In the past 20 years, Bankruptcy Code Section
Buyers, however, should not confuse the advantages of a Section 363(b) sale with an assurance of risk-free investment, especially when applicable state law could impose successor liability on an asset buyer under “product line” or other similar theories. Although bankruptcy courts have broad statutory power to reduce the risk of such liability, the courts’ ability to eliminate claims can be overestimated.
The U. S. Bankruptcy Court for the Southern District of New York provided an important reminder of this point in the recent case of In re Grumman Olson Industries, Inc.
This article will use the Grumman decision as an opportunity to explore the boundaries of a bankruptcy court’s power under Section 363 to insulate an asset buyer from successor liability with respect to harm that has not occurred until after entry of the sale order. We also examine the practical lessons of Grumman, and discuss how practitioners might better anticipate, evaluate, and mitigate the threat of successor liability in the Section 363 sale context.
Successor Liability in Non-Bankruptcy Asset Deals
Generally, under state law, liabilities of the seller do not become the purchaser’s in an asset sale, except to the extent that the purchaser explicitly assumes such liabilities. In situations where a corporation sells all its assets and liquidates promptly after the closing, this general rule can work a harsh result because persons harmed by the pre-sale activities of the seller no longer have an existing entity from which they can recover damages. Therefore, courts have, on a case-by-case basis, developed certain exceptions to the general rule, including the doctrines of (i) fraudulent transaction, (ii) de facto merger, (iii) mere continuation, and (iv) product line continuation.
Under the fraudulent transaction doctrine, courts have imposed successor liability on asset purchasers when the court determines that the transaction was essentially a sham, effected to enable the seller to escape liabilities. Courts have typically analyzed the transaction “for certain ‘badges of fraud’ which might include: (1) a close relationship among the parties to the transaction; (2) a secret and hasty transfer not in the usual course of business; (3) inadequacy of consideration; (4) the transferor’s knowledge of the creditor’s claim and the transferor’s inability to pay it; (5) the use of dummies or fictitious parties; and (6) retention of control of the property by the transferor after the conveyance.”
In applying the de facto merger doctrine, courts have held purchasers liable where parties to an M&A transaction have structured it nominally as an asset sale, but effected a deal that more closely resembles a merger. Courts adhering to this theory have held that the substance of a business combination transaction should outweigh the form in determining whether purchasers remain liable for the liabilities of their sellers. The application of the doctrine has varied widely, and determinations have been fact-specific. In making such a determination, courts have generally looked at four central factors: (i) the continuity of the enterprise, (ii) the continuity of ownership, (iii) the dissolution of the transferor, and (iv) an assumption by the buyer of the obligations and liabilities necessary for the continuation of the ordinary business operations associated with the assets.
Under the mere continuation doctrine, an asset purchaser may become liable for the seller’s liabilities if there are substantial similarities in the ownership and control of the business before and after the asset transfer. In applying this doctrine, courts have focused on certain objective continuities, including whether the buyer retains the seller’s (i) name, (ii) location, (iii) employee base, (iv) services or products, and (v) management structure.
http://www.abiworld.org/committees/newsletters/assetsales/vol5num3/TakingSuccess.pdf.
The product-line continuation exception is a controversial extension of the de facto merger and mere continuation doctrines that has been adopted in a minority of states. Established in the 1977 decision, Ray v. Alad Corporation,
• the buyer should be liable if the transaction caused the seller’s existence to cease and in doing so destroyed a plaintiff’s remedies against the seller;
• the buyer should be liable because it has a greater ability to absorb the risk of harm for the defective products than does the injured party; and
• the buyer should be liable because in continuing the product line with minimal alteration, the buyer benefits from the goodwill accumulated by the seller.
http://www.milesstockbridge.com/pdfuploads/607_EffectOfProductLineSuccessorLiabilityException1.pdf
In bankruptcy proceedings, however, policies that arguably support successor liability collide with the objectives of maximizing recoveries to stakeholders (who themselves have been harmed by the debtor’s financial failure) and ensuring that recoveries are paid in accordance with the absolute priority rule.
‘Free and Clear’ Sales Under Section 363(f)
Section 363 of the Bankruptcy Code provides an M&A technique that can reduce successor liability risks to purchasers in asset sales. Under Section 363(b), the “trustee, after notice and a hearing, may use, sell, or lease, other than in the ordinary course of business, property of the estate.”
The power of the free-and-clear doctrine, and the definition of its limits, rests on the definition of the term “interest” as it is used in Section 363(f). The proper definition has been, and continues to be, the subject of significant debate among courts, academics and practitioners. While the legal community remains divided on the issue, an initial inclination toward a narrow definition has generally given way to a broader interpretation.
Under the narrow view, Section 363(f) provides only in rem relief, extinguishing claims against the transferred property itself, and not against the purchaser.
Courts taking a broader view, however, have interpreted Section 363(f) to authorize the bankruptcy court not only to provide in rem relief but also to grant in personam protection similar to that of post-confirmation relief under Bankruptcy Code §1141(c),
In providing such relief, Section 363(f) promotes two interrelated objectives central to the bankruptcy process. First, as the U.S. Court of Appeals for the Second Circuit noted in Douglas v.
Stamco, the “chilling effect of allowing a tort claim subsequent to the sale would run counter to a core aim of the Bankruptcy Code, which is to maximize the value of the assets and thereby maximize potential recovery to the creditors.”
Bankruptcy courts have used this broad statutory power to extinguish myriad claims that may have otherwise survived under state law theories of successor liability. For example the U.S. Court of Appeals for the Third Circuit set aside employment-related successor liability claims following the Section 363(b) sale of the assets of Trans World Airlines, agreeing with TWA and purchaser American Airlines that “while Congress did not expressly define ‘interest in property,’ the phrase should be broadly read to authorize a bankruptcy court to bar any interest that could potentially travel with the property being sold, even if the asserted interest is unsecured.”
Similarly, the U.S. Court of Appeals for the Second Circuit affirmed a bankruptcy court’s power to extinguish claims in the Section 363(b) sale of Chrysler’s assets, barring both environmental and existing product liability claims.
The Problem of the Unknowable Claim
Prior to the Grumman decision, courts had struggled with the analogous problem of debtors that had reorganized under Chapter 11, only to face subsequent tort claims brought by victims of defective products produced by the debtor before the filing of a bankruptcy petition. Such claims fall into two general categories. The first consists of claims by plaintiffs who were injured by a harmful product prior to filing of a bankruptcy petition, but whose symptoms did not manifest themselves until after the debtor emerged from Chapter 11. The classic example is asbestos, where exposure to the product (and the initial cellular injury) may occur years prior to the manifestation of symptoms. The second category consists of claims by victims who are first injured by a defective product that was manufactured by the seller only after the reorganized seller emerges from bankruptcy.
While the case law remains somewhat unsettled, courts have been more willing to bar post-confirmation claims in the first category. In such cases, the claim is viewed as having arisen at the time of exposure to the harmful product, i.e. pre-petition. As the court in Grumman explained: <-long-quote>-long-quote>
Although the claimants, particularly in asbestos cases, may not be identifiable during the bankruptcy case or aware of the pre-petition exposure to the debtor’s product or the fact of their injury, courts have dealt with due process concerns caused by the discharge of their claims through the appointment of a future claims representative to protect their interests and the creation of a trust to pay their claims.
The second category of successor liability claims arises from products that do not cause harm upon exposure, but the use of which nonetheless creates a high likelihood of future injury. In these scenarios the identity of future claimants is unknown at the time that the debtor emerges from bankruptcy, because injury has not yet occurred. The U.S. Court of Appeals for the Second Circuit, analyzing successor environmental liabilities in In r
e Chate
aug
ay Corporation, described the more general problem as follows: <-long-quote>-long-quote>
Consider, for example, a company that builds bridges around the world. It can estimate that of 10,000 bridges it builds, one will fail, causing 10 deaths. Having built 10,000 bridges, it becomes insolvent and files a petition in bankruptcy. Is there a “claim” on behalf of the 10 people who will be killed when they drive across the one bridge that will fail someday in the future? If the only test is whether the ultimate right to payment will arise out of the debtor’s pre-petition conduct, the future victims have a “claim.” Yet it must be obvious that enormous practical and perhaps constitutional problems would arise from recognition of such a claim. The potential victims are not only unidentified, but there is no way to identify them. Sheer fortuity will determine who will be on that one bridge when it crashes. What notice is to be given to these potential “claimants”?
In the process of grappling with the difficulties posed by what has become known as the “Chateaugay hypothetical,” courts have developed several related tests to determine whether a potential future claim has risen to the level of a “claim” under the Bankruptcy Code. In Chateaugay, the court applied a “fair contemplation” test to the environmental claims at issue in order “to distinguish between contingent or unmatured claims, which are claims within the meaning of [the Bankruptcy Code], and potential future tort claims, which are not. Under that test, a contingent or unmatured obligation is a claim if the occurrence of the contingency or future event that would trigger liability was within the actual or presumed contemplation of the parties at the time the original relationship between the parties was created.”
Three years after the Chateaugay decision, the U.S. Bankruptcy Court for the Southern District of Florida, considering the case of In re Piper Aircraft, in which Piper Aircraft sought relief from successor liability after the confirmation of its plan of reorganization, acknowledged it was facing a direct test of the Chateaugay hypothetical: <-long-quote>-long-quote>
The problem posed by [the Chateaugay] hypothetical has become reality here. We know that some planes in the existing fleet of Piper aircraft will crash, and we know that there may be injuries, deaths and property damage as a result. We also know that under theories of negligence and products liability, Piper, if it remains in existence, would be liable for some of these damages. Even so, there is no way to identify who the victims will be or to identify any particular prepetition contact, exposure, impact, privity or other relationship between Piper and these potential claimants that will give rise to these future damages.
In response, affirming the decision of the bankruptcy court, the U.S. Court of Appeals for the Eleventh Circuit established a two-pronged, hybrid test: <-long-quote>-long-quote>
[A]n individual has a…claim against a debtor manufacturer if (i) events occurring before confirmation create a relationship, such as contact, exposure, impact, or privity, between the claimant and the debtor’s product; and (ii) the basis for liability is the debtor’s prepetition conduct in designing, manufacturing and selling the allegedly defective or dangerous product. The debtor’s prepetition conduct gives rise to a claim to be administered in a case only if there is a relationship established before confirmation between an identifiable claimant or group of claimants and that prepetition conduct.
By introducing a pre-petition conduct element to the fair contemplation test, Piper provides an effective filter to separate out the truly unknowable claim. Under the Piper test, an individual injured after the debtor emerges from bankruptcy, by products manufactured before emergence and who had no pre-petition relationship with the debtor does not hold a “claim” under the Bankruptcy Code. It is the holders of this class of unknowable future claimants that the court in Piper, and subsequently Grumman, sought to protect.
The Grumman Case
Grumman extended the application of the Piper test to the Section 363(b) asset sale context. The claim at issue in Grumman arose in 2009, when Denise Frederico struck a telephone pole in a Federal Express truck, leaving her with serious injuries. Frederico claimed that defects in the body of the truck caused the crash. The truck body was manufactured by Grumman in 1994, eight years before Grumman filed a Chapter 11 petition in the U.S. Bankruptcy Court for the Southern District of New York. In 2003, seven months after Grumman filed its petition, the court entered a sale order approving the Section 363(b) sale of certain of Grumman’s “Lot 2” assets, including the truck-body product line which, six years later, would allegedly lead to Frederico’s accident. The sale order included a broad release of Morgan Olson, the purchaser of the Lot 2 assets, from in personam successor liability: <-long-quote>-long-quote>
[T]he Purchaser shall have no liability or responsibility for any liability or other obligation of the Debtor arising under or related to the Lot 2 Assets other than for the purchase price payable under the Lot 2 APA. Without limiting the effect of the foregoing, the transfer of the Lot 2 Assets … will not subject the Purchaser to any liability for claims against the Debtor or the Lot 2 Assets, including, but not limited to, claims for successor or vicarious liability, by reason of such transfer under the laws of the United States, any state, territory or possession thereof or the District of Columbia applicable to such transactions. The Purchaser shall not be deemed, as a result of the consummation of the transaction contemplated by the Lot 2 APA to: (a) be the successor of the Debtor; (b) have, de facto or otherwise, merged with or into the Debtor; (c) be a mere continuation or substantial continuation of the Debtor or the enterprise of the Debtor; or (d) be responsible for any liability of the Debtor or for payment of any benefit accruing to the Debtor, except as specifically provided for in the Lot 2 APA.
The sale order language was drafted specifically to address theories of successor liability extant under state law. When Frederico brought suit against Morgan Olson in New Jersey in 2009 under a product-line continuation theory, Morgan Olson moved to re-open the case in bankruptcy court, arguing for summary judgment based on the release provided in the sale order.
Frederico’s claim in Grumman epitomizes the due process and practical risks identified by the U.S. Court of Appeals for the Second Circuit in Chateguay. The sale order purported to bar recourse for a class of future claimants, the identity of whom was unknown at the time of the sale order but whose identity would later emerge as defects in the products sold by Grumman years before its bankruptcy caused injury. The court, applying the Piper test, found that while the sale order extinguished all existing claims at the time of the sale, it could not extinguish the claim of Denise Frederico, who had no prepetition contact with Grumman and who could not have known at the time of the sale that she might some day in the future be injured in an accident involving a product manufactured by Grumman.
The Grumman court placed no weight on the language of the sale order entered by the bankruptcy court in Chrysler, instead aligning with cases in the Piper line that have held “for reasons of practicality or due process, or both…[that] a person injured after the sale…by a defective product manufactured and sold prior to the bankruptcy does not hold a claim in the bankruptcy case and is not affected by the §363(f) sale order or the discharge order under
Given that the Fredericos neither held a claim at the time of the sale, nor received notice of such sale, the court held that its 2003 sale order could not bar the Frederico’s 2009 claim. The court declined to decide the merits of the Frederico’s underlying claims under any state law theory of successor liability, remitting determination of that question to the New Jersey trial court.
Lessons of Grumman
Grumman is a reminder that potential purchasers in a Section 363(b) asset sale must do their best to anticipate, evaluate, and mitigate the threat of successor liability regardless of the breadth of release language that they are able to obtain from the bankruptcy court in the sale order.
Anticipation and Evaluation
Grumman first and foremost highlights the necessity of meticulous legal and business due diligence in Section 363(b) sales. In our experience, over-eager purchasers often think that they are safe in focusing only on the adequacy of the assets for which they are bidding in Section 363(b) sales, giving short shrift to liability concerns because of a misunderstanding of the effect of the sale order on potential successor liability. While the timeline for such diligence is sometimes compressed, failure to assess adequately the potential for future tort claims carries significant risk.
Proper diligence in such sales should include a survey of the states in which the target assets operate and an initial evaluation of the state-law successor liability theories in those states, under which future claimants may bring suit.
• A detailed litigation profile of the target assets or products to evaluate (i) which assets or products have generated claims in the past, (ii) whether such claims have been successful, (iii) the magnitude of defense costs, and (iii) the magnitude of settlements and judgments has the seller has paid regarding the assets.
• A litigation profile of the industry in which the assets or products are used to evaluate the frequency and exposure associated with claims against similar and related assets or products.
• Engagement of actuarial experts to determine the statistical likelihood of future claims and related monetary exposure.
http://www.foley.com/files/tbl_s31Publications/FileUpload137/5648/Chapter11_WP.pdf.
Mitigation
Once diligence is complete and the risk of future tort claims analyzed, buyers might take one of two approaches to the problem. The first and much more traditional approach is to monetize the risk and adjust the price that one is willing to bid accordingly.
A second, potential approach has been suggested by some commentators
Conclusion
Section 363(b) asset sales, while providing significant advantages in risk reduction for buyers, cannot wholly eliminate the threat of future claims. However, by combining a sale order drafted as broadly as the case law will bear with careful diligence and well-crafted mitigation measures, counsel for buyers can assist their clients in obtaining the maximum protection from this increasingly popular M&A technique.
