Buyers Beware

Purchasing Assets of a Bankrupt Product Manufacturer “free and clear” DOES NOT always mean “free and clear” from successor products liability.

May 2012 By Beth Schneider Nayor and Paige Ellerman
Products Liability | Legal Briefs

If you are one of the lucky product manufacturers who weathered the recent economic downturn well and are looking to buy assets from those who did not survive…beware!

Section 363(f) of the U.S. Bankruptcy Code permits the sale of property of a bankrupt estate “free and clear.” A bankruptcy sale order “is a judgment that is good as against the world, not merely as against parties to the proceeding.”1 Indeed, the Section 363(f) “free and clear” transfer is a crucial inducement in attracting purchasers and obtaining the maximum sale price for the assets. A priority of the Bankruptcy Code is maximizing the value of the assets to generate money that will in turn be distributed to the creditors of the bankrupt estate. The law is relatively settled that creditors, including products liability claimants, whose claims accrued before or during the bankruptcy proceeding and who had the opportunity to participate in the bankruptcy case are bound by a bankruptcy sale order and cannot pursue the purchaser of the bankrupt assets. It is substantially less clear, however, with regard to future claimants whose claims do not arise until after confirmation of the plan and Section 363 (f) transfer of assets. 

For example, under state successor liability laws, a plaintiff injured after the bankruptcy by an allegedly defective product manufactured and sold by the bankrupt predecessor may still have a valid cause of action against the purchasing entity.  Saddling the purchaser of the bankrupt assets with the potential for significant liability and risk associated with products manufactured by the bankrupt predecessor runs contrary to the core aim of the Bankruptcy Code. Pursuant to the Bankruptcy Code’s priority scheme, a products liability claimant who is aware of his or her claim at the time of the bankruptcy will have a low-priority unsecured status. As such, some courts have held that a future claimant should not be put in a better position by allowing a cause of action against the purchaser of the bankrupt assets. “To allow [a plaintiff] to assert successor liability claims against [the purchaser of bankrupt assets] while limiting other creditors’ recourse to the proceeds of the asset sale would be inconsistent with the Bankruptcy Code’s priority scheme.”2   

The importance of the “free and clear” transfer to the purchaser is evident in most Section 363(f) sale orders which contain express language negating many factors in determining state successor liability (e.g. the purchaser “is not a mere continuation of the debtor,” or “does not constitute a successor to the debtor.”)  Yet, courts have routinely performed legal back flips to avoid enforcing the express language of Section 363(f) “free and clear” transfers. 

The two most often cited reasons for refusing to protect a Section 363(f) purchaser from successor products liability claims are due process concerns and the product line continuation exception. In states that recognize that the purchaser of assets is a successor if it continues the same product line, courts are likely to impose liability against a Section 363(f) purchaser. The New Jersey Superior Court held that a Section 363(f) sale order did not preclude successor liability because the court believed that a purchaser of assets should not be allowed to enjoy the benefits of long-standing customers without also incurring the liabilities that result from such relationships.3   

The second and more difficult challenge to Section 363(f) sale orders has been framed as a due process issue by several federal courts. These courts have held that depriving future claimants (individuals injured post-bankruptcy with a pre-bankruptcy manufactured and sold product) of their day in court is a violation of due process.4  Accordingly, due process requires that claimants, who had not yet discovered the injury or had not been injured as of the date of the Section 363(f) sale, are entitled to pursue their claims.5   

This unsettled conflict, which pits the authority of U.S. Bankruptcy Courts to sell bankrupt assets “free and clear” pursuant to the U.S. Bankruptcy Code6  against state law successor liability and due process concerns, is a roulette wheel for a prospective purchaser of assets of a bankrupt product manufacturer. Even a well-crafted Section 363(f) sale order that expressly negates all factors relating to state successor liability laws is not a sure bet against the future claimants pursuing the purchaser of the bankrupt assets. The court presiding over the Chrysler bankruptcy teed up this precise issue, but unfortunately declined to reach a decision.7 After unequivocally upholding the broad authority given to the U.S. Bankruptcy Courts under Section 363(f), the Chrysler court declined to definitively rule on the validity of a Section 363(f) sale order which expressly extinguished future claims. 

“[This Court] decline[s] to delineate the scope of the bankruptcy court’s authority to extinguish future claims, until such time as we are presented with an actual claim for an injury that is caused by Old Chrysler, that occurs after the sale, and that is cognizable under state successor liability law.” 8

So stay tuned, but in the meantime: buyers beware!

1 Regions Bank v. T.R. Oil Co., LLC, 387 F.3d 721, 732 (8th Cir. 2004).

2 In re Trans World Airlines, Inc., 322 F.3d 283, 292 (3d Cir. 2003).

3 Lefever v. K.P. Hovnanian Enterprises, Inc., 160 NJ 307 (NJ 1999); see also Wilkerson v. C.O. Porter Machinery Co., 237 NJ Super 282 (NJ 1989).

4 Zerand-Bernal Group Inc. v. Cox, 23 F.3d 159 (7th Cir. 1994). 

5 In re Grumman Olson Industries, Inc., 445 B.R. 243, 254 (S.D.N.Y. 2011).  (A person injured post-sale by a defective product manufactured and sold prior to the bankruptcy does not hold a claim in the bankruptcy and is not affected by the Section 363(f) sale order.)

6 Since theChrysler decision, the court overseeing the General Motors bankruptcy weighed in stating that the Second Circuit has “affirmed the proposition that section 363(f) authorizes the sale of assets ‘free and clear’ of successor tort liability.”  In re Motors Liquidation Co., 428 B.R. 43, 58-59 (S.D.N.Y. 2010); see also, Douglas v. Stamco, 2010 WL 337043 (2d Cir. Feb. 1, 2010). 

7 In re Chrysler LLC, 576 F.3d 108, 127 (2d Cir. 2009).

8 Id.