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Seventh Circuit Decision May Open Door To Junior Creditors’ Sharing In § 363 Sales – Glass & Goldberg | Financing, Property & Bankruptcy Law
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Seventh Circuit Decision May Open Door To Junior Creditors’ Sharing In § 363 Sales

The Seventh Circuit Court of Appeals’ recent decision in Illinois Department of Revenue v. Hanmi Bank challenges the prevailing view that as a matter of law an underwater senior creditor always could retain the entire proceeds of a free-and-clear sale with junior creditors receiving nothing. The Seventh Circuit’s decision may allow junior creditors in future bankruptcy cases a recovery based on the theory that a free and clear sale under § 363 of the Bankruptcy Code (Title 11) creates a premium for those assets that a junior creditor may potentially be entitled to share.

A sale under § 363 of the U.S. Bankruptcy Code (Title 11) allows the sale of assets through an auction and enables debtors with no desire to reorganize an opportunity to obtain the best possible return on their assets. While Hanmi deals with a state taxing authority and its particular rights under Illinois state law, nothing in the Seventh Circuit opinion limits its holding to the facts or to a specific type of creditor.

The court reasoned that a free-and-clear sale inherently creates a premium in value since it eliminates junior interests that otherwise may be difficult to eliminate. Some portion of the sale proceeds should be allocated to the eliminated junior interest, rather than going entirely to the underwater senior creditor. Although The court ultimately held in favor of the senior secured lenders on the evidence presented finding a failure of proof by the junior creditors of the value of the interest they would theoretically lose in the sale, the court’s reasoning opens the door to future bankruptcy cases where junior creditors may potentially receive a share of the sale proceeds.

The decision may allow junior creditors in future bankruptcy cases significant, and unprecedented, leverage to convince senior creditors into agreeing to share some of the proceeds of a free-and-clear sale, or otherwise submit to a contested evidentiary hearing regarding either the value of the interest lost by the junior creditors or the amount of the premium paid by the sale purchaser based on the enhanced protection of a free-and-clear sale because of the eliminated junior interests.

It is possible that other courts could narrowly regard the opinion and only apply it in circumstances where a junior creditor holds a successor liability claim against the purchaser at the sale personally rather than any claim against the selling debtor. The Seventh Circuit speculated that the purchasers at the sale may have paid a premium specifically to be insulated from any successor liability, and it is possible that a court would find no existing premium

While not all of the effects of this decision may be apparent, the possibility exists that increased delays may arise from the necessity to negotiate these sales with obstinate or defiant junior creditors. The decision also makes § 363 sales costlier and more unpredictable as it extends the life of the bankruptcy case and potentially reduces the recoveries of other creditor classes.

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