On June 6, 2013, the US Bankruptcy Court for the Eastern District of North Carolina held, in In re L.L. Murphrey Co., that a bona fide dispute existed regarding the validity of a creditor's liens arising from security instruments on tracts of real property and associated personal property, which allowed the trustee to sell the property free and clear of those liens under section 363(f) of the Bankruptcy Code. This dispute also constituted sufficient "cause" to deny the creditor the right to credit bid at the proposed sale of the property under section 363(k) of the Bankruptcy Code.

On June 8, 2000, L.L. Murphrey Company (Debtor) filed a voluntary Chapter 11 petition. At the time, the Debtor was in default to Wachovia Bank, N.A. (Wachovia) for about $12.8 million under five separate promissory notes. The promissory notes were secured by a deed of trust, assignment of rents, security agreement and financing statement executed in favor of Wachovia. As additional security, Wachovia perfected security interests in the Debtor's fixtures and personal property. The Court confirmed a plan of reorganization, which, among other things:

Post-confirmation, Wachovia's claim and any liens it held under the original promissory notes were acquired by CadleRock Joint Venture, L.P. and then assigned to D.A.N. Joint Venture Properties of North Carolina, LLC (DAN).

After the Debtor filed a voluntary Chapter 7 petition in May 2012, DAN filed a proof of claim for over $6 million, asserting $3.5 million of this amount as a secured claim based on the value of the real and personal property, which DAN claimed was perfected by a mortgage, security agreements and a UCC-1, and asserting the remainder as a general unsecured claim.

In early 2013, the trustee filed motions requesting approval to conduct a proposed public section 363 sale of the debtor's real and personal property free and clear of liens, with any such liens transferred to the proceeds of the sale. The trustee may sell property of the estate free and clear of any interest in such property if it can establish any one of the five separate grounds provided under section 363(f) of the Bankruptcy Code. DAN objected, arguing that the trustee had failed to satisfy this requirement. Specifically, DAN argued that with respect to section 363(f)(4), its interest is not subject to a factual or legal dispute because there are no pending objections to its proof of claim and the underlying debt was explicitly reaffirmed by an order entered by the Court in a related adversary proceeding.

In May 2013, the trustee submitted a draft of a complaint in support of its sale motion, which asserted that the security instruments that form the basis for DAN's liens are avoidable under section 544(a)(3) of the Bankruptcy Code. Section 544(a)(3) allows a trustee to avoid any transfer of property of the debtor that is voidable by a bona fide purchaser of real property. The trustee also claimed that sets of security instruments were invalid because they were released upon confirmation of the plan in the debtor's previous Chapter 11 case. Additionally, the trustee claimed that both sets of security instruments failed to accurately describe the underlying obligations created in Class III of the previously confirmed fourth amended plan of reorganization.

DAN filed an amended and supplemental objection to the trustee's sale motion, arguing that the confirmed plan only required the execution of new deeds of trust that were "reasonably requested" by Wachovia, and therefore any claim that DAN's liens were released upon confirmation is without merit and should not be used by the trustee to create a "bona fide dispute" under section 363(f)(4) of the Bankruptcy Code.

Under section 363(f)(4) of the Bankruptcy Code, a trustee is permitted to sell property free and clear of any interest in the property if the interest is in "bona fide dispute." While the Bankruptcy Code does not define the phrase "bona fide dispute," courts have held that a bona ride dispute "entails some sort or meritorious, existing conflict" and for this purpose exists when "there is an objective basis for either a factual or legal dispute as to the validity of the asserted interest." The Court determined that the trustee had established the existence of a "bona fide dispute" as to the validity of DAN's liens. It reasoned that the confirmed plan unambiguously required the parties to execute amended and restated agreements, instruments and other loan documents. In addition, the execution and delivery of amended and restated loan documents was a condition precedent for setting the implementation date for Note A and Note B as October 1, 2001. Without these amended and restated loan documents, the Court held that the description of the notes, their terms, obligations and treatment of Wachovia were not proper negotiable instruments under Article 3 of the Uniform Commercial Code. Therefore, the Court held that the trustee demonstrated an objective basis for its argument that DAN's failure to execute and deliver the amended and restated loan documents permitted avoidance of DAN's liens under section 544(a)(3) of the Bankruptcy Code and allowed the trustee to sell the property free and clear of these liens under section 363(f)(4) of the Bankruptcy Code.

The trustee also argued that under section 363(k) of the Bankruptcy Code, the dispute surrounding the extent and validity of DAN's liens provides requisite "cause" to deprive DAN of the right to credit bid at the proposed sale. Typically, a secured creditor may bid for its collateral using the debt it is owed to offset the purchase price, allowing it to take possession of its collateral rather than be left under-compensated if the collateral is sold to a third party for less than its secured claim. Although "cause" to deny a secured creditor's ability to credit bid under section 363(k) is determined on a case-by-case basis, courts have generally held that a sufficient dispute regarding the validity of the lien forming the basis for the credit bid qualifies as sufficient "cause." Therefore, the Court agreed with the trustee that cause existed to deny DAN the right to credit bid at the proposed public sale under section 363(k) of the Bankruptcy Code for the same reasons it found a bona fide dispute existed allowing the sale to be free and clear of DAN's liens.

This case serves as an important reminder that even minor defects in the documentation of a secured loan may allow a a lien to be successfully challenged. Although the liens survived the debtor's prior confirmed plan, the failure of the creditor's predecessor to amend and restate the loan documents was enough to create a bona fide dispute regarding the validity of the liens. This ultimately enabled the trustee to sell the property free and clear of the creditor's liens, while creating "sufficient cause" to deny the creditor the right to credit bid at the proposed sale. Therefore, to protect recovery on their claims and avoid the loss of their liens and credit bidding rights in the event of bankruptcy, creditors must always make sure that their liens are properly and unequivocally perfected.

For more information on asset sales in bankruptcy, see Buying Assets in a Section 363 Bankruptcy Sale: Overview.

For more information on credit bidding, see Practice Note, Credit Bidding in Section 363 Bankruptcy Sales.