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Seventh Circuit: Section 363(m) Does Not Moot but Instead Provides a Defense to an Appeal of an Unstayed Bankruptcy Asset Sale Order

In Trinity 83 Dev., LLC v. ColFin Midwest Funding, LLC, 917 F.3d 599 (7th Cir. 2019), the U.S. Court of Appeals for the Seventh Circuit held that section 363(m) of the Bankruptcy Code does not moot an appeal involving a dispute over the proceeds of a sale of assets in bankruptcy. In concluding that section 363(m) does not moot such an appeal, but merely provides the purchaser with a defense in litigation challenging the sale, the Seventh Circuit overruled its prior decision on the scope of section 363(m) in In re River West Plaza-Chicago, LLC, 664 F.3d 668 (7th Cir. 2011). According to the Seventh Circuit in Trinity 83, "We now hold that § 363(m) does not make any dispute moot or prevent a bankruptcy court from deciding what shall be done with the proceeds of a sale or lease." The court ultimately held that the bankruptcy court did not err in finding that a secured lender that mistakenly released its mortgage, but then unilaterally canceled the release before the borrower filed for bankruptcy or another party’s rights intervened, did not forfeit its rights in the collateral and its proceeds.

Mootness and Section 363(m)

"Mootness" is a doctrine that precludes a reviewing court from reaching the underlying merits of a controversy. An appeal can be either constitutionally, equitably, or statutorily moot. Constitutional mootness is derived from Article III of the U.S. Constitution, which limits the jurisdiction of federal courts to actual cases or controversies and, in furtherance of the goal of conserving judicial resources, precludes adjudication of cases that are hypothetical or merely advisory.

By contrast, the judge-fashioned remedy of "equitable mootness" bars adjudication of an appeal when a comprehensive change of circumstances has occurred such that it would be inequitable for a reviewing court to address the merits of the appeal. In bankruptcy cases, appellees often invoke equitable mootness as a basis for precluding appellate review of an order confirming a chapter 11 plan if the plan has been substantially consummated.

An appeal can also be rendered moot (or otherwise foreclosed) by statute. For example, section 363(m) of the Bankruptcy Code provides that "[t]he reversal or modification on appeal of an authorization … of a sale or lease of property does not affect the validity of a sale or lease … to an entity that purchased or leased such property in good faith." Although courts disagree on the point, section 363(m) has been interpreted "to render statutorily moot any appellate challenge to a sale that is both to a good faith purchaser, and not stayed." Mission Product Holdings, Inc. v. Old Cold, LLC (In re Old Cold, LLC), 879 F.3d 376, 383 (1st Cir. 2018). Section 363(m) is a powerful protection for good-faith purchasers because it limits appellate review of a consummated sale irrespective of the legal merits of the appeal. See Made in Detroit, Inc. v. Official Comm. of Unsecured Creditors of Made in Detroit, Inc. (In re Made in Detroit, Inc.), 414 F.3d 576 (6th Cir. 2005).

Section 363(m) serves important public-policy considerations. Maximization of value is a fundamental goal of the Bankruptcy Code. Toibb v. Radloff, 501 U.S. 157 (1991). By protecting the finality of bankruptcy sales, section 363(m) helps to maximize the value of a debtor’s estate by encouraging the participation of buyers who are assured that a deal consummated with a debtor or bankruptcy trustee will not be modified by an appellate court after a sale transaction closes. Weingarten Nostat, Inc. v. Serv. Merch. Co., 396 F.3d 737 (6th Cir. 2005).

The courts of appeals are split regarding whether section 363(m) automatically moots an appeal of an order approving a sale under all circumstances. Some circuits, including the First, Second, Fifth, Eleventh, and D.C. Circuits, have held that, in the absence of a stay of the sale order, the court must dismiss a pending appeal as moot unless the purchaser did not act in good faith. Old Cold, 879 F.3d at 383; U.S. v. Salerno, 932 F.2d 117 (2d Cir. 1991); In re Sneed Shipbuilding, Inc., 916 F.3d 405 (5th Cir. 2019); In re Steffen, 552 F. App’x 946 (11th Cir. 2014); In re Magwood, 785 F.2d 1077 (D.C. Cir. 1986); see also In re Ern, LLC, 124 F. App’x 151, 152 (4th Cir. 2005) (unpublished ruling) (dismissing an appeal of a sale order as moot because the assets had been transferred and the party challenging the sale failed to obtain a stay pending appeal); In re Trism, Inc., 328 F.3d 1003, 1007 (8th Cir. 2003) (mooting under section 363(m) "a challenge to a related provision of an order authorizing the sale of the debtor’s assets" because the related provision was integral to the sale of the assets and reversing the provision would adversely alter the parties’ bargained-for exchange); In re Rimoldi, 172 F.3d 876, 1999 WL 132260, *1 (9th Cir. 1999) (unpublished ruling) ("This court has recognized only two exceptions to section 363(m)’s rule of mootness. The first applies where real property is sold subject to a statutory right of redemption; the second applies where state law otherwise would permit the transaction to be set aside."). Before Trinity 83, the Seventh Circuit had strictly interpreted section 363(m). See River West, 664 F.3d at 671–72.

Other circuits, including the Third, Sixth, and Tenth Circuits, have rejected the view that section 363(m) automatically moots an appeal. Instead, these courts have held that an appeal is not moot so long as it is possible to grant effective relief without impacting the validity of the sale. See In re ICL Holding Co., Inc., 802 F.3d 547, 554 (3d Cir. 2015) (section 363(m) did not moot the government’s appeal of the terms for distribution of escrowed funds for administrative expenses and settlement proceeds from the sale of substantially all of the debtors’ assets since the court could order redistribution of the sale proceeds without disturbing the sale); Brown v. Ellmann (In re Brown), 851 F.3d 619 (6th Cir. 2017) (finding that parties alleging statutory mootness under section 363(m) must prove that the reviewing court is unable to grant effective relief); Osborn v. Duran Bank & Trust Co. (In re Osborn), 24 F.3d 1199 (10th Cir. 1994) (holding that an appeal of a sale order was not mooted by section 363(m) when under Texas state law a constructive trust could be imposed on the sale proceeds), abrogated in part on other grounds by Eastman v. Union Pac. R.R., 493 F.3d 1151 (10th Cir. 2007); In re C.W. Min. Co., 740 F.3d 548, 555 (10th Cir. 2014) (section 363(m) will moot appeals in cases where the only remedies available are those that affect the validity of the sale).

River West

In River West, a creditor filed a prepetition state court action against the debtor alleging that the creditor was entitled to a percentage of the profits generated by the debtor’s shopping center under a written agreement. After the debtor filed for chapter 11 protection in the Northern District of Illinois, the creditor filed a proof of claim asserting that a lis pendens he had filed in connection with the state court action gave him a lien on the debtor’s real property.

The bankruptcy court disallowed the claim, finding that the creditor had nothing more than an equity interest in the property. The court then authorized the sale of the debtor’s property free and clear of all interests under section 363(f) of the Bankruptcy Code. It later confirmed a liquidating chapter 11 plan for the debtor. Both the bankruptcy court and the district court denied the creditor’s motion for a stay of the sale order pending appeal. The district court ultimately dismissed the creditor’s appeal of the sale order as being moot under section 363(m) because the creditor neither obtained a stay of the order nor challenged the buyer’s status as a good-faith purchaser.

The Seventh Circuit affirmed on appeal. In doing so, the court noted that, even if the bankruptcy court erroneously stripped away the creditor’s asserted interest in the property, section 363(m) prevented the court "from resurrecting that interest in the real estate itself … [because the creditor did] not contest [the buyer’s] status as a good-faith purchaser, which is the sole ground § 363(m) provides for modifying the terms of a sale completed in the absence of a stay."

The Seventh Circuit also rejected the creditor’s argument that he was seeking not to upset the validity of the sale, but merely to "rearrange the distribution of the sale proceeds." The court reasoned that: (i) the creditor appealed only the sale order, not the order confirming the debtor’s (then effective) liquidating chapter 11 plan, under which proceeds of the sale had been distributed to creditors; and (ii) in keeping with its purpose, section 363(m) prevents a court from upsetting the expectations from a sale that other creditors had when deciding to support it. The Seventh Circuit wrote that "[c]ourts take a dim view of arguments that attempt to craft any sort of ‘end run around the appeal and stay requirements of § 363(m)’" (citation omitted).

The Seventh Circuit revisited its view of the scope of section 363(m) in Trinity 83.

Trinity 83

In 2006, Trinity 83 Development, LLC (the "debtor") borrowed $2 million secured by a mortgage on certain real property. In 2013, the servicer of the loan mistakenly recorded a satisfaction of the mortgage. Despite the recorded satisfaction, both parties continued to perform under the loan agreement.

After becoming aware of the mistake in 2015, the lender unilaterally recorded a document canceling the satisfaction. Soon afterward, the debtor defaulted on the mortgage and the lender commenced foreclosure proceedings in state court.

The debtor filed for chapter 11 protection in the Northern District of Illinois in 2016. It then commenced an adversary proceeding against the lender that sought a determination that the satisfaction cancellation was unenforceable under state law, rendering the underlying note invalid. The bankruptcy court granted the lender’s motion for summary judgment dismissing the complaint. The court concluded that, because no third parties’ security interest had attached to the property during the interval between the filing of the mistaken mortgage satisfaction and its cancellation, the unilateral cancellation and the note were enforceable.

The district court affirmed, and the debtor appealed to the Seventh Circuit. However, before the Seventh Circuit could hear the appeal, the bankruptcy court approved the debtor’s motion to sell the property free and clear of all interests under section 363(f) and to distribute the sale proceeds to the lender. The lender then argued that, in the absence of any stay pending appeal of the order approving the sale, the pending appeal of the bankruptcy court’s order dismissing the debtor’s complaint was moot under section 363(m).

The Seventh Circuit’s Ruling

A three-judge panel of the Seventh Circuit ruled that the appeal was not foreclosed by section 363(m). According to the court, in this case, it was not "impossible for a court to grant any effectual relief whatever to the prevailing party" because the debtor was seeking money from the lender rather than invalidation of the sale. "That request may be inconsistent with a statute," the Seventh Circuit wrote, "but a defense to payment concerns the merits, not mootness." The court further explained that section 363(m)’s foreclosure of particular relief does not render an action moot—it simply provides a buyer with a defense to any challenge to an unstayed sale order.

The Seventh Circuit panel expressly overruled River West on this point. It also faulted River West’s conclusion regarding the impact of section 363(m) on disposition of the proceeds of a sale. Section 363(m), the Trinity 83 panel wrote, "does not say one word about the disposition of the proceeds of a sale or lease." That question, the Seventh Circuit panel explained, "is a subject within the control of the bankruptcy court," as has been recognized in many decisions both within and outside the Seventh Circuit.

Finally, addressing the merits, the Seventh Circuit ruled that, even though the debtor’s appeal was not mooted by section 363(m), the lower courts correctly ruled that the lender’s claim and lien were valid and enforceable because, under applicable state law, "a mistaken release of a mortgage is ineffective between the mortgagor and mortgagee," and the lender remedied the mistake before the bankruptcy petition date and before any third party’s rights intervened.

Outlook

The Seventh Circuit’s ruling in Trinity 83 is significant for a number of reasons. First, the panel expressly overruled the court’s previous decision in River West, eroding what is recognized as the majority approach in the circuits on the scope of section 363(m). Second, and perhaps more notably, the Seventh Circuit held that section 363(m) does not moot an appeal of an unstayed order approving a sale to a good-faith purchaser, but merely provides the good-faith purchaser of the assets with a defense in litigation challenging the validity of the sale. In taking mootness out of the equation, the Seventh Circuit appears to be an outlier among the circuits. According to the Seventh Circuit, a dispute concerning distribution of the proceeds of a sale does not implicate section 363(m). Finally, the facts and procedural posture of River West are unusual. The lender did not raise mootness as a defense to a direct challenge to the order approving the sale of the property. Instead, the lender sought to preclude an appeal of the order dismissing the complaint, which, if disturbed, could indirectly impact the sale order by altering the distribution of the sale proceeds.

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