INSIGHT: Creditors Not Required to Share Sale Proceeds to Pay Taxes

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By Stephen T. Bobo

Where the Illinois Department of Revenue (IDOR) failed to establish how much it would have received from bankruptcy sales, the proceeds of which had been paid to the secured lenders, it was not entitled any share of the proceeds of sales that were allowed to proceed free and clear of its interest, according to the recent decision of the U.S. Court of Appeals for the Seventh Circuit in Ill. Dep’t of Revenue v. Hanmi Bank, 2018 BL 241633, No. 17-01575 (July 9, 2018).

The issue arose in consolidated appeals from two separate bankruptcy cases. The appellate court held that without proof of its loss, IDOR had no right to rely on the section 363(e) of the Bankruptcy Code, which provides for adequate protection of a creditor’s interest in the debtor’s assets that is wiped out in a sale free and clear of such interests. Accordingly, the Seventh Circuit, in an opinion authored by Judge Ilana D. Rovner, affirmed the bankruptcy courts’ opinions assigning no value to IDOR’s interests in the sale proceeds.

The case involved certain Illinois statutes, referred to as “Bulk Sale Provisions,” that allow IDOR to collect unpaid state taxes from a purchaser where a taxpayer sells the majority of its assets outside of the normal course of business. IDOR contended that selling the assets free and clear of its rights against the purchaser made them worth more and it was entitled to a share of the sales proceeds as compensation for removal of this interest. The secured lenders disagreed because they had undisputed senior liens on the sale assets and first right to the proceeds. In their view, allowing IDOR to share in the proceeds would permit it to “jump the queue” of creditors.

Proceeding Below

In both cases, the debtor’s assets were subject to senior liens securing bank loans that were far larger than the value of the assets. In one case, the debtor owed more than $14 million to the bank and owed more than $1.8 million in taxes to IDOR, whereas the sale proceeds were only $5.2 million. In the other case, the bank was owed nearly $4 million, and the IDOR was owed nearly $600,000 in taxes, which were far more than the sales proceeds.

The bankruptcy courts had approved the sales free and clear of any creditor interests, including the Bulk Sales Provisions, pursuant to Section 363(f) of the Bankruptcy Code. IDOR requested that portions of the proceeds be set aside to cover the taxes owed, citing Section 363(e) that allows for protection of interests affected by a sale of assets. However, both courts rejected IDOR’s request for a share of the sale proceeds.

IDOR appealed the ruling in each case to the district court, with the result that the cases were partially remanded for further proceedings to determine how much the free and clear sales had cost IDOR. The bankruptcy judges then ruled against IDOR a second time because it had not established what it could have recovered on account of its interest. Therefore, the sale free and clear had not decreased the value of that interest and IDOR had no entitlement to compensation pursuant to section 363(e).

Thereafter, IDOR appealed directly to the Seventh Circuit. Although it affirmed the rulings of the bankruptcy courts, the Seventh Circuit seemed open to the concept that IDOR could collect some value from the proceeds of the sales, notwithstanding the rights of the secured lenders.

The Seventh Circuit’s Analysis

A significant aspect of the Seventh Circuit’s decision is that the panel expressly “assume[d] without deciding” that IDOR’s ability to collect taxes due from a purchaser was an “interest” in a debtor’s property that would entitle it to adequate protection under section 363(e). Such adequate protection would conflict with the senior rights of the secured creditors to sales proceeds. The issue had been litigated below but not preserved on appeal. The opinion refers to IDOR’s Bulk Sales Provisions allowing collection of unpaid taxes from purchasers as “a unique and powerful weapon.” This assumption appears likely to be the subject of litigation in the future, since the Bulk Sales Provisions create legal rights against a non-debtor party, rather than directly against property of the debtor’s estate being sold pursuant to section 363(f).

From this point, the Seventh Circuit was faced with the question of how to value the assumed IDOR’s interest that would entitle it to a share of the sale proceeds ahead of more senior creditors. IDOR asserted entitlement to 100 percent of its unpaid taxes, arguing that its interest had been included in the prices paid for the debtors’ assets because the purchasers believed they were avoiding claims against them for the unpaid taxes. However, IDOR failed to offer any evidence supporting this result. The Seventh Circuit panel was left to analyze the issue in hypothetical terms. “It might have struck a deal with the banks and/or the purchasers to recover something less than 100 percent of the taxes, but at no point in the proceedings has [IDOR] offered any evidence, or articulated any methodology, by which we could determine how much it might have recovered in such a deal and in turn the extent to which the value of its interest decreased when the bankruptcy court lifted its interest from the debtors’ properties.”

If instead, the bankruptcy courts had authorized asset sales under terms that took into account the overdue taxes, the purchasers would have made arrangements with IDOR that would have involved payment of something less than 100 percent, the panel said. On the other hand, the secured lenders could have sought leave to sell the assets pursuant to their rights under Article 9 of the Uniform Commercial Code, either through public foreclosure sales or private sales of an operating business. Such sales by the secured lenders would not have triggered the Bulk Sales Provisions and would not have afforded IDOR to any right to payment from the purchaser.

The opinion strongly suggests that the parties should work out a middle ground regarding the sales proceeds. “Given that the banks and IDOR both have the means to block a sale that does not adequately address their respective interest in compensation, a compromise as to the allocation of sale proceeds is likely the only way that a bulk sale would proceed in a case where the seller’s assets fall short of making whole even the senior-most creditor, let alone that creditor and IDOR both. A compromise, of course, would entail the bank agreeing to let IDOR, notwithstanding its status as a junior creditor, take some portion of the sale proceeds in exchange for releasing the purchaser from successor liability for unpaid taxes, and IDOR agreeing to accept something less than 100 percent of the amount the Bulk Sales Provisions would allow it to collect.”

Without IDOR presenting evidence that could be used to calculate how much it would have collected on account of its interest, it was not wrong for the bankruptcy judges to set the values at zero in each case, Judge Rovner wrote.

Comments

The issues underlying the decision seem ripe for further litigation, both in the bankruptcy courts and before the Seventh Circuit, since sales under section 363 free and clear of creditor rights such as Bulk Sales Provisions are common. The next time such issues arise, at least in Illinois, it can be expected that IDOR and secured lenders would present conflicting expert testimony about the relative costs and benefits of alternative means of selling the assets, including foreclosure sales, and what would have been a reasonable compromise to allow the 363 sale to proceed. This would leave the court to attempt to divine an answer without much guidance from the Hanmi Bank decision. Sale hearings may also be more likely to include evidence from the purchaser (and perhaps from other bidders) that it would have walked away from the sale if IDOR had maintained its right to pursue the purchaser for the debtor’s taxes. While these various forms of evidence may be at least partially conjectural, they would be more than the Seventh Circuit had to work with in the case before it.

In addition, the Seventh Circuit’s assumption that the Bulk Sales Provisions amount to an “interest” in the debtor’s property for purposes of section 363 should invite further litigation to resolve this point. This may be important in other jurisdictions as well, since the opinion refers to similar laws in several other states.

Finally, the uncertainty regarding these issues presents a risk of discouraging purchaser interest in such sales, leading to fewer bidders and depressed offer amounts. Another risk of concern to secured creditors is that purchasers may more focus on protecting themselves through appropriate holdbacks of portions of the purchase price. Even where a bankruptcy court enters an order approving a sale free and clear of all interests, there may be a heightened concern that the order could be reversed on appeal with resulting exposure for the purchaser.

Author Information

Stephen T. Bobo is a partner at Reed Smith LLP in Chicago. He is a member of the Financial Industry Group, practicing in the area of Restructuring & Insolvency. His practice focuses on restructuring and workout matters and related litigation, representing both debtors and creditors.

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