Fifth Circuit Held Lender is a “Good Faith Purchaser” When Bidding on Affiliate’s Property

Julianne Buff

St. John’s University School of Law

American Bankruptcy Institute Law Review Staff

In In re RE Palm Springs II, L.L.C., the Fifth Circuit of the Unites States Court of Appeals found that after a lender accelerated its loan to a real property developer and the developer transferred the property to the lender’s affiliate, the lender was entitled to make a credit bid to purchase the property in the affiliate’s bankruptcy case.[1] Additionally, the Fifth Circuit found, over the objection of a junior lien holder, that the lender was a good faith purchaser and entitled to the protections under section 363(m) of the Bankruptcy Code.[2]

Palm Springs, LLC (the “Developer”) is a commercial real estate developer that owned property in California (the “Property”) and contracted with SR Construction to develop the Property and build a hotel.[3] The Developer financed the project and provided a deed of trust to Hall Palm Springs, LLC (the “Lender”).[4] The Lender entered into a subordination agreement with SR Construction, which gave the Lender priority of repayment.[5] The Developer was unable to complete the project and terminated its contract with SR Construction on October 22, 2019, owing SR Construction $14,151,000.00.[6] Nine days later, the Developer defaulted on its loan, and the Lender accelerated the debt.[7] On November 25, 2019, SR Construction filed a mechanic’s lien on the Property.[8] SR Construction also filed suit in California state court in January 2020, seeking to foreclose on its mechanics lien in a position superior to the Lender’s lien.[9] Thereafter, in February 2020, the Lender’s president formed an entity affiliated with the Lender (“Affiliate”), and the Developer conveyed the Property to the Affiliate pursuant to a conveyance agreement.[10] The Affiliate filed for bankruptcy on July 22, 2020, and the Bankruptcy Court approved an auction of the Property, but no successful bids were submitted.[11] The Bankruptcy Court then approved a credit bid submission by the Lender and the Property was sold to the Lender free and clear of all liens.[12] SR Construction appealed the sale of the Property claiming that the Lender was not a “good faith purchaser,” under section  363(m) of title 11 of the United States Code (“Bankruptcy Code”).[13] The District Court found the Lender to be a “good faith purchaser” and dismissed all claims.[14] SR Construction subsequently appealed to the Fifth Circuit.[15]

Section 363(m) of the Bankruptcy Code states “[t]he reversal or modification on appeal of an authorization . . . of a sale . . . of property does not affect the validity of a sale . . . under such authorization to an entity that purchased . . . such property in good faith . . . .”[16]  While the Bankruptcy Code does not define “good faith,” the Fifth Circuit has held that a “good faith purchaser” is one who (1) “purchases the assets for value . . . without notice of adverse claims” and (2) “does not engage in ‘misconduct . . . fraud, collusion . . . , or an attempt to take grossly unfair advantage of other bidders.”[17] The Fifth Circuit reviewed the Lender’s actions within the scope of these two elements and reasoned that the Lender was a “good faith purchaser.”[18]

First, the Fifth Circuit analyzed whether the Lender had notice of an adverse claim on the Property.[19] To be considered an adverse claim, there must be “a dispute in ownership interest.”[20] SR Construction argued that the mechanic’s lien and the pending lawsuits in California should be considered a “dispute in ownership interest.”[21] A mechanic’s lien, however, is not enough to constitute an ownership interest.[22] Similarly, the California proceedings did not establish a sufficient ownership interest because the subordination agreement allowed the Lender to retain senior lien holder status.[23] Therefore, the Lender had no notice of any adverse claim.[24]

Second, the Fifth Circuit analyzed whether the Lender engaged in fraud or misconduct.[25] SR Construction argued that the bidding procedures were fraudulent because the process did not give potential buyers enough time to conduct due diligence prior to the bid deadline.[26] Contrary to SR Construction’s contention, the Fifth Circuit found that the bidding procedures were not fraudulent because the Lender marketed the Property, provided financing to prospective purchasers, extended the marketing process, and waited to submit a credit bid until all prospective bidders had fallen through.[27] These acts “satisfied the [L]ender’s burden of establishing itself as a good faith purchaser.”[28]

Accordingly, the Fifth Circuit concluded that the Lender did not fraudulently manipulate the bankruptcy proceedings.[29]  As a result, the Fifth Circuit found that the Lender was a good faith purchaser and entitled to the protections afforded under section 363(m) of the Bankruptcy Code.[30]