Not So Fast – 363 Sales May Not Be Free and Clear of Future Claims

In recent years, section 363 sales have increased in prominence.  According to the UCLA-LoPucki Bankruptcy Research Database, less than 4 percent of all large, public company bankruptcies were resolved by sales of all or substantially all of a debtor’s assets from 1990-2000.  However, in the period from 2001-2010, that figure rose to nearly 20 percent – peaking in 2008 when 32 percent of large public cases were resolved by an asset sale.[i]  Purchasers like section 363 sales because, among other reasons, they purchase assets “free and clear” of all pre-bankruptcy obligations under section 363(f) of the Bankruptcy Code.  However, as 363 sales increased in frequency, courts have begun to limit the free and clear nature of those sales, particularly with respect to future claims that had not arisen at the time of the sale.

In considering the section 363 sale at issue in Chrysler, the Second Circuit declined to address the question of whether the sale order could be enforced against “claimants who, although presently unknown and unidentified, might have claims in the future arising from Old Chrysler’s production of vehicles.”  In re Chrysler LLC, 576 F.3d 108, 123 (2d Cir. 2009).  Similarly, in the General Motors sale, Judge Robert E. Gerber approved the sale free and clear of future claims “to the fullest extent constitutionally permissible” after having previously expressed concerns about whether future claimants could receive due process.  In re General Motors Corp., 407 B.R. 463, 507 (Bankr. S.D.N.Y. 2009).  Neither court directly addressed whether the sale could actually be made free and clear of those future claims, instead deferring the issue for another day.

In In re Grumman Olson Industries Inc., the U.S. District Court for the Southern District of New York addressed the issue directly, holding that a party was not barred from asserting successor liability claims against the purchaser of assets in a 363 sale, where the claims at issue arose after the conclusion of a bankruptcy case and a basis for successor liability was available under state law.  In re Grumman Olson Industries Inc., 2012 WL 1038672 (S.D.N.Y. Mar. 29, 2012).  While the Southern District’s holding in Grumman explicitly declined to enforce a sale order against a future claimant that lacked notice of and was not afforded the opportunity to participant in a prior bankruptcy proceeding, the court limited its holding to the facts at issue in Grumman and declined to answer the broader question of whether and under what circumstances a debtor could transfer assets under section 363 free and clear of future claims.

Background

Morgan Olson L.L.C. is engaged in the manufacture of products for the truck body industry.  Morgan’s predecessor in interest purchased certain assets of Grumman Olson Industries, Inc., which filed for bankruptcy in December 2002, pursuant to a section 363 sale.  The order approving the sale was entered in July 2003 and the bankruptcy cases were ultimately closed in December 2006.  Following the sale, Morgan continued to manufacture and market the Grumman product line.

In October 2008, Denise Frederico and her husband were injured while driving a defective truck that was manufactured and designed by Grumman in 1994.  A year later, the Fredericos filed a complaint in New Jersey Superior Court, which alleged successor liability claims against Morgan.  In asserting such claims, the Fredericos cited the “product line” exception, which the New Jersey Supreme Court had previously recognized as “an exception to the general rule against successor liability.”  Id. at 4.  As noted by the Court in Grumman, “[u]nder this exception, ‘by purchasing a substantial part of [a] manufacturer’s assets and continuing to market goods in the same product line,’ the purchasing company can be held liable as a successor for defects in the predecessor’s products.”  Id. at 4.  The New Jersey Supreme Court has also held that the product-line exception applies even where the purchaser obtained the assets through a bankruptcy sale that purported to transfer such assets free and clear of claims and interests.  Id. at 4.

Morgan subsequently brought an adversary proceeding in the U.S. Bankruptcy Court for the Southern District of New York, which argued that the sale order should bar Frederico’ state court action.  The Bankruptcy Court granted Frederico’s motion for summary judgment  and dismissed the adversary proceeding.  Morgan appealed to the District Court.

Due Process For Future Claimants

Section 363(f) of the Bankruptcy Code allows a debtor to sell estate property “free and clear of any interest in such property” if the sale satisfies one of five conditions.  The Fredericos argued that the purchaser should have been liabile on its claim post bankruptcy because they had no due process – in light of the fact that their injuries arose long after the sale closed.  Judge Oetken agreed and held “[T]he Fredericos did not receive adequate notice of their potential claim in the Grumman bankruptcy proceedings because, at the time of the bankruptcy, there was no way for anyone to know that the Fredericos ever would have a claim.  Enforcing the Sale Order against the Fredericos to take away their right to seek redress under a state law theory of successor liability when they did not have notice or an opportunity to participate in the proceedings that resulted in that order would deprive them of due process.”

In so holding, the Court acknowledged that if sale orders cannot bar successor liability claims, notwithstanding the “free and clear” provisions that have become boilerplate in most sale orders, the consideration offered for assets in a 363 sale will be depressed by the uncertainty related to the likelihood and size of potential future claims.  However, the Court reasoned that “to whatever extent maximizing the value of the estate is an important policy of the Bankruptcy Code, it is no more fundamental than giving claimants proper notice and opportunity to be heard before their rights are affected, to say nothing of constitutional requirements of due process.”

Future Claims Representatives

In evaluating whether sufficient due process was afforded to the Fredericos during the Grumman bankruptcy, the Court noted that some bankruptcy courts deal with future claims by appointing a future claims representative and creating trusts funded to facilitate distributions to future claimants.  However, the Court noted the obvious differences between mass tort cases, like those involving asbestos or medical implants, where a discernible class of claimants has already been exposed to a product and future injuries are inevitable, with situations similar to Grumman or the bridge hypothetical, where the existence and identity of future claimants is unknown during the pendency of the bankruptcy cases.  The Grumman Court noted that bankruptcy courts have often rejected efforts by future claims representatives to set up trusts in the latter situation, finding that the pre-confirmation nexus between the future claimant and the debtor was insufficient to have such future claims adjudicated in a bankruptcy case. The Court in Grumman also explicitly stated that it did not have a view as to whether the appointment of a future claims representative would have been appropriate or permissible in Grumman, but cited the absence of a future claims representative or other “provisions made for unrepresented future claimants” as further evidence that “the Fredericos (and other future claimants in their position) were not afforded either the notice and opportunity to participate in the proceedings or representation in the proceedings that due process would require in order for them to be bound by the Bankruptcy Court’s orders.”

Conclusion

Judge Oetken limits his holding to the facts at issue in Grunman (no way for the Fredericos to have notice of the bankruptcy, no process for future claimants to seek rederess, and a specific state law creating potential successor liability).  However, his decision makes clear that, at least in the Southern District of New York, sales under section 363 may not be truly free and clear of all claims.

In tying its holding to the facts at issue in Grumman, the Court declined to address the larger question of “whether or not there may be circumstances under which a Section 363 sale order could extinguish the claims of future claimants who, because they were not injured before the close of the bankruptcy, had no way to receive notice of the bankruptcy proceedings.”  Additionally, the Court offered little clarity on whether use of a future claims representative can resolve the due process concerns successfully advanced by the Fredericos.

The decision clearly suggests that despite the plain language of section 363(f), sales in the Southern District of New York do necessarily transfer assets free and clear of all future claims.  Read in conjunction with Judge Stein’s recent decision in Hispanic Independent Television Sales LLC v. Kaza Azteca America Inc., 10 Civ. 932 (SHS), 2012 U.S. Dist. LEXIS 46239 (S.D.N.Y. Mar. 30, 2012), where the court found that a claimant’s affirmative defense of recoupment was not extinguished by operation of section 363(f), courts in the Southern District are beginning to articulate limitations on section 363(f) that all parties in interest should consider before proceeding with a section 363 sale.



[i] ] UCLA-LoPucki Bankruptcy Research Database, 363 Sales of All or Substantially All Assets in Large, Public Bankruptcies, as a Percentage of all Cases Dispited, by Year of Case Disposition, available at http://lopucki.law.ucla.edu/tables_and_graphs/363_sale_percentage_graph_4-6-2011.pdf

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