Cleansing Bankruptcy Acquisitions of Successor Liability:
Part 3

(TMA International Headquarters)

This is the third of a three-part series on the problem of successor liability in buying businesses and assets out of bankruptcy. Last month’s article discussed the successor liability problem in the context of “free and clear” sales under section 363 of the Bankruptcy Code. This article focuses on how the successor liability problem is dealt with in sales under confirmed Chapter 11 plans.
____________________________________________________________

While sales of assets under confirmed Chapter 11 plans are by no means “bulletproof,” they often stand a better chance of precluding successor liability claims than “free and clear” sales under section 363 of the Bankruptcy Code. This reflects a judicial recognition that reorganizations under Chapter 11 should offer more comprehensive relief. As such, more narrow non-bankruptcy law rights such as successor liability must yield the broader goals of complete financial rehabilitation. At least, that’s how it’s supposed to work.

A “Claim” Is a “Claim”

As previously discussed, acquisitions of assets out of business bankruptcy cases are generally made either as sales out of the ordinary course of business under section 363 of the Bankruptcy Code or under a confirmed Chapter 11 plan of reorganization (or liquidation). One problem with “free and clear” sales under section 363 of the Bankruptcy Code is the “claim” vs. “interest” distinction. Some courts have held that section 363 only permits sales which are “free and clear” of “interests” in property (liens, mortgages, judgments, etc.), but not of “claims” for successor liability. This limitation does not, however, appear in the sections of the Bankruptcy Code that authorize asset sales under a confirmed Chapter 11 plan.

Section 1123(a)(5)(D) of the Bankruptcy Code authorizes sales of assets “free and clear,” notwithstanding any otherwise applicable non-bankruptcy law. More importantly, section 1141(c) of the Bankruptcy Code provides that property sold under a plan is “... free and clear of all claims and interests of creditors...” (emphasis added). Read together, these sections provide the statutory basis for precluding subsequent assertions of claims based on successor liability. Moreover, if there was any doubt that such successor liability claims are “claims” for purposes of section 1141(c), the term “claim” has been interpreted broadly enough to encompass any types of pre-petition liability, whether contingent, non-contingent, liquidated or unliquidated. Thus, expansively defined “claims” referred to in section 1141(c) would almost certainly include those types of successor liability claims which are traditionally asserted against asset buyers under state law.

Because of this language, some courts have been willing to close the gap left by the “claim” vs. “interest” distinction in order to give more comprehensive and preclusive effect to confirmed Chapter 11 plans. This is especially so because the formal requirements of the Chapter 11 plan confirmation process offer creditors a higher level of procedural and substantive safeguards. This, in turn, provides claimants with a more meaningful opportunity to participate in the process that might result in cutting off their future rights. As such, asset buyers stand a better chance of precluding successor liability by effecting the transaction through a confirmed Chapter 11 plan.

More on Federal Pre-emption

For sales under section 363 of the Bankruptcy Code, some courts are unwilling to hold that federal bankruptcy law pre-empts successor liability claims arising under state law. There is a much stronger policy reason for precluding successor liability claims for sales under confirmed Chapter 11 plans. Where the imposition of state successor liability laws creates an actual conflict with federal law, the Supremacy Clause of the United States Constitution provides the basis for preclusion of such state law-based successor liability claims. Courts that have upheld federal pre-emption have identified the broad “free and clear of claims and interests” language of section 1141(c) of the Bankruptcy Code as the source of the conflict between state and federal law.

Pre-emption of state successor liability laws has been supported by findings that they frustrate the full purpose of federal bankruptcy law. This occurs by, among other things, chilling the prices for sales of assets out of the bankruptcy estate, creating unequal distributions among similarly situated creditors and selectively benefiting certain types of claimants in violation of the federal statutory priority scheme. As with other aspects of the successor liability debate, however, this view is not universal and not all courts have agreed that federal pre-emption is justified. State courts, in particular, have been more willing to reject federal pre-emption by focusing on different federal bankruptcy law policies which are not necessarily frustrated by the subsequent imposition of state law successor liability claims.

Limits of Plan Injunctions

Carefully drafted plans include injunctions enjoining the assertion of successor liability claims against asset buyers after the sale has been consummated. This can be a powerful tool in precluding subsequent successor liability claims, if for nothing else more than the chilling effect it may have on potential future lawsuits. Unfortunately, these types of injunctions are not always effective as written, especially if they purport to bind claims that did not arise during and could not have been discharged in, the bankruptcy case. Courts are generally unwilling to enforce such post-confirmation injunctions against certain types of product liability claims or other so-called “future claims” where the injury occurred post-confirmation even though the product was manufactured, or conduct giving rise to the claim occurred, pre-confirmation.

The problem is rooted in the fact that the claimant may not know it holds a claim at the time the bankruptcy case is pending. Here again, courts are faced with the nettlesome question of when is a “claim” a “claim” for bankruptcy purposes. In cases where unknown future claimants are likely to be significant (in terms of sheer numbers of claimants and/or aggregate dollar amounts of claims), the preclusion of successor liability is more likely to be enforced where the confirmation process includes a court-appointed legal representative for the future claimants who participate in the bankruptcy case and where the plan provides a means for future claimants to effectively share in distributions when such claims eventually arise (a post-confirmation trust fund dedicated to payment of future claims). There is little formal guidance on how to do this right; rather, most reported cases chronicle how it was done wrong. Only for asbestos-related bankruptcy cases, however, is there an express statutory prescription (section 524(g) of the Bankruptcy Code) for precluding successor liability.

A Solution?

Regrettably, there is no uniformity in judicial thinking on the issue of successor liability as courts continue to strain to reach results in individual cases. This is often the case when courts must struggle to reconcile competing policies of maximizing values for the benefit of creditors by free transferability of assets in bankruptcy against the rights of certain types of injured creditors to alternative remedies. As a result, uncertainty for asset buyers continues in the face of conflicting decisions both at the federal circuit court and state supreme court levels. It does not appear, however, that a solution is anywhere near.

The reconciliation of the competing policies must come from either the United States Supreme Court or from Congress. Only the Supreme Court can clarify the constitutional question of whether the ability to transfer assets “free and clear” under federal bankruptcy law pre-empts otherwise applicable state law rights to enforce successor liability against asset buyers as an alternative remedy. Alternatively, only Congress can effect a legislative clarification that, in all instances, “free and clear” means what it appears to say.

(Editor’s note: The author was unsuccessful in urging the National Bankruptcy Review Commission to recommend a comprehensive legislative solution to the successor liability problem in its Report to Congress in October 1997, although the Commission did make certain helpful recommendations about dealing with the problem of future claims. None of this, however, found its way into the bankruptcy legislation that came close to being enacted in late 1998.)

Until the successor liability problem is resolved in a comprehensive manner, the lingering uncertainty will likely continue to generate litigation both in and out of bankruptcy as both creditors and asset buyers each try to stick each other with someone else’s unpaid bills.