A Section 363 Sale Does NOT Transfer Property Free and Clear of an Equitable Servitude

Sales in bankruptcy court under 11 U.S.C. § 363 (called “363 Sales”) are often used to sell property during a bankruptcy case.  The 363 Sale process provides an efficient procedure to liquidate estate property and offers several advantages to sales outside of bankruptcy – including the highly desirable ability to sell property “free and clear” of interests.  The procedure is used so regularly and with such great success that parties often expect 363 Sales to transfer property free and clear of all interests as a matter of course.  That result, however, is not always the case.

In re Hassen Imports Partnership reminds us that a 363 Sale does not automatically transfer title free and clear of all interests in real property.  In Hassen, a district court judge reversed a bankruptcy court’s order authorizing a 363 Sale of real property free and clear of an equitable servitude.[1]

The City of West Covina entered into a development agreement with the debtor, Hassen Imports, in 1999 regarding the debtor’s ownership and use of certain car dealerships.  The agreement gave the City the right to approve any future owner of the property, the right to approve any future operators of the property, and required the property to be used solely for automobile-related purposes.

The debtor filed for bankruptcy in 2011, and a trustee sought to sell the property free and clear of the City’s recorded agreement.  The bankruptcy court correctly found that the agreement with the City was an equitable servitude (because the agreement was recorded and related to the use and occupancy of the land), but concluded that the trustee could nevertheless sell the property free and clear of the City’s interest under 11 U.S.C. § 363(f)(5).

Subsection (f)(5) authorizes a sale “free and clear of any interest in such property of an entity” if “such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.”  In other words, if a proceeding (such as a foreclosure sale) can compel an entity (such as a junior lienholder) to accept money in exchange for its interest (such as a junior lien), then the bankruptcy court can sell property free and clear of that entity’s interest.

The Hassen bankruptcy court concluded that because California law allows a foreclosure sale by a senior lender to wipe out a junior equitable servitude, 11 U.S.C. § 365(f)(5) therefore authorized the bankruptcy court to sell the property free and clear of the City’s interest.  The City appealed this decision to the district court.

The district court reversed, because under California law, a foreclosure sale would not entitle the City to any right in the proceeds from the foreclosure sale.  In other words, the City would not receive any money from a foreclosure sale as a result of its equitable servitude interest.  Thus, the district court determined that a foreclosure sale proceeding could not be used to compel the City to accept a “monetary satisfaction” in exchange for its interest.  Accordingly, the sale could not proceed to the buyer free and clear of the City’s interest under the plain language of Bankruptcy Code § 363(f)(5).

In addition to reminding us that 363 Sales are (contrary to popular belief) not without limits, the holding in Hassen highlights the importance of understanding the interests that are encumbering property to be sold.  Going forward, buyers and sellers of property in bankruptcy may not be able to rely on a 363 Sale (or at least subsection (f)(5)) to avoid burdensome non-lien interests similar to equitable servitudes, real covenants at law, easements, etc.  Instead, parties may have to come up with more creative solutions to sell around these types of interests.