On March 30, 2012, the US District Court for the Southern District of New York (District Court) issued an opinion in the case of Hispanic Independent Television Sales LLC v. Kaza Azteca America Inc. ruling that sales free and clear of interests under section 363(f) of the Bankruptcy Code do not extinguish a creditor's affirmative defense of recoupment. Recoupment allows a creditor to apply a debt owed to it by the debtor against a debt it owes to the debtor, if the debts arise from the same transaction. The creditor's debt is reduced by the amount which is recouped. In this case, the District Court held that Kaza Azteca America's (Kaza) recoupment defense survived the section 363(f) sale, even though the sale extinguished Kaza's underlying breach of contract claim.

In December 2005, Interep National Radio Sales (Interep) and one of its wholly owned subsidiaries entered into a national television sales representation agreement with Kaza. As part of the agreement, Kaza retained Interep to sell television spots and Interep agreed to serve as Kaza's exclusive national representative for the sale of national television spot advertising time.

On March 30, 2008, Interep and its subsidiaries filed for Chapter 11 bankruptcy protection. In October 2008, the US Bankruptcy Court for the Southern District of New York (Bankruptcy Court) converted the Chapter 11 case into a Chapter 7 proceeding and appointed a trustee.

In May 2008, Kaza filed a proof of claim asserting liquidated damages for breach of contract and withheld $522,536.55 otherwise owed to Interep to partially satisfy its claim. In December 2008, the trustee, as seller, and Hispanic Independent Television Sales LLC (HITS), as buyer, entered into an asset purchase agreement under section 363(f) of the Bankruptcy Code. Kaza objected to the sale and the Bankruptcy Court ruled that the trustee could sell Kaza's accounts receivable but could not assume and assign the Kaza agreement to HITS.

In early 2010, HITS brought an action in New York state court, seeking to recover the accounts receivable from Kaza that it had acquired from Interep in the section 363 sale. Kaza removed the proceeding to the District Court on February 4, 2010. It filed an answer and asserted a recoupment defense, demanding a deduction from the amount of the monetary claim brought by HITS.

In December 2010, Interep objected to Kaza's proof of claim, which the Bankruptcy Court disallowed because the claim was extinguished by the section 363(f) sale. In March 2011, Kaza filed a motion for consideration, requesting that the Bankruptcy Court set aside its order granting the claim objection. Kaza stated that it intended to withdraw its proof of claim if the motion was granted and that it filed the motion solely to preserve its recoupment defense against a successful collateral estoppel challenge to its claim by HITS. In September 2011, the Bankruptcy Court granted the motion for reconsideration.

HITS moved to dismiss Kaza's counterclaim, arguing that the bankruptcy proceedings and the section 363(f) sale collaterally estopped Kaza from asserting its recoupment defense. The key issue was whether Interep's section 363(f) sale of its accounts receivable free and clear of interests extinguished Kaza's recoupment defense.

The District Court denied HITS's motion to dismiss. It held that Kaza could assert a recoupment defense, even though Kaza's underlying breach of contract claims were extinguished by the section 363(f) sale. Recoupment rights are determined by state law. Under New York law, a party must have legally subsisting cause of action upon which it could maintain an independent claim.

However, in reaching its decision, the District Court noted the equitable nature and purpose of recoupment and that, in other cases, a recoupment defense survived a statute of limitations, a bankruptcy reorganization plan and an assignment of an original claim. In each of these instances, the party asserting the recoupment defense did not have a presently existing affirmative claim, but was still able to proceed with its recoupment defense.

In addition, the District Court concluded that Kaza's recoupment rights survived the section 363(f) sale because recoupment is a defense and not an interest or claim within the meaning of the Bankruptcy Code which can be extinguished by a section 363(f) sale.

Following the District Court's decision in Kaza Azteca, purchasers of assets in section 363(f) sales should be aware that affirmative defenses of those holding an interest in the sold property survive the sale, even if the sale extinguishes their underlying claims. Therefore, a creditor can still assert a recoupment defense against a purchaser of the assets.

For more information on section 363 sales, see Practice Notes, Buying Assets in a Section 363 Bankruptcy Sale: Overview, Key Differences in Purchase Agreements for Section 363 Sales and Timeline of a Section 363 Sale.