In Spark Factor Design, Inc., et al. v. Hjelmeset (In re Open Medicine Institute, Inc.), No. 22-60017 (9th Cir. Oct. 30, 2023), the Ninth Circuit Court of Appeals recently found that a bankruptcy court has discretion of whether to apply the standards under section 363(b) of the Bankruptcy Code in cases where a debtor’s sale of assets is imbedded into a compromise and settlement under Bankruptcy Rule 9019.

Debtor Open Medicine Institute, Inc. (“OMI“) was in the medical research/IT business before converting models to a commercial leasing company.  The conversion took its toll and OMI eventually ran out of money, after incurring substantial debt, and was forced to file chapter 7 bankruptcy.

A little over a year before OMI filed bankruptcy, OMI’s founder sold 93% of the Company’s equity to 2 investors, who took control of the management and made significant improvements to OMI’s primary asset, its leased premise.  The idea behind the improvements was that it would make OMI’s lease easier to assign, which, in turn, would reduce OMI’s overall liability on the lease.  This strategy failed for the most part, as the lease was never fully assigned to a third party.  The investors later caused OMI to sue the founder for breach of fiduciary duties.

In OMI’s subsequent bankruptcy, the chapter 7 trustee inherited the lawsuits against the founder, and after arms-length negotiations, ultimately settled with the founder, which settlement entailed selling OMI’s existing and potential claims against the founder and the investors.  Pursuant to the settlement, the founder agreed to pay OMI’s trustee (a) $200,000 for such claims and (b) to investigate and initiate any claims against the investors, as well as 55% of any recovery against the investors.

The investors objected to the proposed compromise with the founder and made a competing offer to purchase the trustee’s claims for $300,000, as well as provide the trustee 100% of the net recoveries from claims against the founder.

Notwithstanding the competing offer, the bankruptcy court approved the settlement with, and sale of claims to, the founder, pursuant to Bankruptcy Rule 9019.  Under Bankruptcy Rule 9019, which governs the approval of compromises, a bankruptcy court can approve a settlement “so long as it is fair and equitable.”

But, the bankruptcy court did not apply section 363(b)(1) of the Bankruptcy Code, which generally governs the sale of assets in bankruptcy, in its analysis.   Unlike Bankruptcy Rule 9019, section 363(b) requires a showing of a valid business justification and, in cases involving insider transactions, is subject to heightened scrutiny.

On appeal, the investors claimed that the bankruptcy court erred in not applying section 363(b) to the sale of the claims to the founder and, if it had, the court would have chosen the investors’ alternative settlement offer.

The Ninth Circuit recognized that there are often situations where a compromise under Bankruptcy Rule 9019 also entails a sale of assets under section 363(b).  However, the Ninth Circuit has not yet articulated a specific rule when such overlap requires the application of both provisions to approve a transaction.

Accordingly, based on the particular facts involved in Spark Factor Design, the Ninth Circuit allowed the bankruptcy court to have discretion in deciding whether or not to apply the formal sale procedures of section 363, in addition to the standards under Bankruptcy Rule 9019.  Citing In re Mickey Thompson Ent. Grp., Inc., 292 B.R. 415, 422 (9th Cir. 2003).

Takeaway

The holding leaves uncertain as to how much authority Bankruptcy Rule 9019 and the extent to which it can be used to circumvent other provisions of the Bankruptcy Code.  While the trustee in Spark Factor Design was able to circumvent section 363(b), one can readily imagine more complicated settlements that purport to confer broader authority, generally governed by other provisions of the Bankruptcy Code.  Without a clear line of demarcation, there is little doubt that litigants in bankruptcy will try to fit more unconventional compromises into solely the rubric of Bankruptcy Rule 9019.

For example, looking forward, what if the Supreme Court overrules the Second Circuit’s current endorsement of involuntary third-party releases in the Purdue Pharma case?  Could Bankruptcy Rule 9019 be used more aggressively to settle the same third-party claims with a future claims representative and a committee of tort claimants, thereby circumventing the restrictions under section 524 of the Bankruptcy Code?  Would that really be stretching Bankruptcy Rule 9019’s intended use?  We will have to wait and see how the arguments develop over time.