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Better watch your assets in bankruptcy sales

March 2014  |  SPECIAL REPORT: GLOBAL RESTRUCTURING & INSOLVENCY

Financier Worldwide Magazine

March 2014 Issue

March 2014 Issue


Over the past several years, many companies have restructured in bankruptcy proceedings through ‘free and clear’ asset sales. Free and clear asset sales under the Bankruptcy Code give a buyer the opportunity to acquire a seller’s assets – and often going-concern business – without becoming responsible for claims against the seller and existing interests in the purchased property. 

But buyers of assets from debtors in bankruptcy need to be aware that even assets blessed as ‘free and clear’ by a bankruptcy court may not be fully cleansed. That may be because of procedural issues, like deficient notice to creditors, or it may be because of the type of liability. This article focuses on claims that may survive bankruptcy sales. Despite the nomenclature, there are some claims that may be particularly problematic even in ‘free and clear’ sales and, in turn, prospective buyers should understand that they may be acquiring more than just assets. 

The general rule against successor liability

Although the law varies by state, a purchaser of assets is ordinarily not liable for the seller’s liabilities. Courts in most states recognise four narrow exceptions to this rule against successor liability: (i) the purchaser expressly or impliedly agrees to assume the seller’s liabilities; (ii) there was a consolidation or merger of seller and purchaser; (iii) the purchaser is merely a continuation of the seller; and (iv) the transaction was fraudulently entered into to escape liabilities. A purchaser usually can avoid being saddled with most liabilities through careful drafting and observing robust corporate formalities. But some liabilities may be difficult to shed. 

The extra protections of the Bankruptcy Code

When a company goes into bankruptcy, a sale of substantially all of its assets to a buyer may be the best strategy to maximise value for the company’s creditors. In such a sale, the buyer will benefit not only from traditional state law rules that disfavour successor liability, but also from additional protections offered by the Bankruptcy Code. Specifically, the Bankruptcy Code provides two alternatives for a purchaser to acquire assets from a debtor in bankruptcy ‘free and clear’ of claims, interests, or encumbrances in the transferred assets: (i) an asset sale approved by the bankruptcy court under section 363 of the Bankruptcy Code; and (ii) a creditor-approved and bankruptcy court-confirmed Chapter 11 plan of reorganisation. In either case, a claimant seeking to impose liability on a buyer under a successor liability theory faces a steep climb because the court’s order approving the sale will dictate that the assets transfer to the buyer ‘free and clear’ of any claims, interests, and encumbrances in the transferred assets. See 11 U.S.C. §§ 363(f), 1141(c). 

Limitations on free-and-clear orders: inadequate notice

A buyer of a debtor’s assets is not necessarily out of the woods even if it gets a free and clear order from the bankruptcy court at the time of acquisition. Whether a free-and-clear order fully protects the buyer against potential claimants also depends in large part on the degree to which they were on notice of the sale. The rule of thumb: the more notice, the better. 

Courts find that if a creditor did not have adequate notice of the sale then it cannot necessarily be bound by a free-and-clear order. As a result, the more notice given to creditors and other potential claimants, the more likely a court will find that the buyer cannot be held responsible for the seller’s liabilities. See Western Auto Supply v. Savage Arms, 43 F.3d 714 (1st Cir. 1994). 

When a debtor sells assets free and clear under section 363(f), it typically conducts a robust, open auction and shows the bankruptcy court that the winning bidder presented the best and highest offer for the sold assets. The sale process can be limited to a few months – in extenuating circumstances, even to a few weeks. Thus, a Section 363 sale can be done quickly and cheaply, because, unlike with a Chapter 11 plan, in most cases there is no need to provide notice to all of the company’s creditors or to solicit votes on the sale. The cost and efficiency of a Section 363 sale is one of its most attractive features as compared to a Chapter 11 plan. 

Obtaining confirmation of a bankruptcy plan sale takes longer and is more expensive than approval of a Section 363 sale. This is in large part because confirmation of a plan of reorganisation requires the company to solicit the votes of all creditors followed by a confirmation hearing. The solicitation period can last several months, particularly with very large companies. But although a sale through a plan is more time-consuming and expensive than a Section 363 sale, it does have some advantages. The fact that all creditors receive notice of the plan may give a buyer additional protection against successor liability claims. Also, it may be possible to provide treatment in a plan for future unknown claimants. This may be a mechanism to address problematic future claims discussed below. 

Limitations on free-and-clear orders: certain types of claims

There are some claims that, no matter the degree of notice, may still transfer to the buyer. This often depends on whether the claim in question is a claim or interest in the transferred property. Section 363(f) permits sales that are free and clear of interests “in the property”, while section 1141(c) provides that “the property dealt with by the plan” may be sold free and clear. Courts have grappled with this concept, and have found that numerous categories of claims are not claims ‘in’ the property, and so can be asserted against the buyer. Buyers must be aware of these claims before an acquisition, because a buyer may not be able to protect itself from these claims after the acquisition. 

These claims include: 

Products liability claims. There is increasing case law indicating that products liability claims are not extinguished in a 363 ‘free and clear’ order where the product was designed and sold by the seller but the injury occurred after the sale. In Morgan Olson, LLC v. Frederico (In re Grumman Olson Industries, Inc.), 445 B.R. 243 (Bankr. S.D.N.Y. 2011), the bankruptcy court permitted plaintiffs to proceed with their defective design lawsuit against Morgan Olson, the asset purchaser, even though the injury occurred more than five years after the sale. The bankruptcy court concluded that the sale order did not extinguish the claims because: (i) the injury did not occur until after the sale; and (ii) the plaintiffs did not have adequate notice of the sale. This is arguably a change in the law: just a few years beforeGrumman Olson, the same bankruptcy court ruled in the Chrysler and General Motors bankruptcies that product liability claims can be extinguished in a Section 363 sale order. In re Chrysler LLC, 576 F.3d 108 (2d Cir. 2009); In re General Motors Corp., 407 B.R. 463 (Bankr. S.D.N.Y. 2010). Acquisition through a Chapter 11 plan may be one way to mitigate this risk. In the asbestos context, the Bankruptcy Code expressly authorises the creation of trusts to limit future claimants’ claims to a known pool of assets. 

Employment liability. Although the only court to deal squarely with the issue found the sale to be free and clear, recent case law suggests that some labour-related claims may survive a sale. In In reTrans World Airlines, Inc., 322 F.3d 283 (3d Cir. 2003), the Third Circuit found that employment discrimination claims against seller TWA did not transfer to buyer American Airlines, because it found that the claims “flow[ed] from the ownership of the property” and thus were extinguished with the bankruptcy sale order. In contrast, in Teed v. Thomas & Betts Power Solutions, LLC, 711 F. 3d 763 (7th Cir. 2013), the Seventh Circuit Court of Appeals permitted a lawsuit under the federal Fair Labor Standards Act to proceed against the buyer, even though the buyer expressly conditioned its acquisition on it being free and clear of all liabilities, because federal common law favoured allowing these claims to survive the lawsuit. While the case did not involve a court order, it does hint that some courts may be sceptical of assertions that a transaction freed an asset buyer of liability. 

Environmental claims. There are cases where courts also broadly construe successor liability exceptions in connection with environmental claims. See United States v. Carolina Transformer Co., 978 F.2d 832 (4th Cir. 1992). In Carolina Transformer, the Fourth Circuit Court of Appeals found that the acquirer was subject to liability for its predecessor’s violations of the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), emphasising that “CERCLA is a remedial statute, [and] its provisions should be construed broadly to avoid frustrating the legislative purpose”. LikeTeedCarolina Transformer did not involve a bankruptcy court’s free-and-clear order, but it does suggest that some courts may resist absolving a buyer of liability from claims based on a federal statute. 

Conclusion: buyer beware

While there are not many cases exploring the limits of free-and-clear orders, lessons can be drawn from those that do. First, notice is key – the more potential claimants the parties reach during the sale process, the more likely it is a court will find that the buyer did not assume the seller’s liabilities and will refuse to permit claimants to assert pre-sale claims against the buyer. Second, be aware of the kinds of claims at issue. Courts are particularly loathe to extinguish claims based on federal law and where liability may not be manifest for years after the transactions. A cautious buyer should examine these claims carefully before buying assets out of bankruptcy.

 

Suzzanne Uhland and Andrew Parlen are partners, and Daniel Shamah is a counsel, at O’Melveny & Myers LLP. Ms Uhland can be contacted on +1 (415) 984 8941 or by email: suhland@omm.com. Mr Parlen can be contacted on +1 (213) 430 6262 or by email: aparlen@omm.com. Mr Shamah can be contacted on +1 (212) 326 2138 or by email:  dshamah@omm.com.

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