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Illinois Department of Revenue v. Hanmi Bank and Eugene Crane, Trustee

United States Court of Appeals, Seventh Circuit

July 9, 2018

Illinois Department of Revenue, Appellant,
v.
Hanmi Bank and Eugene Crane, Trustee, Appellees. Illinois Department of Revenue, Appellant,
v.
First Community Financial Bank, Appellee.

          Argued December 1, 2017

          Appeal from the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division. No. 12-49658 - Timothy A. Barnes, Bankruptcy Judge.

          Appeal from the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division. No. 15-05384 - A. Benjamin Goldgar, Bankruptcy Judge.

          Before Bauer, Flaum, and Rovner, Circuit Judges.

          Rovner, Circuit Judge.

         The bankrupt businesses in both of these consolidated appeals had debts that far exceeded the value of their assets. The bankruptcy court authorized the sale of the firms' principal assets (several gasoline service stations and a movie theater and café), and those sales qualified as bulk sales under Illinois statutes we shall refer to as the Bulk Sales Provisions. Among other things, the Bulk Sales Provisions give the Illinois Department of Revenue ("IDOR") the right to pursue the purchaser in a bulk sale for state taxes owed by the seller. However, in order to facilitate sale of the debtors' properties, the bankruptcy court, pursuant to section 363(f) of the Bankruptcy Code, allowed the sales to proceed free and clear of the interests in those properties held by any entity other than the bankruptcy estates, including IDOR's interest under the Bulk Sales Provisions. 11 U.S.C. § 363(f). This meant that IDOR lost its right to impose successor liability on the purchasers for the taxes owed by the sellers. Pursuant to section 363(e) of the Code, a party whose interest has been removed from property in this way is entitled to "adequate protection," which typically takes the form of a payment from the sale proceeds to compensate the party for the decrease in value of its interest. See id. §§ 361, 363; Precision Indus., Inc. v. Qualitech Steel SBQ, LLC, 327 F.3d 537, 548 (7th Cir. 2003). The bankruptcy court in each case below agreed or assumed that IDOR was entitled to adequate protection for its interest under section 363. But the court also went on to conclude that because the sale proceeds were insufficient to satisfy the claims of the senior-most creditors (the banks that held the mortgages on the properties), IDOR was entitled to no portion of the sale proceeds; to grant IDOR any share in those proceeds would be to impermissibly allow it to "jump the queue" of creditors. And because there were no other assets available from which to compensate junior creditors like IDOR, IDOR was left with nothing.

         IDOR contends that the bankruptcy court's disposition fails to account for its authority, which other creditors did not enjoy, to pursue not only the debtor but the purchaser of the debtors' property-personally-for unpaid taxes. When the bankruptcy court authorized the sale of the debtors' properties in these cases free and clear of IDOR's interest, it made the properties much more attractive to prospective purchasers than they otherwise would have been. Consequently, in IDOR's view, the final sale price for the properties necessarily included consideration for the removal of IDOR's interest, and it is entitled to a share of the sale proceeds pursuant to sections 361 and 363(e) to compensate it accordingly.

         For the reasons that follow, we affirm the bankruptcy court's judgments. We agree with IDOR that the Bulk Sales Provisions give it a powerful means of securing payment for delinquent taxes that most other creditors lack, and that removal of IDOR's interest likely increased the price bidders were willing to pay for the debtors' properties in these cases. But assuming that IDOR's interest is cognizable under section 363, it has not given us a realistic assessment of the value of its interest. IDOR's position in these appeals is that it is entitled to a share of the sale proceeds equal to 100 percent of the taxes it was authorized to collect from the purchasers, given that it was forced to give up its right to pursue the purchasers for those taxes. As we explain, however, we are skeptical of the notion that IDOR necessarily would have recovered 100 percent of the tax delinquency from an informed purchaser; and although IDOR might have been able to strike a deal with the purchaser and the seller's senior creditors giving it some lesser payment on the outstanding taxes, IDOR has offered no evidence to establish what its potential recovery might have been. In short, its claims were properly denied for want of evidence enabling the bankruptcy court to assign a reasonable value to its interest for purposes of section 363(e).

         I.

         These appeals involve two different sets of debtors. The Elk Grove debtors owned and operated five BP gas stations in Elk Grove Village and other Chicago suburbs. Hanmi Bank, formerly known as United Central Bank (hereinafter, "UCB"), held mortgages on the real properties along with security interests in the personal property at each location. The Naper-ville debtor operated a cinema and adjoining café in the Chicago suburb of Naperville. First Community Financial Bank ("First Community") held the mortgage on these properties.

         The debtors initially sought relief under Chapter 11 of the Bankruptcy Code. In each instance, the debtors' outstanding liabilities substantially exceeded the value of their assets. The Elk Grove debtors owed north of $14 million to UCB, and the Naperville debtor owed just under $4 million to First Community. Both debtors also owed substantial Illinois taxes to IDOR: the Elk Grove debtors owed the state more than $1.8 million in sales, employee withholding, and motor fuel taxes (approximately $1.38 million of which was secured by liens on the debtors' properties) and the Naperville debtor owed nearly $600, 000 in sales and withholding taxes (none of which was secured by liens). In the Elk Grove proceeding, a trustee was appointed at the request of the creditors.

         The Elk Grove trustee and the Naperville debtor both sought the bankruptcy court's approval pursuant to section 363(b) and (f) of the Bankruptcy Code to sell the debtors' principal assets-the gas stations and the theater/café-free and clear of all liens, claims, encumbrances, and interests held by entities other than the estate. In each instance, IDOR contended that to the extent the court deemed its right to impose successor tax liability on the purchaser of the property an "interest" that could be extinguished pursuant to section 363(f), the court should set aside a portion of the sale proceeds sufficient to satisfy the outstanding tax obligations as "adequate protection" for IDOR's interest pursuant to section 363(e), regardless of the fact that IDOR's claims against the debtor were junior to those of the banks. In both cases, that request was denied.

         In the Elk Grove case, Judge Barnes denied the set-aside request but directed the trustee to hold the proceeds of the sale subject to a further order of the court, so that IDOR's right, if any, to a share of the sale proceeds could be assessed. After the sale of the gas stations closed, yielding net proceeds of roughly $5.23 million, UCB asked that its secured claim against the estate be allowed and that the full proceeds of the sale be turned over to it (recall that the debtors owed UCB more than $14 million in total). IDOR objected to UCB's request, insofar as it sought the turnover of all proceeds to UCB, and asked that a portion of the proceeds equal to the amount of unpaid taxes that IDOR could have collected from the purchaser pursuant to the Bulk Sales Provisions-roughly $1.53 million-be turned over to IDOR first, with the remainder going to UCB.[1] IDOR contended that its interest in the sale proceeds was effectively superior to UCB's in view of the fact that IDOR had the authority-before the bankruptcy court allowed the sale free and clear of all interests-to hold the purchaser of the property personally liable for the unpaid taxes. In IDOR's view, because it was entitled to "adequate protection" for its interest pursuant to section 363(e), it was owed full recompense for the taxes it was owed.

         Judge Barnes allowed UCB's claim in full and denied the relief that IDOR requested. In re Elk Grove Vill. Petroleum, 510 B. R. 594 (Bankr. N.D.Ill. 2014) ("Elk Grove I"). He determined that UCB had a secured claim that exceeded by some $8 million the amount of the sale proceeds; that IDOR had a partially secured but junior claim of $1.88 million (secured by liens to the extent of $1.38 million); that IDOR's successor liability claims under the Bulk Sales Provisions constituted an "interest" that could be extinguished in the sale of the gas stations pursuant to section 363(f); but that IDOR's interest had not decreased in value by virtue of the sale, such that it would be entitled to adequate protection under section 363(e), because that interest was inferior to UCB's security interest both before and after the sale. Id. at 603-05. Judge Barnes acknowledged that, by virtue of the court's free-and-clear order under section 363(f), IDOR had lost the ability to pursue the purchaser of the property for the unpaid taxes. Id. at 605. But other creditors with liens on the debtors' property had likewise lost the ability to enforce those liens against the purchaser of the property. Had the sale taken place with all such liens, encumbrances, and interests in place, IDOR still would have taken nothing, the court believed, as a creditor whose claims were inferior to those of the bank. Id. (The judge did not consider IDOR's right to pursue the purchaser personally for the delinquent taxes.) Thus, IDOR's interest had not, in practical terms, decreased in value by virtue of the court's free-and-clear order. "IDOR was out of the money prior to the [s]ale and would remain out of the money subsequent to the [s]ale, whether or not section 363(f) is applied." Id. Therefore, IDOR was not entitled to adequate protection under section 363(e) in the form of compensation from the sale proceeds.

         In the Naperville case, Judge Goldgar simply overruled the debtor's request outright. Recall that First Community was owed $3.92 million on the loans it had made to the Na-perville debtor, and First Community, by virtue of the promissory notes underlying those loans, had a first-priority security interest in the debtor's property. IDOR, for its part, had an unsecured claim in the amount of $593, 000 for unpaid sales and withholding taxes. When the debtor sought the court's approval to sell its property, IDOR filed a limited objection to the sale, insisting that it was entitled to direct payment from the sale proceeds pursuant to section 363(e) as adequate protection of its interest under the Bulk Sale Provisions. Absent assurance of such payment, IDOR argued, the sale could not be approved. Looking to Judge Barnes' decision in Elk Grove I, Judge Goldgar overruled the objection, authorized the sale of the debtor's property, and allowed First Community to take and apply the proceeds (after certain fees and carve-outs) to the debt it was owed. In re Naperville Theater, LLC, No. 15 B 05384, R. 127 at 7, 23. As in the Elk Grove case, IDOR would take nothing from the sale proceeds. The Naperville case, like the Elk Grove Village case before it, was later converted to a Chapter 7 proceeding and a trustee was appointed.

         IDOR appealed in both cases. In the Elk Grove case, Judge Blakey vacated the bankruptcy court's order in part. Ill. Dep't of Revenue v. Elk Grove Vill. Petroleum, 541 B.R. 673 (N.D. Ill. 2015) ("Elk Grove II"). As the appellees did not dispute the point, Judge Blakey assumed that IDOR's right to impose successor liability on a bulk-sale purchaser for delinquent taxes constituted an interest warranting recognition and protection pursuant to section 363. Id. at 676. He therefore focused on whether that interest had any concrete value for which IDOR was entitled to protection under section 363(e). Judge Blakey noted that the "adequate protection" called for by section 363(e) is intended to prevent-i.e., compensate for-a decrease in value of the creditor's interest in property that has been extinguished pursuant to section 363(f). Id. at 677 (citing § 361). That decrease is properly calculated by comparing what the creditor will recover in bankruptcy where its interest in property has been extinguished pursuant to section 363(f) with what its recovery would have been had its interest remained intact. Id. at 678. As to the first question, the judge agreed that UCB's interest was superior to that of IDOR and the Bulk Sales Provisions did not permit IDOR's interest to jump ahead of UCB in the queue of creditors and have first bite at the sale proceeds. Id. But as to the second question, Judge Blakey was not convinced that IDOR again would have been left "out of the money" (as Judge Barnes had assumed) had the sale taken place subject to IDOR's interest. Notwithstanding the fact that UCB had a superior claim to the sale proceeds themselves, the Bulk Sale Provisions gave IDOR the right to look beyond those proceeds and pursue the purchaser personally for the unpaid taxes. Thus, allowing the sale free and clear of IDOR's interest indeed may have caused its interest to decrease in value, as it eliminated IDOR's ability to hold the purchaser personally liable for the taxes. To that extent, IDOR might be entitled to compensation. Id. at 679. The court remanded the matter for development of the record and resolution of two issues: (1) what IDOR would have recovered from the purchaser had the service stations not been sold free and clear of its interest under the Bulk Sales Provisions; and (2) by what means IDOR could be compensated for the value of this interest pursuant to section 363(e) given, inter alia, the relative priority of UCB's liens on the property and the depletion of estate assets. Ill. Dep't of Revenue v. Elk Grove Vill. Petroleum, LLC, 2015 WL 8481961, at *4 (N.D. Ill.Dec. 9, 2015) ("Elk Grove III").

         On remand, the bankruptcy court again denied IDOR relief upon addressing the two issues the district court had tasked it to consider. In re Elk Grove Vill. Petroleum, LLC, 562 B.R. 708 (Bankr. N.D.Ill. 2016) ("Elk Grove IV"). In valuing IDOR's interest, Judge Barnes drew a distinction between the calculable value and realizable value of the interest. The interest had a nominal, calculable value of $1.53 million-i.e., the amount that IDOR theoretically could collect from the purchaser pursuant to the Bulk Sales Provisions, see n.1, supra- but in the judge's view, the realizable value of the interest was effectively zero, as there was no realistic possibility that IDOR would ever have been able to collect on the unpaid taxes notwithstanding its rights vis-à-vis the purchaser. So far as the record revealed, the purchaser of the gas stations was a special-purpose entity with no assets other than the purchased stations themselves; so, apart from waiting to see if the stations turned a profit in the future, there would be nothing other than the properties themselves to which IDOR could look as a source of payment. Id. at 719 n.11. And if the stations had been sold without a section 363(f) free-and-clear order, leaving IDOR's interest intact, then it was fair to assume that UCB's interest as the debtors' lender also would have remained intact. Id. at 718-19. Because the purchase price for the stations did not come close to paying off the debt to UCB, and its interest was senior to that of IDOR, UCB as the senior lienholder would have a superior claim against any funds the purchaser had set aside on instructions from IDOR to account for the delinquent taxes as well as a superior right to enforce its liens on the purchaser's sole asset-the stations themselves. Id. at 720. Once again, IDOR, as the junior creditor, would be left with no source of payment for the unpaid taxes. Given that IDOR was likely to recover nothing regardless of the operation of section 363(f), there was no need to consider how, logistically, IDOR could be given adequate protection in the form of cash compensation pursuant to section 363(e); its interest had not been diminished as a result of the court's free-and-clear order. Id. IDOR had already been given all the protection to which it was entitled by virtue of the court's sale order, which allowed IDOR's interest, such as it was, to follow the sale proceeds. Id. at 720-21. To the extent IDOR was seeking payment from those proceeds, it was asking the court to reorder the creditor queue and give IDOR a first-priority status which the law did not allow:

Nothing in the Sale Order ensured a recovery on the preserved interests in the Proceeds. They must still be weighed against the priorities of all parties whose interests were also preserved; in this case, the priority of the UCB liens that were also attached to the Proceeds. By arguing that the court must permit IDOR a recovery on the preserved interests above that afforded UCB, IDOR ...

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