DIP Lender's Knowledge Of Adverse Claim To Collateral Scuttles Mootness Bar To Appeal Of Financing Order Based On 'Good Faith'

The Bankruptcy Code provides certain protections to buyers of bankruptcy estate assets and to entities that extend credit or financing to a trustee or chapter 11 debtor-in-possession ("DIP"). However, these safe harbors are available only if a buyer or lender is deemed to have acted in "good faith," a concept that is not defined in the Bankruptcy Code.

In TMT Procurement Corp. v. Vantage Drilling Co. (In re TMT Procurement Corp.), 2014 BL 244511 (5th Cir. Sept. 3, 2014), reh'g denied, No. 13-20622 (5th Cir. Oct. 23, 2014), the U.S. Court of Appeals for the Fifth Circuit vacated DIP financing orders of the bankruptcy court and district court, notwithstanding express findings by the lower courts that the lender had acted in good faith. Such findings ordinarily would have mooted any appeal in the absence of a stay pending appeal. The Fifth Circuit ruled that: (i) the appeals were not statutorily moot because, having been aware of an adverse claim to stock that was pledged as collateral for the DIP loan, the DIP lender lacked "good faith"; and (ii) the lower courts lacked subject-matter jurisdiction to enter the DIP financing orders. The ruling is a cautionary tale for any prospective asset purchaser or lender in a bankruptcy case.

Safe Harbors for Orders Approving Sale of Estate Property and DIP Financing

Pursuant to section 363 of the Bankruptcy Code, a trustee or DIP may: (i) under subsection (c)(1), enter into ordinary-course transactions involving the use, sale, or lease of estate property without court authority; and (ii) under subsection (b), with court approval after notice and a hearing, use, sell, or lease estate property outside the ordinary course of business (with certain specified exceptions). Estate property may be sold free and clear of any interest in the property asserted by a third party under the circumstances set forth in section 363(f).

An order approving a sale under section 363(b) is stayed until 14 days after it is entered (subject to the court ordering otherwise), at which point the order becomes "final." See Fed. R. Bankr. P. 6004(h) and 8002. Moreover, unless the appellant obtains a further stay pending the resolution of its appeal, section 363(m) provides that any reversal or modification of the sale order on appeal has no effect on the validity of the sale to "an entity that purchased . . . such property in good faith."

Section 364(a) of the Bankruptcy Code authorizes a DIP or trustee to obtain unsecured credit and to incur unsecured debt in the ordinary course of business without court approval. A DIP or trustee may also obtain credit or incur debt outside the ordinary course of business on either an unsecured or secured basis with court approval under the circumstances specified in sections 364(b), 364(c), and 364(d).

Like section 363(m)'s safe harbor for good-faith purchasers, section 364(e) provides that, unless the party challenging an order authorizing credit or financing obtains a stay pending appeal:

[t]he reversal or modification on appeal of an authorization . . . to obtain credit or incur debt, or of a grant . . . of a priority or a lien, does not affect the validity of any debt so incurred, or any priority or lien so granted, to an entity that extended such credit in good faith, whether or not such entity knew of the pendency of the appeal.

Thus, pursuant to sections 363(m) and 364(e), the failure to obtain a stay of an order approving a sale of assets or authorizing financing moots any appeal of the order where the purchaser or lender acted in good faith, a preclusion commonly referred to as "statutory mootness."

The court in In re EDC Holding Co., 676 F.2d 945, 947...