Caveat Emptor: What A Buyer Knows Could Hurt Them

It is generally recognized that a sale of assets free and clear of successor liability claims (a “free-and-clear sale”) enhances the value of the bankruptcy estate because the purchaser will pay a higher premium for assets that do not carry liability.[1] There is often a tension between creditors — who seek to maximize their recovery — and purchasers — who seek to avoid liability for the sins of their predecessors.

In a recent opinion for In re Piper,[2] a bankruptcy court allowed certain claims arising out of defective products manufactured by a debtor prior to the sale to proceed against a party who purchased assets from a bankruptcy estate free and clear of liens. In In re Piper, a party (New Piper) purchased substantially all of Piper Aircraft Corp.’s (Old Piper) assets free and clear of all claims, including successor liability claims, under a plan confirmed in 1995. A trust was created and funded to address all future claims brought by parties seeking to recover damages against Old Piper. A channeling injunction funneled all future claims — including successor liability claims — to the trust and prohibited suits against the purchaser.

The trust defined “future claims” as any claim that could be asserted against Old Piper, but only to the extent that liability existed prior to the confirmation date. Included within the definition of “future claims” were claims based on “product liability, design defects and failure to warn.”[3] Notwithstanding the broad definition, the trust documents also exempted the trust from indemnifying New Piper for “that part of any future claim” arising from any failure by New Piper to warn of defects discovered after the effective date of the plan.[4]

Two different owners of aircraft manufactured by Old Piper concurrently filed claims against the trust and sued New Piper in state court. One group of plaintiffs sued New Piper for strict liability, negligence, breach of express and implied warranties, and for fraud, misrepresentation and concealment.[5] The other group of plaintiffs brought an action “solely on New Piper’s failure to update a [pilots’ operating handbook]” after federal agencies issued a safety recommendation.[6]

New Piper removed the actions to federal court and filed pleadings in the bankruptcy court to enforce the “free and clear” provisions of the confirmed plan and the channeling injunction. The plaintiffs argued that their claims were not “Future Claims” because their claims were based solely on New Piper’s failure to warn of defects discovered after the effective date. The bankruptcy court summarized the plaintiffs’ state court claims as seeking to impose liability on New Piper only for post-confirmation wrongdoing by New Piper.

Is There a New Exception to Free-and-Clear Sales?

Does a failure to warn of known defects or newly discovered defects create an exception to a free-and-clear sale? At first glance, the plaintiffs’ claims appeared to be “future claims.” The plan defined “future claims” to include any post-confirmation claim that could be brought against Old Piper for design or manufacturing defects, including Old Piper’s failure to warn. Likewise, the predicate for the plaintiffs’ claims were defects in products manufactured by Old Piper, as reflected by the plaintiffs also asserting claims against the trust. Finally, the trust documents specifically included claims based on the failure to warn, which were included within the definition of “future claims.”

Nevertheless, the bankruptcy court held that the plaintiffs’ claims were not “future claims” because the plaintiffs had not alleged any wrongdoing by Old Piper in the state court actions. The court adopted a two-part test for determining what constitutes a “future claim.” First, liability must exist for parts manufactured by Old Piper. Second, the liability must be based on Old Piper’s wrongdoing. The court found that the plaintiffs could only succeed in their suit if they proved wrongdoing by New Piper.

New Piper reasonably believed that it would not be subjected to successor liability claims — the same claims that had brought down Old Piper. In fact, the court in Piper even acknowledged that the trust and the channeling injunction had worked for 20 years without the need for further court intervention. New Piper had likely made business decisions and forecasts in reliance upon the expectation that it would not be liable for the sins of its predecessor. Now New Piper must account for potential liability for product defects created by Old Piper based on the allegations that New Piper allegedly knew of such defects and failed to warn.

Or Is the Exemption Creative Lawyering?

The plaintiffs artfully pled their amended complaints to avoid any allegations that would classify their state court claims as “future claims.” Instead, the plaintiffs carefully focused their claims in the state court pleadings on the exception to the “future claims” definition in the indemnification provisions of the trust documents. The amended complaint filed in the state court limited claims to damages arising from New Piper’s failure to warn and pled that such claims were not known or reasonably could have been known by Old Piper on the effective date of the plan, which the plaintiffs asserted excluded the trust’s obligation to indemnify New Piper. The only wrongful activity alleged was New Piper’s apparent failure to warn owners of material defects in the Old Piper airplanes.

While the failure to warn was included in the definition of “future claims,” the trust’s obligation to indemnify New Piper for “future claims” excluded certain claims for the failure to warn. The bankruptcy court in Piper appeared concerned that plaintiffs would have a right without a remedy. Considering the possibility that the plaintiffs’ claims could be “future claims” without a corresponding obligation by the trust to indemnify, the bankruptcy court refused to enjoin the plaintiffs’ claims against New Piper.

Conclusion

The Piper decision has been appealed. It remains to be seen whether the holding in Piperwill be a trend affecting future free-and-clear sales and product-liability cases, or whether it is an aberration based on the careful pleading decided on the precise definitions and the carve-out of indemnification provision under the trust documents.

A general exception to a free-and-clear sale that imposes liability on a purchaser for the failure to warn would be good news for a potential plaintiff and bad news for potential purchasers and sellers in bankruptcy cases. A plaintiff could seek to impose product liability upon a successor by alleging that the successor has failed to warn owners of newly discovered defects. On the other hand, prospective purchasers of bankruptcy assets will have to consider and evaluate the additional risk of nondisclosure of defects. Although some aspects of the Piper opinion may be attributed to creative lawyering based on the express provisions of the plan and trust documents, prospective purchasers must nevertheless consider the possibility of a new exception to free-and-clear sale provisions, because what a purchaser knows could hurt them.