Section 363 Sales Let the Buyer Beware

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Jul/Aug 2002

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A debtor's assets may be sold free and clear of liens, encumbrances and interests,
with those liens, encumberances and interests attaching to the proceeds of the sale.
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §363</a>. Indeed, the "§363 sale" has become common in today's
commercial bankruptcies, particularly in the telecommunications area. In fact, certain
courts have commented on the desire to hear fewer "chapter 3" cases and more chapter
11 cases.

Nonetheless, a §363 sale is sometimes the best and/or only exit strategy, as
some debtors have absolutely no ability to reorganize, yet the value of their assets
as a going concern exceeds the shut-down value. Additionally, a §363 sale is
often attractive to a potential purchaser of assets because of the ability to buy such
assets free and clear of all liens, encumbrances and interests, thereby taking the
assets without the liabilities.

Despite §363's provisions, §363 sales do not necessarily protect a purchaser
of assets in bankruptcy. In fact, certain courts have held that §363 sales do
not insulate a purchaser from future claims under the theory of successor liability.
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Aircraft Inc. v. Cambell (In re Fairchild Aircraft Corp.), 184
B.R. 910 (Bankr. W.D. Tex. 1995); vacated, 220 B.R. 909
(Bankr. W.D. Tex. 1998)</a>. It is important, therefore, for a buyer of
assets from a §363 sale to know what they are buying and the risks associated with
such purchases.

<h3>Fairchild Aircraft Inc. v. Campbell</h3>

In Fairchild, the debtor manufactured and sold commuter aircraft, the last sale
of which occurred in 1985. In 1990, the debtor filed a voluntary petition
under chapter 11. Subsequently, the court appointed a chapter 11 trustee, who
sought and located a purchaser for the debtor's assets. Instead of a §363 sale,
the trustee formulated and filed a liquidating plan via the sale of the debtor's assets
to the purchaser for $5 million, plus the assumption of certain secured debt,
pursuant to an executed asset purchase agreement. The asset purchase agreement expressly
provided that the purchaser would not be responsible for the debtor's other obligations
or liabilities regardless of when they occurred.

The court confirmed the plan and approved the asset purchase agreement in its
confirmation order. Pursuant to the confirmation order, the debtor's assets were sold
free and clear of all liens, claims and interests, and the purchaser was not
responsible for any liabilities or debts of the debtor. Additionally, the confirmation
order contained an injunction prohibiting all creditors and other persons from pursuing
claims against the purchaser, along with a finding of fact that notice of the plan
was reasonable and adequate.

Nearly three years later, after an aircraft manufactured by the debtor crashed and
killed four people, several plaintiffs brought a wrongful death action against the
purchaser under the theory of successor liability. In response, the purchaser initiated
an adversary proceeding against the plaintiffs in bankruptcy court, seeking both
injunctive and declaratory relief to the extent that (i) the confirmation order
authorized the sale of the debtor's assets "free and clear," (ii) the provisions of
the Asset Purchase Agreement "cleansed" the assets acquired by the purchaser of any
future liability and (iii) the plaintiffs' wrongful death action violated the permanent
injunction set forth in the confirmation order.

Ultimately, the court found that it lacked subject matter jurisdiction to enjoin the
plaintiffs from bringing claims against the purchaser because the confirmation order did
not enjoin or otherwise affect the plaintiffs' wrongful death action against the
purchaser. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 184 B.R. at 934</a>. Specifically, while the confirmation
order provided for the sale of the debtor's assets free and clear of all liens,
encumbrances and interests, there was no provision for treatment of future claimants,
nor were current owners and operators of aircraft manufactured by the debtor given
notice, even though the debtor was aware of many of those owners and operators. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

at 914</a>.

More specifically, the court held that the term "any interest" was limited to sales
free and clear of in rem (i.e., property) interests, but did not include sales
free and clear of in personam liabilities such as those presented by the plaintiffs.
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 184 B.R. at 917-18</a>; citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Wolverine Radio Co.,

930 F.2d 1132, 1147 (6th Cir. 1991)</a>, cert. dism'd., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S. 978 (1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Fleishman, 138 B.R. 641, 647
(Bankr. D. Mass. 1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Dartmouth Audio Inc., 42 B.R. 871
(Bankr. D. N.H. 1984)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Precision Colors Inc., 19 B.R.
415 (Bankr. S.D. Ohio 1982)</a>. The court noted that perhaps bankruptcy courts

should have the power to sell free and clear of "trailing liability" for future
claims, but that a policy decision of this nature must be made by Congress, not
the courts. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 184 B.R. at 918-19</a>. Thus, while in rem interests
are extinguished, in personam interests such as successor liability are not. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

<h3>Fairchild's Reasoning</h3>

The theory of successor liability is an exception to the general rule that the
transfer of assets does not pass on the liabilities of the seller to the purchaser,
similar to where there is (1) an express or implied assumption of liabilities,
(2) a consolidation or merger, (3) a "mere continuation" of the seller, and/or
(4) a fraudulent transfer to avoid creditors. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 920</a>, citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;
International Union Pension Fund v. Artistic Furniture of Pontiac, 920 F.2d
1323, 1326 (7th Cir. 1990)</a>. More importantly, the theory of successor
liability does not create a new or independent cause of action. Instead, successor
liability is based on the transfer of the seller's liability arising from the assets
sold to the purchaser. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;, citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… State Bottling Co. Inc. v. NLRB,

414 U.S. 168 (1973)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Ins. Co. of New York v. Allied Mut.
Ins., 955 F.2d 1353, 1357 (9th Cir. 1992)</a>, cert. den'd.,
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S. 1221 (1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Equipment Co. v. Dial Corp., 25
F.3d 1384, 1387 (7th Cir. 1994)</a>.

Since a claim under the theory of successor liability is not a new claim, one must
examine whether the claimant has a "claim" dischargeable in bankruptcy and/or
extinguishable by a §363 sale. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 184 B.R. at 920-21, n.11</a>.
The Fairchild court examined the various tests of what constitutes a "claim," such
as the accrual test, citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… & Bienes v. M. Frenville Co. (Matter of
Frenville Co. Inc.), 744 F.2d 332, 335-36 (3rd Cir.
1984)</a>; cert. den'd., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S. 1160 (1985)</a>; the conduct test,

citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. Corp. v. Aguilar (In re S.S. Waterman Corp.), 141 B.R.
552 (Bankr. S.D.N.Y. 1992), vacated on other grounds, 157 B.R.
220 (S.D.N.Y. 1993)</a>; the relationship test or conduct plus test, citing
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Official Committee of Unsecured Creditors of Estate of Piper Aircraft
Corp. (In re Piper Aircraft Corp.), 58 F.3d 1573, 1577 (11th
Cir. 1995)</a>; and the Fifth Circuit's version of the "relationship" or "conduct
plus" test, citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Universal Mfg. Corp., 18 F.3d 1268 (5th
Cir. 1994)</a>.

Upon examining the various tests, the court held that although the concept of a
bankruptcy claim should be as broadly defined as possible, the overriding limitation
would be whether the bankruptcy process for dealing with the future claimant had been
fundamentally fair. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 184 B.R. at 924-25</a>. To comport with the
statutory definition of "claims" and assure fundamental fairness for future claimants,
(a) the future claims must be based on the pre-bankruptcy conduct of the debtor,
(b) the debtor must be able to identify the type of future claim so that it can
be "fairly anticipated" that they could arise in the future, and (c) the debtor must
provide for "fair representation and treatment" of that type of future claim, including
some form of notice, representation and/or treatment. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 922-23</a>.

For example, since the Fairchild plaintiffs' causes of action arose out of
pre-petition conduct of the debtor, the debtor had enough information to know and
reasonably anticipate that these types of causes of action could arise in the future,
and since there was no provision for representation and/or treatment of these future
claimants' interests during the bankruptcy case, such future claims could not be treated
as "bankruptcy claims." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 932-33</a>. Thus, since the future claims could
not be treated as bankruptcy claims, they could not be discharged in bankruptcy, or
extinguished pursuant to a §363 sale.

Subsequently, the plaintiffs and the purchaser settled, and the purchaser requested
that the court vacate its opinion. Though reluctant, the court found that the
purchaser had equitable entitlement to the extraordinary remedy of vacatur and vacated
its opinion. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Aircraft Inc. v. Cambell (In re Fairchild Aircraft
Corp.), 220 B.R. 909 (Bankr. W.D. Tex. 1998)</a>.

Despite the subsequent vacatur, several courts and commentators have analyzed and
relied on Fairchild, due in no small part to its thorough analysis. More important
than its thorough analysis is the instruction that Fairchild gave to practitioners
regarding the inclusion of future claims as bankruptcy claims, which subsequent courts
have adopted. See In re Williams v. Todd Shipyards Corp., 1997 U.S. Dist.
Lexis 23 961 (S.D. Tex. 1997) (where a district court declined to grant
summary judgment based on the lack of evidence that the Fairchild standards for
assuring fundamental fairness for the treatment of future claims was met); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
Industries Inc. v. Walker (In re UNR Industries Inc.), 224 B.R. 664,
669-72 (Bankr. N.D. Ill. 1998)</a> (where a bankruptcy court held that
for the trust fund mechanism in the confirmed plan to cover a future claim, such
future claim must be specifically described); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Boiler Corp. v. Smith (In
re Kewanee Boiler Corp.), 198 B.R. 519, 534-36 (Bankr. N.D.
Ill. 1996)</a> (where a bankruptcy court, relying on Fairchild, concluded that
procedural due process and the requirements of meaningful notice are a limitation on
what could constitute a "claim" that could be dealt with in bankruptcy, and, since
the debtor had made no provision for identifying, notifying or treating future
claimants, future claims were not discharged).

<h3>Conclusion</h3>

In addition to holding that §363 sales do not necessarily insulate a purchaser
of assets from all potential liabilities, Fairchild also gave direction as to how to
further insulate a §363 sale purchaser from future claims. However, Fairchild left
certain details unanswered: What type of notice must be given to assure fundamental
fairness for future claimants? Is it necessary to actually appoint a legal
representative for future claimants? How does the Fairchild analysis differ in the
chapter 7 context? Does fundamental fairness require asset sales through a plan, or
can such assurances be made in the context of a §363 sale motion and order?

Indeed, these issues are pertinent for the practitioner, particularly those
representing buyers of assets in bankruptcy, to consider when contemplating a §363
sale. After all, §363 sales are only attractive to purchasers because of the
"protections" afforded under §363. Without those protections, the additional time and
expense of participating in a chapter 11 removes the incentive of a potential
purchaser, thereby diminishing value to the bankruptcy estate. Consequently, complying
with the Fairchild standards is not only in the best interests of the potential
purchaser, but the bankruptcy estate as a whole.

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Monday, July 1, 2002 - 12:00

Bankruptcy Rule

2002