State Court Gives Lessons in Bankruptcy Law

In an unusual reversal of roles, we bankruptcy lawyers can learn some important lessons
about the limitations of bankruptcy law from a state court. In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=… v. K.P. Hovnanian Enterprises Inc.,</i> 734 A.2d 290, 160 N.J. 307 (1999)</a>, the Supreme Court of New Jersey, in a
4-3 decision, enforced successor liability against a manufacturer who had acquired assets
through a "free-and-clear" bankruptcy sale. In doing so, the court held that an intermediate
owner's bankruptcy did not preclude successor liability, even though the claim arose before the
bankruptcy case was filed.

</p><p><i>Lefever</i> involved a forklift operator who suffered injuries when his forklift tipped over. He
asserted a "product-line" successor liability claim in state court against a successor corporate
manufacturer that had purchased its predecessor's product line through a bankruptcy sale. The
purchaser moved to dismiss the claim on the basis that the bankruptcy sale was "free and
clear" of any interest in the property, including any successor liability claims. The trial court
granted the motion to dismiss. On appeal to the intermediate appellate court, however, the trial
court was reversed and the Supreme Court affirmed.

</p><p>The <i>Lefever</i> court squarely faced the question of whether the product-line successor liability
doctrine is applicable when a successor purchases its predecessor's assets at a free-and-clear
bankruptcy sale. After reviewing the development of the product-line successor liability
doctrine under New Jersey law, the court first examined whether the supremacy of federal
bankruptcy law prevents the application of state common law to claims against a successor
business enterprise that acquired assets through a bankruptcy sale. Although answering the
question in the affirmative, the court nimbly maneuvered around this constitutional impediment
by reasoning that the supremacy of federal bankruptcy law applies only if the bankruptcy court
had "dealt with" the claim. The justices examined in this context the function of the bankruptcy
sale and determined the effect it may have on other principles of law that affect the liability of a
successor business enterprise.

</p><p>The court considered whether either of the two means of selling assets in bankruptcy—by a
§363 sale or under a chapter 11 plan—cuts off successor liability claims. It reviewed the
distinction between "claims" and "interests" and how the bankruptcy court's power to sell free
and clear of claims is coextensive with its power to discharge claims under the Bankruptcy Code.
The justices determined that the successor liability claim was not pre-empted because the
plaintiff's claim "was simply not dealt with in the bankruptcy proceedings." This conclusion
rested on the findings that the plaintiff had not filed a claim (although the debtor had listed the
claim on its schedules and, as the dissent pointed out, the plaintiff had the opportunity to file a
claim but chose not to) and that his "claim" was not an "interest" in the sense of a lien or
encumbrance on the assets sold.

</p><p>Having determined that federal law permits the application of the product-line successor
liability doctrine after a bankruptcy sale, the court then considered whether it should in fact
be applied. This involved weighing the competing policies of the Bankruptcy Code (maximizing
the value of assets and providing equality of distribution among creditors of equal legal
status—each of which would be undermined by enforcing successor liability) against the
product-line successor liability doctrine (providing compensation to otherwise remediless
victims of defective products and spreading the risk to society at large for the costs of injuries
from defective products). In deciding to enforce successor liability against the purchaser of
assets at the bankruptcy sale, the court concluded that the policies underlying the product-line
successor liability doctrine outweigh those of the Bankruptcy Code (a balancing of interests that
was roundly criticized by the three dissenting justices.)

</p><p>The main lesson of <i>Lefever</i> is not so much its holding; rather, it is what it teaches us about the
limitations of bankruptcy law itself. As those loyal members of ABI's Asset Sales Committee and
many of our colleagues know all too well, this is certainly not the first instance of a state court
enforcing successor liability notwithstanding a free-and-clear bankruptcy sale.

</p><p>We bankruptcy lawyers must remember that the effectiveness of our work in bankruptcy is
often limited by how it is perceived—and enforced—in the real world. It is all too easy to forget
that the usual and customary rules of law (along with, it sometimes seems, the very fabric of
time and space) are warped by the intense gravitational pull of Planet Bankruptcy. It is also too
easy to forget that bankruptcy is an artificial construct—a life-support system for debtors that
suspends the harsh reality of our otherwise unforgiving economic system. When we try to effect
bankruptcy-like results in a non-bankruptcy forum, we are often strangers in a strange land.

</p><p><i>Lefever</i> is instructive for understanding how state courts tend to "think" about bankruptcy and
for avoiding the perils of our thinking too narrowly. As with the free-and-clear sale order
construed in <i>Lefever,</i> just because we say something in bankruptcy court doesn't necessarily
make it so. The <i>Lefever</i> court was willing to sidestep the Supremacy Clause and apply New
Jersey law simply based on its (perhaps misguided) view that the plaintiff's claim had not been
"dealt with" in the bankruptcy case. It did not hesitate to limit the effect of bankruptcy law to
achieve a result more consistent with the way things work in the real world. To the real world,
results achieved in bankruptcy are often confusing, counterintuitive and just plain offensive to
the mainstream sense of justice and the way things are done. No wonder that state courts like the
one in <i>Lefever</i> look for ways to undo what we've often worked so hard to put together.

</p><p>The <i>Lefever</i> court's willingness to limit the effect of bankruptcy law also teaches an important
practical lesson about <i>where</i> a purchaser of assets out of bankruptcy should go to enforce rights
it believes it has received by a bankruptcy court order approving a sale free and clear. When a
claimant asserts successor liability against a purchaser who assumes there is none, there is a
threshold strategic decision to be made: Which court is more likely to enforce the purchaser's
expectation of what "free and clear" really means? Although it apparently is not entirely clear
from the <i>Lefever</i> opinion, the purchaser adopted a purely defensive strategy in the state court,
relying entirely on the sanctity of the "free and clear" language of the bankruptcy sale order. In
hindsight, however, this may have been a fatal strategic mistake. As was pointed out by the three
dissenting justices, it permitted the <i>Lefever</i> court to undermine the efficacy of a free-and-clear
sale by subordinating the narrow bankruptcy law policies to the more broadly based social
policies underlying the judicially created state law doctrine of successor liability. A more
assertive strategy for seeking injunctive relief from the bankruptcy court that issued the sale
order might have been more successful in blunting the plaintiff's claim. As for bankruptcy
courts vs. state courts, a purchaser's chances of receiving a more favorable result—strictly on
policy grounds, if nothing else—would appear to be better in the former. Bankruptcy courts
might be more likely to give effect to and enforce their own orders than a state court with an
entirely different constituency, agenda and philosophy.

</p><p>We bankruptcy lawyers must try to maintain a distant—and defensive—perspective about how
our work in bankruptcy will be perceived. Otherwise, as <i>Lefever</i> illustrates, an army of fancy
bankruptcy lawyers can be blindsided by a single plaintiff's personal injury lawyer who doesn't
know the first thing about the niceties of §363(f) and couldn't care less. That's a tough lesson to
learn.

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