How Free Is Free and Clear A Practical Guide to Protection Against Successor Liability When Purchasing Assets Out of a Bankruptcy Estate

Generally, the bankruptcy court provides a unique and expedient forum for the purchase
of assets. Prices are generally reduced, due diligence is done quickly, and all
potential bidders are on an equal playing field with respect to access to information
upon which to formulate a bid. Of particular advantage is the ability to purchase
assets out of the bankruptcy proceeding "free and clear of all liens."²

However, "free and clear" is somewhat misleading, and potential purchasers need to
understand that the blessing of a §363 order from the bankruptcy court does not
operate as an absolute bar against the imposition of future liability. Under certain
circumstances, a purchaser can be liable as the successor in interest even if an order
is entered by a U.S. bankruptcy judge declaring that the sale is "free and clear"
of all interests. A properly educated purchaser must fully understand the risks
involved when purchasing assets out of a bankruptcy estate in order to be able to take
some practical steps that may afford additional protection from successor liability.

General State Law: Successor Liability vs. Principles of Bankruptcy Law

Under general state law, when one corporation transfers its assets to another
corporation, the purchaser is generally not responsible for the liabilities of the
seller.³ This rule can apply even if all the assets are transferred by the sale so
that, in effect, the entire business has been sold and the purchaser continues such
business as a going concern.⁴ The general rule of corporate law has also been, and
continues to be, that when one company sells its assets to another, the acquiring
company does not assume the selling company's liabilities. This corporate law rule of
no-successor liability was developed at a time when an acquiring company's primary
concern was responsibility for the seller's financial and other contractual obligations.
Modern products liability law, environmental law and labor law place the traditional
rule under some conceptual strain. A corporation that purchases the assets of another
entity normally is liable under state law⁵ for the debts and liabilities of the seller
only in certain exceptional circumstances:

A corporation may be held liable for the torts of its predecessors if (1)
it has expressly or impliedly assumed the predecessor's tort liability, (2)
there was a consolidation or merger of seller and purchaser, (3) the
purchasing corporation was a mere continuance of the selling corporation; or
(4) the transaction was entered into fraudulently to escape such obligations.⁶

Further complication is added when a bankruptcy proceeding is involved. Issues
concerning successor liability in bankruptcy arise within the general context of court
approval of a sale under §363 or within a chapter 11 plan. While successor
liability is an issue most often raised in the context of an asset-purchase transaction
and is hardly a novel one, intense debate continues over the proper scope and
application of the doctrine.

It is clear that purchasers of assets out of a bankruptcy estate must be protected
and that sales in a bankruptcy proceeding must have finality. Otherwise, creditors
would merely follow the assets to a solvent entity and seek repayment there. However,
a balance must be struck. Courts, including bankruptcy courts, have recognized that
strict application of the traditional rules concerning successor liability would allow the
seller to effectively avoid all of its liabilities through some sort of transactional
creativity, leaving creditors and other claimants without a viable remedy. Accordingly,
many bankruptcy courts have crafted several exceptions to the traditional rule of
successor liability that permit claimants to bring actions against the asset-purchasing
corporation. The bankruptcy courts have struggled with attempting to properly frame these
exceptions, especially in the context of statutory claims. Not only do the courts
disagree about whether the Bankruptcy Code precludes successor liability claims, but
they also lack a common framework to analyze the issue, resulting in analytical
approaches that are varied and incongruous.⁷ Accordingly, exceptions to successor
liability have developed under various state laws, as well as federal common law in
those situations where courts have determined an overriding federal statutory policy
exists.

Examples of Successor Liability Despite General Principles

Successor liability under federal common law can be even broader than the recognized
exceptions under state law. Courts, including bankruptcy courts, have expanded
traditional successor liability when there is an overriding federal policy. Some examples
include NLRB Restatement Orders, civil rights actions under Title VII, pension plan
claims and other claims under certain collective bargaining agreements. In order to
protect federal rights or effectuate federal policies, this theory allows lawsuits against
even a genuinely distinct purchaser of a business if (1) the successor had notice
of the claim before the acquisition and (2) there was a substantial continuity in
the operation of the business before and after the sale.⁸

One appellate court has noted "that the Supreme Court and this [7th] circuit have
imposed liability upon successors beyond the bounds of the common-law rule in a number
of different employment-related contexts in order to vindicate important federal statutory
policies."⁹ Some commentators and critics state that an important objective of the
Bankruptcy Code is to provide equality in the distribution of assets among bankruptcy
claimants by corralling them in a one-to-one bankruptcy proceeding and addressing their
claims in accordance with the statutory priorities. These commentators agree that
successor liability actions distort the priority scheme of the Bankruptcy Code by
permitting unsecured claimants to obtain a complete recovery from the purchasing
corporation while the claims of the secured creditors, who actually participated in the
bankruptcy proceeding, may be left partially or wholly unsatisfied.

However, in an often-cited opinion, the Seventh Circuit Court of Appeals stated
that while fear of successor liability could "chill" sales in bankruptcy, and as a
result, prime employees of the failed business who might have retained jobs with the
successor business, there is no reason to accord the purchasers of formerly bankrupt
entities some special measure of insulation from liability that is unavailable to
ailing, but not yet defunct, entities.¹⁰ The court noted that the supposed chilling
effect is of no concern to it because purchasers can demand a lower price to account
for pending liability of which they are aware, and under federal successor liability
principles will not be held responsible for liabilities of which they had no notice.
Additionally, the court observed that whatever happens with respect to the ability to
assert claims against the successor, it will have no effect on the fully administered
bankruptcy proceeding. "What the imposition of successor liability would accomplish, and
what the district court objected to, would be a second opportunity for a creditor to
recover on liabilities after coming away from the bankruptcy proceeding empty-handed.
But a second chance is precisely the point of successor liability, and it is not
clear why an intervening bankruptcy proceeding in particular should have a per se,
preclusive effect on the creditor's chances."¹¹ Finally, the Chicago Truck Drivers
court noted that the creditor's prior opportunity to satisfy its claim in the bankruptcy
court is a significant factor in deciding whether to allow successor liability.
Although not dispositive, the availability of relief from the predecessor is a factor
to be considered along with other factors in a particular case.¹²

Analysis of Certain Exceptions Recognized and Applied by Bankruptcy Courts

Overall there are several exceptions to the rules that a purchaser is not liable
as a successor in interest that are recognized and applied consistently by judges in
bankruptcy courts. The general categories of exceptions are:

1. Express or Implied Assumption. If the asset-purchase agreement expressly
provides that certain liabilities are assumed, then it is clear that the purchaser
assumes those liabilities. However, the purchaser must be careful because it can also
be held to implicitly assume liability. To determine whether a purchaser implicitly
assumed certain liabilities, courts typically review the acquisition agreements for
ambiguous language and review the post-acquisition conduct of the purchaser.¹³

2. De Facto Merger. A successor corporation is liable for the debts and
liabilities of its predecessor where there is a merger or consolidation of the two
entities.¹⁴ The Second Circuit has stated:

To find that a de facto merger has occurred, there must be continuity of the
selling corporation, evidenced by the same management, personnel, assets and
physical location; a continuity of stockholders, accompanied by paying for the
acquired corporation with shares of stock; a dissolution of the selling
corporation, and the assumption of the liabilities by the purchaser.¹⁵

The continuity of ownership factor also looks to whether shareholders of the predecessor
become shareholders of the successor's corporation at the time of the sale of the
assets.¹⁶

3. Mere Continuation Exception. Although the mere continuation exception is
similar to the de facto merger exception, it focuses on situations in which the
purchaser is merely a restructured or reorganized form of the seller.¹⁷ Successor
liability attaches to a corporation as a mere "continuance" only where "one corporation
survives a transaction; the predecessor successor corporation must be extinguished."¹⁸

A continuance envisions a "common identity of directors, stockholders and the existence
of only one corporation at the completion of transfer...what it accomplishes is
something in the nature of a corporate reorganization, rather than the mere sale."¹⁹
It is not simply the business of the alleged predecessor that continues, but the
corporate entity itself.

Generally, federal law draws attention to three additional tests employed to
determine if "mere continuation" status exists in a particular case: (1) the
"identity test," by which a court looks for "the existence of a single corporation
after the transfer of assets, with an identity of stock, stockholders and directors
between successor and predecessor corporations;"²⁰ (2) the "continuity of enterprises
test," by which the court examines whether the successor maintains the same business
with the same employees doing the same jobs, under the same supervisors, working
conditions and production processes, and produces the same products for the same
customers;"²¹ or (3) the "product line" test, by which the court looks to see
whether a successor that continued to manufacture the same product line as the
predecessor, under the same name, with no outward indication of any change of any
ownership of the business, could be held liable on a products liability claim resulting
from the products manufactured by the predecessor.²²

4. Federal Policy Considerations. As previously stated, certain courts have
imposed liability upon successors beyond the bounds of the common-law rules in a number
of different employment-related contexts in order to vindicate important federal statutory
policies.²³ A few of the more frequently addressed situations are NLRB restatement
orders, Title VII actions, pension claims and those claims afforded under collective
bargaining agreements.

(a) NLRB Restatement Orders. See, e.g., Golden State Bottling Co. Inc. v. NLRB, 414 U.S. 1681, 94 U.S. Ct. 414, 38 L. Ed. 2d
388 (1973).

(b) Title VII actions. See, e.g., EEOC v. Skonska Construction Co.,
2000 WL 1617008 (S.D.N.Y. 2000) (federal common law controls
question concerning successor liability with respect to Title VII claims—enumerates
nine-factor test for successor liability in employment discrimination cases). But,
see Kee Lox Mfg. Co. Inc., 437 F. Supp. 631 (W.D.N.Y.
1977), rev'd. on other grounds (court determined that Act entitles purchasers
at liquidation sales to take property free of all claims including civil rights
claims).

(c) Pension Claims. See Kee Lox, 437 S. Supp. at 631, discussed in
paragraph (b) herein, declined to be followed; Chicago Truck Drivers et al.
Pension Fund v. Tasemkin Inc., 59 F.3d 48, 50 (7th Cir.
1995). The Seventh Circuit and others have acknowledged that state successor
liability rules are preempted in the situation concerning multi-employer pension
contributions by federal common law. Moriarity v. Svec, 154 F.3d 323
(7th Cir. 1998). In order to further congressional objectives, successor
entities can be liable for multi-employer pension contributions if (1) there is
sufficient continuity between the two companies and (2) the successor company had
notice of the predecessor's liability. Upholsterer's Int'l. Union and Pension Fund
v. Artistic Furniture of Pontiac, 920 F.2d 1323 (7th Cir.
1990); see, also, Stotter Division of Graduate Plastics Co. Inc. v.
District 65 United Autoworkers, AFL-CIO, 991 F.2d 997 (2d Cir.
1993). While the Second Circuit has not explicitly held that a successor is
liable for a predecessor's failure to make ERISA contributions, it has cited with
approval to several cases that have so held. See Stotter Division of Graduate
Plastics Co. v. District, 65, 991 F.2d 987, 1002 (2d Cir.
1993). The determination is also fact-specific, and when sufficient genuine
issues of fact are present, they preclude summary judgment. Joseph Hardy and
Harvey L. Sherrod v. Kaszycki & Sons Contractors Inc., et al., 870 F.
Supp. 489 (S.D.N.Y. 1994).

(d) Other Claims Under Collective Bargaining Agreements. See EEOC v. Local
638, 700 F. Supp. 739, 743-46 (S.D.N.Y. 1988) (in view
of substantial continuity and notice of liability, union local was treated as a
successor for purposes of anti-discrimination injunction); See, also, Hawaii
Carpenters Trust Fund v. Waiola Carpenter Shop Inc., 823 F. 2d 289,
294-95 (9th Cir. 1987) (successor employee liable for delinquent
contributions to employee benefit trust funds in absence of bargaining to "impasse"
with incumbent union).

5. Fraudulent Transactions. There is an exception that is recognized with respect
to fraudulent transactions, but it is rarely applied. Generally, if a transaction
is conducted at arm's length and is commercially reasonable, it is not susceptible to
this exception. An example of the application of the fraudulent transaction exception
would be where a purchaser acquires a seller, and after the sale, the seller goes
out of business and attempts to escape tort liability.²⁴

6. A Product Line Exception. Several states have recognized another exception to
the doctrine of successor liability with respect to liability that travels along a
product line. If a purchaser continues to manufacture the same product line under the
same name as the seller, an exception may be imposed with respect to liability that
arises out of the particular product line.²⁵ It should be noted that only a
minority of states such as California, Washington, New Jersey, Pennsylvania,
Massachusetts, Michigan and Connecticut recognize the product-line exception. Other
states, such as New York, liberally construe some of the other general exceptions and
generally reach the same conclusions imposed by the product-line exception.²⁶

Courts are more likely to find successor liability under the product-line theory
when the aggrieved party can show a collusive agreement to use bankruptcy proceedings
to shield the successor corporation from the seller's liabilities.²⁷

Practical Advice

In accordance with the discussions set forth above, a purchaser's exposure to any
possible successor liability for the purchase of some or all of a debtor's assets will
be entirely dependent on intense factual examination. Additionally, to address some of
the areas that could expose the purchaser to possible liability as a successor in
interest, a purchaser can take some preventative measures.

First, it is prudent to incorporate very broad releases in any §363 order (and
having those releases incorporated in any future confirmation order). Such releases should
limit a purchaser's exposure with respect to successor liability. Further, the amount
of protection afforded by any releases approved by the bankruptcy court is completely
dependent on the thoroughness of the notice.²⁸ The more notice provided with an
opportunity to object, the less likely the concern about possible due-process violations.
Second, the court in a recent case, In re Roberts,²⁹ determined that the term
"consents" as used in a statute governing the sale of estate property free and clear
of liens, and the term "fails to object," are not synonymous. According to the court
in Roberts, it is appropriate for the bankruptcy court, sua sponte, and before any
sale order is entered, to raise the issue of whether the consent required for the sale
of estate property free and clear of all liens could be implied from a lienholder's
failure to object after notice.³⁰ The Roberts court found it could not be implied,
and therefore, an order finding the sale free and clear of all liens could not be
entered.³¹ Although the Roberts holding has not been cited by any other court, it
suggests that perhaps consents should be obtained from all lienholders as a practical
measure prior to seeking a §363 "free and clear of all liens" order.

Any or all of the following steps taken by a purchaser at the time of a sale
should minimize the risks concerning the imposition of successor liability under state
law and federal common law:³²

1. A purchaser should shut down the debtor for more than one day.
2. A purchaser should fire and hire new employees under new contracts (including
   new collective bargaining agreements) in accordance with a provision in the sale
   documents stating that a purchaser is under no obligation to hire existing employees
   and that the purchaser has no obligations to existing employees.
3. A purchaser should not honor outstanding purchase orders or accept any returns.
4. A purchaser should be dissolved or liquidated.
5. Public notice of the §363 sale should be sent to the most widespread
   audience possible under the circumstances. The notice should also be sent to all
   holders of contingent claims, and a purchaser may want to require public notice in
   a newspaper or over the Internet.
6. If the proposed sale is outside of a reorganization plan, a purchaser should
   insist that any future plan fully adopt or modify the sale transaction so that a
   purchaser can obtain the benefit of a discharge pursuant to §1141 of the
   Bankruptcy Code. (A purchaser may, of course, also request that the sale of
   assets be conducted pursuant to the plan of reorganization, but this would likely
   impose an unwanted delay.)
7. The asset purchase agreement should clearly (1) identify those liabilities
   being assumed, (2) state that a purchaser will not be assuming any of the
   debtor's remaining liabilities and (3) disclaim any express or implied agreements
   by a purchaser to assume the remaining liabilities.
8. The asset-purchase agreement should specify both the assets being purchased and
   those not being purchased. To the extent that a purchaser does not purchase all
   of the debtor's assets, a purchaser will be less likely to be held liable as the
   successor corporation.
9. A purchaser should include a mechanism to address existing employee
   disputes/claims in the context of the debtor's bankruptcy proceeding.
10. A purchaser should not employ the officers, directors and managers who are
    employed by the debtor unless absolutely necessary.
11. A purchaser might attempt to require that a portion of the sale proceeds
    be escrowed for several years with a purchaser retaining a right of set-off in
    order to get the most benefit from any indemnification claim in the asset-purchase
    agreement.
12. A sale order should provide that the transaction is not being entered into
    fraudulently and that the notice is proper and all aspects of the transaction
    adequately disclosed.
13. Additionally, the sale order also should:
    • Provide for the sale free and clear of all liens, claims, interests
      and encumbrances and be based on both §§105 and 363 of the
      Bankruptcy Code, and if the sale is conducted pursuant to a plan of
      reorganization, based on §§1123(a)(5)(D) and 1141(c).
    • Include specific findings that (1) a purchaser is not a successor to
      the debtor, (2) that the sale is not a de facto merger or
      consolidation of the debtor and a purchaser; (3) a purchaser's business
      is not a mere continuation or substantial continuation of the debtor's
      businesses, and (4) a purchaser is entering into the sale in good faith
      and not for the purpose of avoiding the debtor's liabilities.
    • Include an injunction, pursuant to §105 of the Bankruptcy Code,
      prohibiting any holder of a claim from taking any action or enforcing any
      lien or encumbrance for the purpose of obtaining payment on account of
      such claim from a purchaser to justify such an injunction. The sale order
      should also include a finding that the injunction is necessary to (1)
      minimize any indemnification set-off claims against the debtor and against
      any deferred portions of the purchase price held in escrow and (2)
      preclude creditors from obtaining a greater recovery from the debtor's estate
      than other similarly situated creditors.
    • Provide a purchaser with an administrative priority claim under
      §503(b)(1) of the Bankruptcy Code for any claims that a purchaser
      may have against a seller, including indemnification obligations, over all
      other obligations of the debtor.
    • Expressly provide that the bankruptcy court retains exclusive jurisdiction
      to enforce the sale order.
    • State that there are no common incorporators, officers, directors or
      material stockholders between the debtor and a purchaser.

Conclusion

Ultimately, given that the courts' analyses are so factually dependent and that the
law is somewhat in a state of evolution, there is no way to predict that a purchaser
will not be exposed to successor liability. However, if a purchaser obtains the
releases suggested above, in addition to taking many of the steps outlined above, the
risk of liability should be minimal. More importantly, by providing the broadest
notice possible to all possible claimants before the §363 sale, a purchaser will
likely be more aware of any threat of successor liability before electing to proceed
to the closing of the sale and, before closing, can take the steps necessary to
minimize any claim that a party did not have notice and an opportunity to object.

Footnotes

¹ Ms. Brighton is a partner in Nixon Peabody LLP's Manchester, N.H., office in its Bankruptcy Group, where she practices
primarily in the area of bankruptcy, workouts and secured lending. She is certified in business bankruptcy by the American Board of
Certification. Return to article

² 11 U.S.C. §363(f). Specifically, §363(f) of the U.S. Bankruptcy Code provides:

(f) The trustee may sell property under subsection (b) or (c) of this section free and clear of any interest in such property of
an entity other than the estate, only if—

(1) applicable non-bankruptcy law permits sale of such property free and clear of such interest;

(2) such entity consents;

(3) such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all
liens on such property;

(4) such interest is in bona fide dispute; or

(5) such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest. Return to article

³ See, eg., RTM Exec. Gallery Corp. v. Rols Capital Co., 901 F.Supp. 630 (S.D.N.Y. 1995). Return to article

⁴ Id. See, also, Solow and Israel, "Buying Assets in Bankruptcy: a Guide to Purchasers," 10 J. Bankr. Law and Practice,
87, 93 (2000). Return to article

⁵ New York's common law concerning successor liability is reflective of many jurisdictions. Return to article

⁶ See Shamis v. Ambassador Factors Corp., 34 F. Supp. 2d 879, 896 (1999), citing Shumacher v. Richard Shear Co.
Inc., 451 N.E.2d 195, 198, 59 N.Y.2d 239, 245, 464 N.Y.S.2d 437, 440. See, also, In re National
Pipe & Plastics Inc., 2000 Bankr. LEXIS 1329 at *13 (D. Del. 2000). Return to article

⁷ See, generally, "An Examination of Successor Liability in the Post-Bankruptcy Context," 22 Iowa J. Corp. L.(1997). Return to article

⁸ In re National Pipe & Plastics Inc., 2000 Bankr. LEXIS 1329 at *18. Return to article

⁹ Upholsterers Int'l. Union Pension Fund v. Artistic Furniture of Pontiac, 920 F.2d 1323, 1325 (7th Cir. 1990). Return to article

¹⁰ In re Chicago Truck Drivers Pension Fund et al. v. Tasemkin Inc., 59 F.3d 48 at 50 (7th Cir. 1995). Return to article

¹¹ Id. at 50. Return to article

¹² Id. Return to article

¹³ See generally, Solow and Israel, "Buying Assets in Bankruptcy: a Guide to Purchasers," 10 J. Bankr. Law and Practice, 87,
93 (2000). See, also, RCM Executive Gallery Corp. v. Rols Capital Co., 901 F. Supp. 630, 635 (S.D.N.Y.
1995) (successor potentially liable for usurious transaction because there was no specific provision related to the assumption of liabilities).
See generally, Solow and Israel, "Buying Assets in Bankruptcy: a Guide to Purchasers," 10 J. Bankr. Law and Practice, 87, 94
(2000). Return to article

¹⁴ Shamis, 34 F. Supp. 2d at 897. Return to article

¹⁵