The Decline in Value Formulation: How Courts Should Approach State Bulk Sale Provisions in Bankruptcy

• Publication year: 2020

The Decline in Value Formulation: How Courts Should Approach State Bulk Sale Provisions in Bankruptcy

Anthony Check

THE DECLINE IN VALUE FORMULATION: HOW COURTS SHOULD APPROACH STATE BULK SALE PROVISIONS IN BANKRUPTCY

Abstract

Bulk sale provisions give state departments a unique power that distinguishes them from the traditional creditor. In light of the special nature of the interests derived from bulk sale provisions, courts should recognize such interests to be protectable by § 363(e), even if traditional bankruptcy procedures would value that interest at $0. In lieu of blindly protecting the interests of state departments or senior creditors, courts should meet somewhere closer in the middle of each party's interests. In reaching this middle ground, to assess the degree to which this protection should extend, the burden should be on the state department to prove that the stripping away of its interest resulted in that interest declining in value. To prove such a fact, a state department must show that it would have recovered value from its interest, notwithstanding the fact that the interest was stripped away. Courts should place a value on such an interest that is commensurate to the decline in value of that interest, provided the state department has proven the decline in value. The recognition of such an interest as protectable serves to avoid litigation about how courts should recognize such an interest. Furthermore, it will allow parties to approach a bulk sale without having to worry about dealing with inconsistent courts that oftentimes unduly favor state departments over individual creditors, and vice-versa. By clearing up such confusion, buyers, sellers, creditors, and state departments will be more likely to negotiate with each other before the purchase occurs, allowing all parties to ensure their interests are well represented. Accordingly, courts should adopt a "decline in value" formulation, provided in dicta of Illinois Department of Revenue v. Hanmi Bank, to determine what value to place on interests deriving from bulk sale provisions.

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Introduction

The Seventh Circuit's recent decision in Illinois Department of Revenue v. Hanmi Bank has left many questions unanswered regarding how "bulk sale provisions" should be treated when exercised by state revenue departments.¹ For the purposes of this Comment, bulk sale provisions are state statutes requiring the purchaser in a bulk sale to follow certain procedures aimed at protecting the ability of the state to collect unpaid taxes. Following this decision, it is prescient to explore whether bulk sale provisions create an interest in state revenue departments, and, if they do, how courts should classify and treat such interests. This question is important because how we classify bulk sale provisions affects not only the debtor and creditor-revenue departments, but also the non-revenue department creditors and potential purchasers.

Historically, states instituted bulk sale provisions to protect against debtors liquidating a large portion of their inventory and absconding with the proceeds.² This was common in inventory transactions, in which a debtor would acquire all or most of inventory on credit.³ After the acquisition of this inventory, a debtor could simply sell off the inventory and leave the state.⁴ Typically, this occurred between small business and wholesale providers. Modern advances in credit reporting have greatly minimized this risk because wholesale providers now have much better means of assessing the credibility of an institution.⁵

To supplement or replace state law, the original UCC Article 6 was enacted. This provided that buyers who were receiving assets in a bulk sale must contact the seller's creditors and maintain a list of all creditors, as well as a schedule of property in the bulk sale.⁶ If the buyers did not comply with UCC Article 6, the creditors had the ability to void the sale.⁷ While only a model, the original UCC Article 6 was adopted by various states who desired to protect creditors from being spurned by duplicitous debtors who were commencing a bulk sale.⁸

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Because of advances in credit reporting, and a general disappearance of the original problem, the original UCC Article 6 was seen as overly burdensome on buyers.⁹ Thus, the revised UCC Article 6 was set forth. The revised version allows states two options. Option A allows states to repeal UCC Article 6.¹⁰ Option B offers a revised and updated Article 6 to those states and jurisdictions that will evaluate the positions of creditors, sellers, and buyers, and then decide whether to retain a bulk sales law.¹¹

The initial aim of UCC Article 6 was to protect creditors. Many state bulk sale provisions have this aim in mind as well, but often with an emphasis on a narrower subset of creditors, i.e., creditors who owe back taxes to the state. These taxes may have resulted from a failure to pay taxes over time,¹² however, it is often the case that the unpaid taxes stem from sales taxes that accompany the bulk sale itself. Typically, these bulk sale provisions apply when an entity sells or transfers a substantial portion of its business, outside of its normal business operations—thus the reasoning behind the name "bulk sale."¹³

The bulk sale statute relied upon in Hanmi is typical of many states' bulk sale edicts, and dictates that a purchaser in a bulk sale must give notice of the purchase to the Illinois Department of Revenue (IDOR).¹⁴ From there, IDOR reserves the ability to issue a "stop order" commanding the purchaser to set aside an estimated portion of the purchase monies to cover any unpaid taxes owed by the seller to IDOR.¹⁵ IDOR then has sixty business days to determine the actual amount owed, and to issue a revised stop order compelling the purchaser to continue holding the set-aside purchase monies.¹⁶ Should the seller fail to pay the unpaid taxes, IDOR may issue a demand to the purchaser to turn over the set-aside funds.¹⁷ If the purchaser fails to provide notice, reserve the requisite funds, or turn over the reserved funds, IDOR has the ability to go after the purchaser personally.¹⁸

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This relatively straightforward process becomes increasingly muddled when bulk sales are part of a bankruptcy proceeding. Because bulk sales carry the specter of 11 U.S.C. § 363(f) with them—providing that the bankruptcy trustee may sell property "free and clear of any interest in such property of an entity other than the estate" so long as certain factors are satisfied¹⁹ —this strips away IDOR's interest in the property (the ability to collect unpaid taxes), and the purchaser receives the property without having to worry about any liability due to IDOR.²⁰ However, § 363(f) does not leave interest holders at a complete loss.²¹ Entities whose interests are stripped via § 363(f) may request adequate protection pursuant to § 363(e), which provides:

Notwithstanding any other provision of this section, at any time, on request of an entity that has an interest in property used, sold, or leased, or proposed to be used, sold, or leased, by the trustee, the court, with or without a hearing, shall prohibit or condition such use, sale, or lease as is necessary to provide adequate protection of such interest.²²

In other words, § 363(e) provides a mechanism by which an entity whose interest has diminished in value may be recompensed to the degree that interest decreased in value.²³ Such compensation typically comes from the proceeds of the sale.²⁴

The instant issue arises because of the way in which courts apply § 363(e). It is customary for courts to grant adequate protection only to protect the relevant interest from a decline in value.²⁵ The burden of showing that an interest has declined in value is on the interest holder.²⁶ The bankruptcy court has the discretion to determine whether the interest holder has overcome this burden by proving that the interest has declined or is declining in value.²⁷ The practical

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effects of the "declining in value" formulation of § 363(e) are apparent when a creditor seeks to utilize § 363(e) in a bankruptcy proceeding in which junior creditors are set to receive nothing. For example, imagine a creditor (Creditor A) wishes to assert § 363(e) to protect its claim of $100,000 in a proceeding in which the assets of the estate amount to $500,000. Imagine further that a second creditor (Creditor B) has a secured claim of $1 million dollars. The bankruptcy trustee strips away Creditor A's interest and pays the entirety of the estate to Creditor B. Creditor A then applies for adequate protection, arguing that its interest has diminished from $100,000 to $0. The bankruptcy court would assuredly deny Creditor A's request, because its interest never actually diminished in value. Given that the estate was insolvent, and the entirety of the assets were owed to Creditor B whose claim had priority over Creditor A, Creditor A would have never received anything from the estate, regardless of whether its interest was stripped away pursuant to § 363(f). Thus, Creditor A's interest was always worth $0, and therefore could not have diminished in value.

The notion that adequate protection may only be granted when a creditor's interest has diminished in value is a crucial step in understanding why state departments such as IDOR contend that their interests stemming from bulk sales should be viewed differently than, for example, the interest held by Creditor A. The distinguishing factor, as IDOR and other state departments contend, between a creditor like Creditor A, and a state department operating pursuant to a bulk sale provision, is that a state department's interest diminishes in value the moment a state department can no longer seek payment through successor liability doctrine. Regardless of whether a state department would receive any value deriving from its claim in the bankruptcy proceeding, it would be able to seek the...