The Sins of the Father: Successor Liability in § 363 Sales

One of the hallmarks of purchasing assets from a bankruptcy estate under § 363 of the Bankruptcy Code is the perceived ability of a buyer to purchase those assets “free and clear of any interest in such property” if certain conditions are met.[1] A common phrasing in many motions seeking to sell assets under § 363 is that the assets are to be sold “free and clear of all liens, claims and encumbrances.” But that is not what the statute actually says. Section 363 simply refers to sales potentially being “free and clear of any interest in such property.”

Somewhat notoriously, the Bankruptcy Code then fails to provide a definition of the term “interest.” That omission has left the courts to struggle for decades to address whether a debtor’s assets were sold “free and clear” of a particular claim or interest in the assets sold, sometimes well after the conclusion of the sale to the purchaser. Perhaps in no context is this more aggressively litigated than in the context of claims for which the purchaser is subject to successor liability on account of action or inaction by the debtor-seller.

A Historical Perspective of the Successor Liability Issue

One of the early cases interpreting § 363(f) and the power of a bankruptcy court to authorize a sale of a debtor’s assets free of successor liability claims was In re White Motor Credit Corp.[2] Despite being more than 30 years old, the case remains instructive regarding the issues examined by courts when they consider whether they have the power to approve sales under § 363(f) free of successor liability claims.

Significantly, the White Motor court did not consider the source of its power to approve a sale free of successor liability claims to be § 363(f). Instead, that court interpreted § 363(f) narrowly, finding that the subsection “authorizes sales free and clear of specific interests in the property being sold; liens for example” and that “[g]eneral unsecured claimants, including tort claimants, have no specific interest in a debtor’s property.”[3] Rather than rely on § 363(f), the White Motor court found it had the power to sell the debtor’s assets free and clear of successor liability claims based on the court’s “general equitable powers” under Bankruptcy Code § 105 and pursuant to its “duty to distribute debtor’s assets and determine controversies thereto.”[4] The court was particularly influenced by the overarching purposes of the Bankruptcy Code to give a debtor a fresh start and to ensure the equitable distribution of assets, particularly as set forth in Bankruptcy Code § 1141.[5] The court observed:

The effects of successor liability in the context of a corporate reorganization preclude its imposition. The successor liability specter would chill and deleteriously affect sales of corporate assets, forcing debtors to accept less on sales to compensate for this potential liability. This negative effect on sales would only benefit product liability claimants, thereby subverting specific statutory priorities established by the Bankruptcy Code. See 11 U.S.C. §§ 507 and 1129(a)(9). This result precludes successor liability imposition.[6]

The White Motor case is an example of a line of decisions that limit the scope of § 363(f) to what is sometimes referred to as “in rem” property “interests,” meaning that in order for a claim against a successor to be cut off by a sale order, the claim had to directly relate to the property being sold. Other decisions that similarly adopt that narrow interpretation of § 363(f) include In re Wolverine Radio Co.[7] and Zerand-Bernal Group v. Cox.[8]

The weight of more current authority takes a broader view of what constitutes an “interest” under § 363(f). The Second Circuit’s decision in In re Chrysler LLC[9] falls with that group and is worth exploring because of its endorsement of the approach taken in two other circuits and by the district court in Myers v. United States[10] and because of the Second Circuit’s more recent decision on the successor liability issue in In re Motors Liquidation Co.[11]

In Chrysler, the Second Circuit specifically rejected the argument that personal injury claims do not fall within the species of “any interest in such property” as that phrase is used in § 363(f). It relied heavily upon the Third Circuit’s decision in In re Trans World Airlines Inc.,[12] which involved employment-discrimination claims and a voucher program and whether those claims constituted “interests” in property for purposes of § 363(f). The Chrysler court summarized the TWA court’s analysis as follows:

The Third Circuit reasoned that “to equate interests in property with only in rem interests such as liens would be inconsistent with section 363(f)(3), which contemplates that a lien is but one type of interest.” 322 F.3d at 290. After surveying its own precedents and the Fourth Circuit’s decision in [In re Leckie Smokeless Coal Co.], 99 F.3d 573 (4th Cir. 1996), the TWA court held that “[w]hile the interests of the [plaintiffs] in the assets of TWA’s bankruptcy estate are not interests in property in the sense that they are not in rem interests,... they are interests in property within the meaning of section 363(f) in the sense that they arise from the property being sold.” 322 F.3d at 290.[13]

Ultimately, the Chrysler court agreed with the Third Circuit in TWA and the Fourth Circuit in In re Leckie Smokeless Coal Co.[14] to conclude that the term “any interest in property” encompasses those claims that “arise from the property being sold.”[15] Thus, the Chrysler court found that “New Chrysler” was permitted to acquire the assets of “Old Chrysler” free of product-liability claims in vehicles produced by Old Chrysler because those claims arose from the property sold to New Chrysler.[16]

Retreat from Extending Sales “Free and Clear” to All Successor-Liability Claims

An expansive reading of Chrysler suffered a setback when the Second Circuit revisited the issue of successor liability in In re Motors Liquidation Co.[17] In that case, the debtor (“Old GM”) had obtained approval in a sale order to sell its assets to a purchaser (“New GM”) “free and clear of liens, claims, encumbrances and other interests,… including rights or claims … based on any successor or transferee liability.”[18] The sale order did include certain liabilities that were to be assumed by New GM. Before approving the sale, the bankruptcy court had ordered Old GM to send direct-mail notices to numerous interested parties, including those parties “known to have asserted any lien, claim, encumbrance, or interest” in the assets to be sold, and to publish notice in major publications, including the Wall Street Journal and The New York Times.[19] The bankruptcy court then heard more than 850 objections to the proposed sale order over the course of three days before approving the sale on July 5, 2009, just over a month after Old GM had filed its chapter 11 petition.[20]

After the sale closed a few days later, New GM began operating and Old GM went through the process of liquidation.[21] A bar date of Nov. 30, 2009, was set,[22] and after two amendments, Old GM confirmed its liquidating plan on March 29, 2011, which included a trust funded with certain Old GM assets (including stock in New GM) to pay unsecured creditors on account of their claims.[23] By March 31, 2014, the trust had distributed approximately 90% of the assets available for distribution. It was just about at this time, on Feb. 7, 2014, that New GM first informed the National Highway Traffic Safety Administration that it would be recalling, among other vehicles, the 2005 Chevrolet Cobalt due to a defect in the ignition switch that could prevent airbags from deploying or could cause the car to stall on the road.[24] This defect was something that Old GM knew about no later than 2002 based on engineer reports and customer complaints.[25]

Soon after New GM initiated its first recall, individuals filed “dozens” of class action lawsuits for personal injuries and economic losses sustained both before and after the sale from Old GM to New GM closed.[26] New GM sought to invoke the sale order to shield itself from claims amounting to an estimated $7-10 billion in economic losses, as well as damages from pre-closing accidents.[27]

On these facts, the Second Circuit declined to apply Chrysler[28] to allow New GM to shield itself from successor liability. It noted at the outset that the decision in Chrysler had been vacated by the Supreme Court for mootness in Ind. State Police Pension Tr. v. Chrysler LLC,[29] which prevented Chrysler from “spawning any legal consequences.”[30] It then appeared to scale back its statements in Chrysler to observe that rather than formulating a precise definition of what is meant by the “any interest in such property” language in § 363(f), “courts have continued to address the phrase ‘on a case-by-case basis.’”[31] It reaffirmed its continued support for the decisions in Leckie and TWA and other decisions to the effect that the term “interests” is broader than mere “in rem” interests in the property being sold, and stated that it “agree[d] that successor liability claims can be “interests” when they flow from a debtor’s ownership of transferred assets.”[32] However, it also cautioned that “successor liability claims must also qualify as ‘claims’ under Chapter 11.”[33]

The GM court next proceeded to consider what claims may be barred under chapter 11 generally. Following that review, the GM court summarized its conclusion as follows:

To summarize, a bankruptcy court may approve a § 363 sale “free and clear” of successor liability claims if those claims flow from the debtor’s ownership of the sold assets. Such a claim must arise from a (1) right to payment (2) that arose before the filing of the petition or resulted from pre-petition conduct fairly giving rise to the claim. Further, there must be some contact or relationship between the debtor and the claimant such that the claimant is identifiable.[34]

The court then applied the foregoing standard to the different groups of claimants in GM, seeking to avoid the impact of the free-and-clear language in the sale order in that case. The GM court concluded that persons holding “pre-closing accident claims” fell within the scope of the sale order because those claims directly related to the ownership of the GM automaker’s business and because “those plaintiffs’ claims are properly thought of as tort claims that arose before the filing of the petition.”[35] The court also found that a second group, the holders of economic loss claims arising from the ignition-switch defect and other defects, also fell within the scope of the sale order, even though the defects were not disclosed until five years after the sale because their claims flowed from the operation of Old GM’s business, because they were holders of contingent claims.[36] The third group consisting of claimants that held claims based on New GM’s post-petition conduct were found not to be barred by the sale order because they were “not claims that are based on a right to payment that arose before the filing of petition or that are based on pre-petition conduct.”[37] And finally, the fourth group of claimants, which consisted of individuals who purchased Old GM cars after the closing, were found to have “had no relation with Old GM prior to bankruptcy” and likewise fell outside the scope of the sale order.

In summary, the first and second claimant groups were found to be covered by the sale order, and the third and fourth groups were outside of the sale order and could proceed with their claims against New GM. But the conclusion that the holders of pre-closing accident claims (the first group) or the holders of economic-loss claims based on the ignition switch and other defects (the second group) fell within the scope of the sale order did not end the inquiry with regard to whether the sale order could be enforced against them. Each of those groups also contended that they did not receive adequate notice of the hearing on the sale order and that they were denied due process as a result of that deficiency.

With regard to the inadequate-notice claim, the bankruptcy court had held below that “because Old GM knew or with reasonable diligence should have known of the ignition switch claims, plaintiffs were entitled to actual or direct mail notice, but received only publication notice.”[38] The Second Circuit found no clear error in that factual finding and upheld it, noting that federal law requires car manufacturers to keep records of the first owners of their vehicles and that Old GM knew of the defects certainly by May 2009 and “did nothing.”[39]

With regard to the due-process claim, the bankruptcy court found that the claimants had suffered no prejudice from the lack of actual or mail notice because their claims or objections would not have changed the outcome of the hearing that led to the sale order, and that therefore, despite the lack of proper notice, the sale order could be enforced against these claimants. The Second Circuit disagreed, notwithstanding that the bankruptcy court had considered more than 850 objections to the sale order and that some of them were likely duplicative.[40] The GM court did not reach the question of whether actual prejudice is required in order to contest a § 363 sale based on inadequate notice because the court found that the claimants had shown prejudice to exist. The court explained:

After examining the record as a whole, we cannot say with fair assurance that the outcome of the § 363 sale proceedings would have been the same had Old GM disclosed the ignition switch defect and these plaintiffs voiced their objections to the “free and clear” provision. Because we cannot say with any confidence that no accommodation would have been made for them in the Sale Order, we reverse.[41]

Essentially, the lack of “actual or mail notice” to claimants that could have been identified by Old GM as purchasers of its vehicles meant that the claimants could not participate in the negotiations that ultimately resulted in a confirmed plan for GM, and that therefore those claimants were prejudiced by the lack of notice. As a result, the sale order could not be enforced against either of the two groups that otherwise fell within the sale order.

Buyer Beware

The weight of authority clearly supports the broader interpretation of § 363(f) to allow it to shield a purchaser of estate assets from successor liability claims.[42] Courts nevertheless continue to struggle with what the limitations on freedom from successor liability claims should be. On the one hand, if buyers are not assured that they will be shielded from successor liability claims, they will either decline to purchase a debtor’s assets, particularly a going concern where the nature of the business sold, statistically speaking, can be expected to cause harm to unknown claimants years after the sale has closed, or they will pay markedly less for such assets to the detriment of existing and known creditors. On the other hand, there are considerations of due process and equity, particularly where the successor is owned or operated by substantially the same owners or operators as were in control of the debtor. The statement of the Second Circuit in GM that the scope of the protection afforded buyers from successor liability will be determined on a “case-by-case basis” does little to comfort buyers that they have paid a reasonable price for the debtor’s assets, given their potential exposure to unknown claims.

To be sure, there are steps that can be taken to increase the likelihood that a sale order protecting a purchaser from successor liability will be upheld, including ensuring that actual or mail notice is given to all identified and identifiable claimants, publishing notice of the sale in appropriate publications, crafting the sale order carefully to cover or at least take into consideration all imaginable claims that are intended to be barred by the order, marketing the assets to demonstrate that a fair price is being paid by the purchaser, and setting up a trust with a portion of the sales proceeds to address unknown claims. Ultimately, although many types of successor liability claims can be cut off by an appropriately worded sale order where adequate notice under the circumstances has been deemed to have been given, there are still circumstances where a court will not enforce the bar on successor liability claims against a particularly sympathetic claimant. It is still a case of buyer beware.