arise from its business operations. Therefore, the operation of most any Chapter 11 debtor's business assets can be said to give rise to its unsecured claims in the same manner as the coal mining assets in Leckie or the airline assets in TWA. Those decisions appear to make a distinction without any practical difference in that regard. However, their lessons are certainly not lost on savvy bankruptcy practitioners looking to clear almost any claims from sale assets on the basis of a Leckie/TWA-style 'relationship' between the claims and the assets.

Clearing Setoff (But Not Recoupment Rights): Folger Adam

Years before its TWA decision, the Third Circuit established certain limitations on the interests that can be stripped in a ' 363(f) sale through its decision in Folger Adam Security, Inc. v. DeMatteis/MacGregor, JV, 209 F.3d 252 (3d Cir. 2000). Folger Adam concerned the extent to which affirmative defenses of setoff, recoupment and other contract defenses constitute interests under ' 363(f) such that the debtor's consequent sale of accounts receivable stripped those defenses from the receivables. Id. at 253-54. The buyer of the receivables argued that the affirmative defenses were akin to claims that could be subjected to the 'free and clear' provision of ' 363(f). Id. at 260. The Third Circuit disagreed, and found that a defense is not necessarily the same as a claim, at least as far as the defense of recoupment is concerned. Id.

In reaching its conclusion in Folger Adam, the Third Circuit followed the reasoning of In re Lawrence United Corp., 221 B.R. 661, 669 (Bankr. N.D.N.Y. 1998). Folger Adam, 209 F.3d at 260-61. In that case, the bankruptcy court had recognized the survival of recoupment rights after a debtor's sale of related contractual rights, noting that the dispute over the efficacy of recoupment rights 'centered on what was actually purchased in the 'free and clear' sale as opposed to what purchaser liabilities resulted from the purchase.' Id. at 261 (citing Lawrence United, 221 B.R. 669). The Third Circuit concurred and also emphasized the distinction between an affirmative claim brought by a creditor as a potential liability against a purchaser and a defense of recoupment raised in response to a purchaser's claim. Id. The former may be characterized as an interest, but the latter is a defense and cannot be extinguished as an interest through a ' 363(f) sale. Id.

The Third Circuit took a different tack with setoff, however, and it consequently reached the opposite conclusion. It noted that the Bankruptcy Code expressly subjects setoff rights to ' 363 sales. Id. at 262. Specifically,
' 553(a) provides that setoff rights may be preserved in bankruptcy 'except as otherwise provided in ' section 363.' Id. (quoting 11 U.S.C. ' 553(a)). Based on this express limitation in the Code as well as its accompanying legislative history, the court concluded that setoff rights could generally be extinguished as an interest through a ' 363(f) sale. Id. at 262-63.

Clearing ' 365(H) Possessory Leasehold Rights: Qualitech

In Precision Indus., Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp.), 327 F.3d 537 (7th Cir. 2003), the Seventh Circuit applied ' 363(f) to a possessory leasehold interest and the lessor's putative rights under ' 365(h). The Seventh Circuit decided that a sale order issued under ' 363(f) extinguished a lessee's possessory interest in the sale property notwithstanding the terms of ' 365(h), which otherwise permit a lessee to remain in possession of estate property irrespective of a debtor in possession's decision to reject the lease. Id. at 548. Though the Seventh Circuit admitted that it did not need to extend ' 363(f) as far as the Third Circuit did in TWA (Id. at 545), its observations on the operative phrase 'any interest in such property' nevertheless suggest a broad scope.

The facts in Qualitech were straightforward. The debtor in possession had sold substantially all of its assets at auction to a group of its senior lenders in exchange for a credit bid. Id. at 540. The sale assets included a warehouse that was subject to the lenders' senior mortgage as well as an unrecorded lease in favor of a lessee in possession of the warehouse. Id. Although the bankruptcy court's sale order provided for the debtor in possession to transfer its assets to the lenders free and clear of all unenumerated liens and interests pursuant to ' 363(f), the lessee later contended that its possessory interest in the warehouse under ' 365(h) had survived the bankruptcy sale. Id. at 541.

Though recognizing its obligation to harmonize ” 363(f) and 365(h) in such a way as to avoid conflicts between the two (Id. at 544), the Seventh Circuit nevertheless concluded that the lessor's possessory rights under the lease and ' 365(h) fell within the scope of 'any interests' that could be appropriately cleared from the warehouse under ' 363(f). Id. at 546-48. The court noted that both of the words 'any' and 'interest' as used in ' 363(f) counseled in favor of a broad interpretation that would include the lessee's possessory interest in the warehouse. Id. at 545. Stopping short of the TWA holding, however, the Seventh Circuit noted that the lessee's interest was 'not simply a right that is connected to or arising from the property ' but a (limited) right to the property itself. That right readily may be understood as an 'interest' in the property.' Id. (Citation to TWA omitted.) The court consequently determined that the broad scope of ' 363(f) trumped the limited scope of ' 365(h). Id. at 547-48.

Apart from its observations on the broad scope of ' 363(f), Qualitech also suggests that adequate protection under ' 363(e) offers some compensatory redress to the holder of an interest that is stripped under ' 363(f). However, that redress may be hollow, particularly in the context of Qualitech's factual circumstances. Adequate protection in a sales context under ' 363(e) typically requires stripped interests to attach to sale proceeds with the same validity and priority as they had with regard to the sale assets under applicable law. See In re Allied Prods. Corp., 288 B.R. 533, 536 (Bankr. N.D. Ill. 2003) (quoting H.R. Rep. No. 95-595 at 345 (1977), reprinted in 1978 U.S.C.C.A.N. 5787, 6302). Since the sale in Qualitech involved a credit bid (Qualitech at 540), however, the sale did not generate any proceeds that could otherwise provide adequate protection. Moreover, since the interest at issue arose from an unrecorded lease (Id.), that interest would presumably be subordinate to the senior lenders' mortgage and 'out of the money' in any event. Adequate protection offers no consolation in such circumstances.

Conclusion

Notwithstanding any particular differences, the decisions in Leckie, TWA, Folger Adam, and Qualitech reflect a common theme. The phrase 'free and clear of any interest in such property,' as contained in ' 363(f) of the Bankruptcy Code, commands a broad interpretation that extends beyond mere liens and other in rem encumbrances on bankruptcy sale assets and reaches a broader range of rights and claims related to or flowing from those assets. The typical and expansive rote of most ' 363(f) sale orders ' 'free and clear of all liens, claims, and other interests' ' not only bears witness to that broad interpretation, but it also demonstrates that the limitations and consequent boundaries which decisions like Leckie, TWA, Folger Adam, and Qualitech articulate may not always be strictly observed in common practice. Only time and future court decisions will tell if those boundaries expand, recede, or become brighter as a result.

Peter J. Roberts is a member of the Commercial Bankruptcy and Restruct- uring Group at Chicago's Shaw Gussis Fishman Glantz Wolfson & Towbin LLC. He may be reached at 312-276-1322 or [email protected].

Bankruptcy offers an attractive platform for the sale of assets because it is injected with a statutory prerogative allowing for the clearance of third- party interests. Specifically, ' 363(f) of the Bankruptcy Code permits the sale of bankruptcy estate property 'free and clear of any interest [of any other entity] in such property' provided that certain conditions are satisfied. See 11 U.S.C. ' 363(f) (2007).

Notwithstanding that grant of authority, however, the Bankruptcy Code does not specifically define the phrase 'any interest in such property' or otherwise specify the scope of interests that the phrase is intended to cover. Therefore, as the Fourth Circuit has noted, 'the precise boundaries of the phrase likely will be defined only as the courts continue to apply it to the facts presented in the cases brought before them.' UMWA 1992 Benefit Plan v. Leckie Smokeless Coal Co. (In re Leckie Smokeless Coal Co.), 99 F.3d 573, 582 (4th Cir. 1996).

This article explores the boundaries of interest clearance under ' 363(f) as examined in four preeminent cases at the Court of Appeals level. Applying ' 363(f)'s key phrase 'any interest in such property' to circumstances involving successor liability, contract defenses, and possessory leaseholds, these cases collectively mark the current boundaries. In that regard, they have had, and will continue to have, a profound impact on the value that bankruptcy estates can expect to generate from the sale of their assets. After all, from a buyer's point of view, asset value necessitates a discount to the extent that any strings are attached to the asset in the form of associated liabilities. Therefore, in order to maximize asset value for their bankruptcy estates, trustees and debtors in possession will continue to push the outer limits of interest clearance to the extent of existing case law and beyond. These decisions show the available paths in varying contexts.

Clearing Successor Liability Claims: Leckie and TWA

Two of the most oft-cited cases on the issue of interest clearance under
' 363(f) are the Fourth Circuit's Leckie decision and the Third Circuit's decision in In re Trans World Airlines, Inc., 322 F.3d 283 (3d Cir. 2003). Both cases examine the extent to which ' 363(f) permits successor liability claims to be stripped from bankruptcy sale assets. Moreover, the latter case's reliance upon the former in its application of ' 363(f) to employment discrimination claims demonstrates the expansive scope of rights and interests that can potentially be cleared from bankruptcy sale assets. Indeed, TWA probably represents the most visible high tide marker of interest clearance under ' 363(f).

In Leckie, the Fourth Circuit dealt with consolidated appeals in which certain debtor coal operators had obtained ' 363(f) orders permitting the sale of their assets free and clear of any potential successor liability arising under the Coal Industry Retiree Health Benefit Act of 1992, 26 U.S.C. ” 9701-9722. Leckie, 99 F.3d at 575-76. Under the Coal Act, successors in interest to applicable coal operators acquire joint and several liability for the operators' Coal Act premium funding obligations. See 26 U.S.C. ” 9701(c)(2), 9704(a).

In assessing whether successor liability under the Coal Act fell within the scope of interests that could be cleared in a ' 363(f) sale, the Fourth Circuit acknowledged the difficulty in settling upon a precise definition of the operative phrase 'interest
in such property' as it appears in ' 363(f). See Leckie, 99 F.3d at 581-82. On the one hand, the Fourth Circuit rejected 'an unduly broad interpretation' that would encompass all general unsecured claims. Id. However, it also noted that 'Congress did not expressly indicate that, by employing such language, it intended to limit the scope of section 363(f) to in rem interests, strictly defined, and we decline to adopt such a restricted reading of the statute here.' Id at 582. The Fourth Circuit consequently determined that a sufficient relationship existed between the debtors' Coal Act liabilities and their sale assets such that the liabilities constituted interests in those assets that were subject to clearance under ' 363(f). Id. It stated that the Coal Act liabilities were 'grounded, at least in part, in the fact that those very assets had been employed for coal-mining purposes.' Id.

In the TWA case, the Third Circuit followed the reasoning of Leckie and applied it to prospective successor liability claims against TWA's buyer, American Airlines. See TWA, 322 F.3d 289-90. The bankruptcy court below had entered a sale order that extinguished successor liability on the part of American for certain employment discrimination claims against TWA as well as claims under a travel voucher program awarded to TWA's flight attendants in settlement of a sex discrimination class action. Id. at 285-87. Noting that 'the trend seems to be toward a more expansive reading of 'interests in property” as that phrase appears in ' 363(f), the Third Circuit examined and adopted the Fourth Circuit's Leckie rationale. Id. at 289. It consequently determined that a requisite 'relationship' existed between the employment claims against TWA and TWA's assets so as to find that the claims constituted 'interests in property within the meaning of ' 363(f) in the sense that they arise from the property being sold.' Id. at 289-290. As the court specifically stated:

Had TWA not invested in airline assets, which required the employment of the EEOC claimants, those successor liability claims would not have arisen. Furthermore, TWA's investment in commercial aviation is inextricably linked to its employment of the [class action] claimants as flight attendants, and its ability to distribute travel vouchers as part of the settlement agreement. Id. at 290.

Though Leckie and TWA both reflect express attempts to circumscribe the scope of general unsecured claims that should be considered interests for purposes of ' 363(f), it is difficult, as a practical matter, to find any clear dividing line. Virtually all claims against a Chapter 11 debtor will arise from its business operations. Therefore, the operation of most any Chapter 11 debtor's business assets can be said to give rise to its unsecured claims in the same manner as the coal mining assets in Leckie or the airline assets in TWA. Those decisions appear to make a distinction without any practical difference in that regard. However, their lessons are certainly not lost on savvy bankruptcy practitioners looking to clear almost any claims from sale assets on the basis of a Leckie/TWA-style 'relationship' between the claims and the assets.

Clearing Setoff (But Not Recoupment Rights): Folger Adam

Years before its TWA decision, the Third Circuit established certain limitations on the interests that can be stripped in a ' 363(f) sale through its decision in Folger Adam Security, Inc. v. DeMatteis/MacGregor, JV , 209 F.3d 252 (3d Cir. 2000). Folger Adam concerned the extent to which affirmative defenses of setoff, recoupment and other contract defenses constitute interests under ' 363(f) such that the debtor's consequent sale of accounts receivable stripped those defenses from the receivables. Id. at 253-54. The buyer of the receivables argued that the affirmative defenses were akin to claims that could be subjected to the 'free and clear' provision of ' 363(f). Id. at 260. The Third Circuit disagreed, and found that a defense is not necessarily the same as a claim, at least as far as the defense of recoupment is concerned. Id.

In reaching its conclusion in Folger Adam, the Third Circuit followed the reasoning of In re Lawrence United Corp., 221 B.R. 661, 669 (Bankr. N.D.N.Y. 1998). Folger Adam, 209 F.3d at 260-61. In that case, the bankruptcy court had recognized the survival of recoupment rights after a debtor's sale of related contractual rights, noting that the dispute over the efficacy of recoupment rights 'centered on what was actually purchased in the 'free and clear' sale as opposed to what purchaser liabilities resulted from the purchase.' Id. at 261 (citing Lawrence United, 221 B.R. 669). The Third Circuit concurred and also emphasized the distinction between an affirmative claim brought by a creditor as a potential liability against a purchaser and a defense of recoupment raised in response to a purchaser's claim. Id. The former may be characterized as an interest, but the latter is a defense and cannot be extinguished as an interest through a ' 363(f) sale. Id.

The Third Circuit took a different tack with setoff, however, and it consequently reached the opposite conclusion. It noted that the Bankruptcy Code expressly subjects setoff rights to ' 363 sales. Id. at 262. Specifically,
' 553(a) provides that setoff rights may be preserved in bankruptcy 'except as otherwise provided in ' section 363.' Id. (quoting 11 U.S.C. ' 553(a)). Based on this express limitation in the Code as well as its accompanying legislative history, the court concluded that setoff rights could generally be extinguished as an interest through a ' 363(f) sale. Id. at 262-63.

Clearing ' 365(H) Possessory Leasehold Rights: Qualitech

In Precision Indus., Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp.), 327 F.3d 537 (7th Cir. 2003), the Seventh Circuit applied ' 363(f) to a possessory leasehold interest and the lessor's putative rights under ' 365(h). The Seventh Circuit decided that a sale order issued under ' 363(f) extinguished a lessee's possessory interest in the sale property notwithstanding the terms of ' 365(h), which otherwise permit a lessee to remain in possession of estate property irrespective of a debtor in possession's decision to reject the lease. Id. at 548. Though the Seventh Circuit admitted that it did not need to extend ' 363(f) as far as the Third Circuit did in TWA (Id. at 545), its observations on the operative phrase 'any interest in such property' nevertheless suggest a broad scope.

The facts in Qualitech were straightforward. The debtor in possession had sold substantially all of its assets at auction to a group of its senior lenders in exchange for a credit bid. Id. at 540. The sale assets included a warehouse that was subject to the lenders' senior mortgage as well as an unrecorded lease in favor of a lessee in possession of the warehouse. Id. Although the bankruptcy court's sale order provided for the debtor in possession to transfer its assets to the lenders free and clear of all unenumerated liens and interests pursuant to ' 363(f), the lessee later contended that its possessory interest in the warehouse under ' 365(h) had survived the bankruptcy sale. Id. at 541.

Though recognizing its obligation to harmonize ” 363(f) and 365(h) in such a way as to avoid conflicts between the two (Id. at 544), the Seventh Circuit nevertheless concluded that the lessor's possessory rights under the lease and ' 365(h) fell within the scope of 'any interests' that could be appropriately cleared from the warehouse under ' 363(f). Id. at 546-48. The court noted that both of the words 'any' and 'interest' as used in ' 363(f) counseled in favor of a broad interpretation that would include the lessee's possessory interest in the warehouse. Id. at 545. Stopping short of the TWA holding, however, the Seventh Circuit noted that the lessee's interest was 'not simply a right that is connected to or arising from the property ' but a (limited) right to the property itself. That right readily may be understood as an 'interest' in the property.' Id. (Citation to TWA omitted.) The court consequently determined that the broad scope of ' 363(f) trumped the limited scope of ' 365(h). Id. at 547-48.

Apart from its observations on the broad scope of ' 363(f), Qualitech also suggests that adequate protection under ' 363(e) offers some compensatory redress to the holder of an interest that is stripped under ' 363(f). However, that redress may be hollow, particularly in the context of Qualitech's factual circumstances. Adequate protection in a sales context under ' 363(e) typically requires stripped interests to attach to sale proceeds with the same validity and priority as they had with regard to the sale assets under applicable law. See In re Allied Prods. Corp., 288 B.R. 533, 536 (Bankr. N.D. Ill. 2003) (quoting H.R. Rep. No. 95-595 at 345 (1977), reprinted in 1978 U.S.C.C.A.N. 5787, 6302). Since the sale in Qualitech involved a credit bid (Qualitech at 540), however, the sale did not generate any proceeds that could otherwise provide adequate protection. Moreover, since the interest at issue arose from an unrecorded lease (Id.), that interest would presumably be subordinate to the senior lenders' mortgage and 'out of the money' in any event. Adequate protection offers no consolation in such circumstances.

Conclusion

Notwithstanding any particular differences, the decisions in Leckie, TWA, Folger Adam, and Qualitech reflect a common theme. The phrase 'free and clear of any interest in such property,' as contained in ' 363(f) of the Bankruptcy Code, commands a broad interpretation that extends beyond mere liens and other in rem encumbrances on bankruptcy sale assets and reaches a broader range of rights and claims related to or flowing from those assets. The typical and expansive rote of most ' 363(f) sale orders ' 'free and clear of all liens, claims, and other interests' ' not only bears witness to that broad interpretation, but it also demonstrates that the limitations and consequent boundaries which decisions like Leckie, TWA, Folger Adam, and Qualitech articulate may not always be strictly observed in common practice. Only time and future court decisions will tell if those boundaries expand, recede, or become brighter as a result.

Peter J. Roberts is a member of the Commercial Bankruptcy and Restruct- uring Group at Chicago's Shaw Gussis Fishman Glantz Wolfson & Towbin LLC. He may be reached at 312-276-1322 or [email protected].