December 20, 2016

Buying Assets in Bankruptcy: Has the Second Circuit Taken the Wind Out of Sales Free and Clear?

Jeanne P. Darcey

Introduction

A bankruptcy filing often signals a stark reality for a faltering business: profits fell woefully short of projections, once-hopeful business strategies failed, and a complete shut down potentially is imminent. However, a chapter 11 proceeding can also lead to opportunity: a business may seek to rid itself of unneeded business lines or assets—or sell itself entirely—to bring in cash for its creditors, or on the buy-side, a purchaser may seek to make a lucrative and perhaps pennies-on-the-dollar acquisition without assuming the liabilities of the seller. A key aspect of any bankruptcy sale transaction is the ability for the purchaser to acquire a business, or specific assets, “free and clear” of the problems (and liabilities) of the debtor-seller. The boundaries of free and clear have been fluid and expansive; however, the Second Circuit’s recent decision in Celestine Elliott, et al. v. General Motors LLC (In re Motors Liquidation Co.), 829 F.3d 135 (2d Cir. 2016), establishes that the protections afforded by a free-and-clear sale order certainly are not limitless.

Statutory Framework

Section 363 of the Bankruptcy Code

The Bankruptcy Code provides a debtor with several avenues for disposing unneeded or burdensome assets, the cornerstone of which is section 363. This section permits a debtor to sell its assets outside of the ordinary course of business free and clear of all liens, claims, encumbrances, or other interests of other parties, so long as certain conditions set forth in section 363(f) are satisfied. Bankruptcy practitioners tout the use of section 363 and generally agree that an acquisition through a bankruptcy sale can provide a purchaser with the “cleanest” title possible. Why so good? A bankruptcy sale will allow a purchaser to buy assets (or an entire business for that matter) and leave any and all liens, claims, encumbrances, and other liabilities to be resolved as part of the bankruptcy case.

Through the use of section 363, a debtor may file a sale motion at any time and establish sale procedures intended to maximize value for the estate. In addition, local bankruptcy rules generally will require that other interested parties be given the opportunity to make a counteroffer, in which case the process will include some type of open or sealed-bid auction to determine the highest and best offer for the assets. Further, the bankruptcy court often will sanction bid protections in the form of overbid and incremental bidding levels, as well as reimbursement for expenses payable to the initial “stalking-horse” bidder if it is not ultimately the successful buyer at the auction.

Plan Sales

The principal goal of any chapter 11 case is to confirm a plan of reorganization that provides acceptable recoveries to creditors. Section 1129(a) sets forth specifically enumerated requirements that must be satisfied for plan confirmation to occur, including that the plan be accepted by each “impaired” class of creditors. Acceptance is articulated in section 1126(c), which provides that a class of claims has accepted a plan if at least two-thirds in dollar amount and more than a majority in number of claims in such class have voted in favor of the plan.

Although labeled the “reorganization” chapter of the Bankruptcy Code, and traditionally used by businesses to restructure their burdensome debt loads and emerge as financially stronger going-concern businesses, a plan may seek to implement a sale of all or any part of the property of the debtor to in order to provide recovery to creditors. Unlike a section 363 sale that can be accomplished by motion, a plan sale necessarily implicates the panoply of plan confirmation requirements. There must be an adequate disclosure statement approved by the court to accompany the plan, voting by creditors, and a confirmation hearing held that requires the debtor to satisfy each of the 16 requirements set forth in section 1129. Consequently, a sale through the mechanism of a plan may be a lengthier process than under section 363.

Section 363 Sale vs. Plan Sale

Once a decision is made that a sale should occur, the parties must determine whether it is appropriate to proceed through a sale under section 363 or by way of a plan. Traditionally, section 363 is used for sales of specific assets that can be sold in order to bring cash into the estate without affecting the balance of the restructured business operations. A sale of all or substantially all of a debtor’s assets, however, historically occurs under a plan of reorganization. Why the difference? A sale under section 363 makes sense if it can occur fairly early on so that potentially idle assets can be sold and provide the debtor with much-needed cash. In addition, because those assets do not affect the entirety of the business, the sale of those assets (and the proceeds received upon their sale) will not be the key determinant of distributions to creditors under a yet-to-be approved plan of reorganization.

On the other hand, a sale of an entire business presumably will gut the estate of all operations and provide the only cash (or cash equivalents) that will be derived in the proceeding. The sole issue remaining after such a sale will be how to divide the proceeds among creditors. For all practical purposes, then, the sale of all or substantially all of the assets constitutes the plan because there is nothing more to do as part of the reorganization process. Therefore, such sales historically have occurred as part of the plan process, providing creditors with the full procedural safeguards attendant to plan confirmation: adequate disclosure of the sale, the classification of creditor claims and the manner in which the sale proceeds will be distributed among those classes, and, ultimately, the necessity of obtaining acceptance of the plan by creditor vote.

Over recent decades, however, the use of the section 363 sale process for entire businesses has gained favor and been approved by the courts so long as adequate notice and opportunity to be heard has been given to parties in interest, and a sound business justification for the sale has been demonstrated. In fact, the rise in use of section 363 sales garnered attention from a leading commission studying necessary reforms to chapter 11. In its December 8, 2014 Report of the ABI Commission to Study the Reform of Chapter 11 (the Report), the American Bankruptcy Institute Commission (the Commission) recommends the inclusion of a new subsection to section 363 specifically addressing the sale of substantially all of a debtor’s assets. Interestingly, the Commission recommends that a sale of substantially all of a debtor’s assets should not occur within the first 60 days of a case, absent clear and convincing evidence of extraordinary circumstances (such as a showing that there is a high likelihood that the value of the assets will decrease significantly during the 60-day period). In addition, the motion to sell must satisfy certain conditions customary within the plan process, including sufficient notice to creditors and proof, by a preponderance of the evidence, that the proposed sale is in the best interest of the estate and satisfies the plan requirements set out in sections 1129(a)(1)–(4) and (a)(9)(A).

So…Just How Free and Clear Is “Free and Clear”?

Free and Clear of Claims

The banner phrase for a bankruptcy sale, whether approved by motion under section 363 or through the plan confirmation process, is that the sale is free and clear of all liens, claims, encumbrances, and other interests in the property of the estate. Most of the cases have revolved around known liens, claims, and encumbrances, and the jurisprudence appears quite clear: the sale can be affected free and clear, with any such liens, claims, and encumbrances attaching to the proceeds of sale, in their respective orders of priority, provided that all holders of such liens, claims, and encumbrances were given proper notice of the sale and an opportunity to object. No need for much discussion on that topic, but should unknown claims also be defeated by a purchaser holding a free-and-clear sale order?

At the forefront of the discussion on the enforceability of free and clear sale orders is the GM case. On June 1, 2009, General Motors Corporation (Old GM) filed a petition under chapter 11 in the United States Bankruptcy Court for the Southern District of New York. On the first day of its case, Old GM also filed a motion, pursuant to section 363, to sell to General Motors LLC (New GM) a substantial portion of its business free and clear of all liens, claims, encumbrances, and other interests, other than expressly defined “assumed liabilities.” New GM had agreed, for example, to assume liabilities for post-sale accidents involving both Old GM and New GM vehicles and liabilities under the express warranty on the sale of any Old GM or New GM vehicle. After much negotiation with various states’ attorneys general, New GM also agreed to assume liabilities under “lemon laws” for both Old GM and New GM vehicles.

Included as part of the draft proposed sale order was a finding that Old GM may “sell the Purchased Assets free and clear of all liens, claims, encumbrances, and other interests, including rights or claims based on any successor or transferee liability. Second, the Proposed Sale Order would enjoin all persons (including litigation claimants) holding liens, claims, encumbrances, and other interests, including rights or claims based on any successor or transferee liability, from asserting them against New GM or the Purchased Assets.”

The bankruptcy court required extensive notice of the sale and proposed order. It required actual notice to all parties who were known to have asserted any lien, claim, encumbrance, or interest in assets being purchased and notice by publication of the sale to all 70 million owners of Old GM automobiles.

Fast-forward to 2014 when New GM announces for the first time serious defects in ignition switches (the Ignition Switch Defect) installed in as many as 27 million of the 70 million Old GM automobiles, going back to the 2005 model year. Bankruptcy Judge Gerber recited in his decision in the case that “at least 24 business and in-house legal personnel at Old GM were aware of the problem. As of June 2009, when entry of the Sale Order was sought, Old GM had enough knowledge of the Ignition Switch Defect to be required, under the National Traffic and Motor Vehicle Safety Act (the Safety Act), to send out mailed recall notices to owners of affected Old GM vehicles. And Old GM knew to whom it had to mail the recall notices, and had addresses for them.”

Old GM failed to give any actual notice, however. Not only did Old GM fail to provide owners of the defective automobiles with actual notice of the proposed sale, but Old GM also had failed to provide them with a recall notice, at any time. Consequently, even if the owners of the defective automobile had learned about the sale through publication, they would have had no idea if they had a claim that could be affected by a sale because they had never received a recall notice!

Once New GM issued a recall of the affected vehicles in 2014 (through which New GM agreed to replace the Ignition Switch Defect at its expense), class actions were commenced almost immediately by four different groups who were not given actual notice of the bankruptcy sale: (1) preclosing accident claims; (2) economic loss claims arising from the Ignition Switch Defect of other defects; (3) independent claims arising from New GM’s conduct; and (4) used car purchasers’ claims. Bankruptcy Judge Gerber had to determine if the free-and-clear sale order could survive and be enforceable against those plaintiffs who had not received actual notice of the sale. He found that virtually all of the arguments of the class-action plaintiffs were raised at the sale hearing by other parties through able counsel and were properly addressed by the court. Thus, Judge Gerber concluded that a lack of due process could be overcome by “proxy” if a party cannot demonstrate that it would have made different arguments than those parties with notice who had objected to the free-and-clear provision.

The Second Circuit Appeal

On appeal, the Second Circuit confirmed the use of section 363 for preplan sales of all or substantially all assets and articulated that a bankruptcy court may approve a sale under section 363 free and clear of successor liability claims. Section 363 continues to be a valuable tool for failing businesses. The court clearly articulated that, to protect a purchaser from a seller’s liability, the “claim must arise from (1) a 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.”

Applying this standard, the Second Circuit determined that not all of the claims at issue were covered by the sale order. As to independent claims, such claims were based on New GM’s conduct and therefore did not have the requisite contact with the debtor; for used-car claimants, those parties purchased Old GM cars after the closing without knowledge of the defect and therefore had no relationship with Old GM prior to its bankruptcy filing. Therefore, the sale order could not insulate New GM from liability for these sets of claims because there was never an existing relationship between the claimant and Old GM.

The Second Circuit found that the other two groups—the preclosing accident and economic loss claimants—fell within the bounds of the articulated test and within the purview of the sale order. On appeal, those claimants argued that, even if the sale order applied to them, enforcing it to preclude their claims would violate due process. The Second Circuit agreed.

First, the Second Circuit agreed with the bankruptcy court that notice by publication to these claimants was not enough. Old GM knew or reasonably should have known that a defect existed, and also knew the identity of the affected parties; however, that is where the Second Circuit’s agreement with the bankruptcy court ended.

Importantly, Bankruptcy Judge Gerber determined that the sale order could survive so long as such claimants were not prejudiced by the lack of due process. Further, Judge Gerber concluded that he would have entered the sale order even if the claimants had filed their objections because they raised no unique objections from parties who had been notified of the sale and who had had their day in court. In addition, the failure to approve the sale was untenable to Judge Gerber. The Second Circuit disagreed. In fact, the circuit court determined that it did not even have to decide if prejudice was a necessary element of a due process claim because it found that the claimants had demonstrated prejudice. Had notice been given, the claimants could have been at the negotiating table, and, similar to the states attorneys general in the case of state “lemon laws,” they could have negotiated an outcome to have their claims assumed by New GM. Without that opportunity, these claimants were prejudiced. Moreover, the Second Circuit was not convinced that Armageddon would result if the sale were not approved; instead, the court believed that other alternatives might have been available if the sale order was not so hastily approved. Finally, there appears to be a clear distaste for a result that would bar these claimants from recovery. A sale to New GM (made up of Old GM’s business and personnel) should not insulate New GM from known, contingent claimants as a result of the failure to provide notice. Unless the U.S. Supreme Court determines to weigh in on successor liability, New GM must cover the claims of all of such parties. The upshot for any purchaser out of bankruptcy: ensure that the debtor provides widespread, actual notice.

Free and Clear of Interests

A separate line of cases has involved challenges to free-and-clear sale orders by asserting that the rights (“claims”) asserted against the successor/purchaser do not constitute “interests” for purposes of section 363 and therefore survive the sale. Section 363(f) provides that a debtor “may sell property under subsection (b) or (c) of this section free and clear of any interest of an entity other than the estate . . . .” (emphasis supplied). Although the Bankruptcy Code does not define “interest” for purposes of section 363, those challenging free-and-clear sale orders assert that the term must be interpreted narrowly to mean only in rem interests, such as liens and security interests, that attach to property. Such an interpretation is bolstered by the words of the statute itself: “free and clear of any interest in such property.” Thus, the types of interests impacted by a sale free and clear are in rem interests that have attached to the property.

The Sixth Circuit agreed with such an approach in Michigan Emp’t Sec. Comm’n v. Wolverine Radio Co. (In re Wolverine Radio Co.), 930 F.2d 1132 (6th Cir. 1991), and held that the debtor’s unemployment contribution rating was not an interest within the meaning of section 363. Wolverine involved the free-and-clear sale of all of the business of Wolverine Radio Company (Wolverine). The Michigan Employment Security Commission (MESC) had filed a claim against Wolverine for unpaid taxes, interest, and penalties in the amount of $7,606.91 and presumably had been notified of the plan and sale. Initially, MESC informed the buyer that it would impose an unemployment tax rate of 2.7 percent based on the buyer’s status as a new employer. Later that year, however, MESC altered its position, determined the buyer to be a successor of Wolverine, and demanded a contribution rate of 10 percent based on Wolverine’s poor experience rating prior to the chapter 11 petition. MESC used Wolverine’s prior 60-month payroll and benefits charges to assess a contribution rate of 10 percent.

MESC argued that the debtor’s experience rating did not constitute an interest for purposes of section 363, and the court agreed. “Similarly, while 11 U.S.C. Sec. § 363(f) provides that property may be sold ‘free and clear of any interest in such property,’ we do not perceive the experience history of Wolverine as an ‘interest’ that attaches to property ownership so as to cloud its title. . . .” Because the debtor’s experience rating was held not to be an interest for purposes of section 363, the Sixth Circuit affirmed the imposition of the higher rating on the successor corporation despite the free-and-clear sale language set forth in the plan. In dicta, the court stated that, even if a contribution rate constituted an interest for purposes of section 363, the conditions set forth in subsection (f) could never be satisfied to permit a sale free and clear.

The growing trend, however, is to interpret the term “any interest” much more broadly. See, e.g., Indiana State Police Pension Tr. v. Chrysler LLC (In re Chrysler LLC), 576 F.3d 108 (2d Cir. 2009) (personal injury claims related to pre-sale automobile accidents were interests for purposes of section 363); In re Precision Indus., Inc. v. Qualitech Steel SBQ, LLC, 327 F.3d 537 (7th Cir. 2003) (the term interest is sufficiently broad to include the debtor’s possessory rights as lessee); In re Trans World Airlines, Inc., 322 F.3d 283 (3d Cir. 2003) (rights to travel vouchers given to flight attendants in settlement of employment discrimination claims were interests for purposes of section 363); United Mine Workers of Am. 1992 Benefit Plan v. Leckie Smokeless Coal Co. (In re Leckie Smokeless Coal Co.), 99 F.3d 573 (4th Cir. 1996) (debtor’s obligation to fund retirement plan was interest for purposes of statute); In re General Motors Corp., 407 B.R. 463 (Bankr. S.D.N.Y. 2009) (following Chrysler).

These cases suggest that the term “interest” should be defined broadly to include all types of obligations that may flow from the ownership of property. See Trans World Airlines, Inc., 322 F.3d at 289. Following this trend is a recent 2013 case from the Bankruptcy Appellate Panel for the First Circuit. In Massachusetts Dep’t of Unemployment Assistance v. OPK Biotech, LLC (In re PBBPC, Inc., f/k/a Biopure Corp.), BAP No. MB 12-042 (B.A.P. 1st Cir. Jan. 17, 2013), the panel, applying a broad interpretation to the term “interests,” precluded imposition of a debtor’s unemployment rating on a section 363 purchaser.

Although the facts in PBBPC are eerily similar to Wolverine, the panel reached a directly contrary conclusion. After a sale under section 363, the Massachusetts Department of Unemployment Assistance (DUA) notified the purchaser that it would be liable as a “successor employer” to the debtor, with a contribution rate of 12.27 percent rather than the rate of 2.89 percent imposed upon new employers. Among other arguments, the DUA stated that the contribution rate was not an interest within the meaning of section 363; therefore, the bankruptcy court could not order a sale free and clear of that contribution rate.

The bankruptcy court disagreed, and the panel affirmed. The panel adopted the expansive definition of “interest” advanced by the Second, Third, Fourth, and Seventh Circuit Courts of Appeals as more consistent with the language of the Bankruptcy Code and the policy set forth in section 363.

We therefore conclude that the term ‘any interest’ as used in § 363(f) is sufficiently elastic to include the Debtor’s experience rate. Indeed, the record reflects that the transfer of an employer’s contribution rate to a successor asset purchaser is really an attempt to recover the money that the predecessor employer would have paid if it had continued in business.

As a result, section 363(f) permitted the court to authorize the sale free and clear of the debtor’s high contribution rate. PBBPC is consistent with other decisions denying the transfer of a debtor’s employee contribution rate to its successor. See In re USA United Fleet, Inc., 496 B.R. 79 (Bankr. E.D.N.Y. 2013) (Department of Labor’s attempt to apply debtor’s experience rating to purchaser of assets from bankruptcy trustee was inappropriate, and assets were transferred free and clear of that interest); In re Tougher Indus., 2013 Bankr. LEXIS 1228 (Mar. 27, 2013) (debtor’s experience rating is an “interest” in property, and such property can be sold free and clear of such interest); Ouray Sportswear, LLC v. Indus. Claim Appeals Office, 315 P.3d 1280 (Colo. App. 2013) (“more recent trend is to read the phrase ‘interest in property’ broadly to include not just liens against property being sold but also claims that arose from the ownership of the property”).

Conclusion

Although some may argue that the Second Circuit’s GM decision could broaden successor liability claims even after a bankruptcy-sanctioned sale, the current trend in the cases is to protect the integrity of bankruptcy sale orders, enforcing free-and-clear language to a broad range of both claims and interests. Despite reversing the bankruptcy court’s decision, the Second Circuit recognized the importance of a free-and-clear sale order as providing vast protections to a debtor who honestly and forthrightly lists all claims against it and provides notice to all such claimants consistent with due process, and for good reason: incentives are appropriate to entice parties to step in to the chapter 11 arena by purchasing assets and providing a recovery for creditors. However, free-and-clear sale orders are not without their limits: under GM, 829 F.3d at 159 (citing Grogan v. Garner, 498 U.S. 279, 286–87 (1991) (quoting Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934)), “. . . if a debtor does not reveal claims that it is aware of, then bankruptcy law cannot protect it. Courts must ‘limit[] the opportunity for a completely unencumbered new beginning to the ‘honest but unfortunate debtor.’’”

Jeanne P. Darcey

Jeanne P. Darcey is a partner in Sullivan & Worcester LLP’s Boston office, and head of the Bankruptcy & Restructuring Practice Group. Ms. Darcey has over 30 years of high-level and varied experience representing debtors, secured and unsecured creditors, indenture trustees and bondholders in out-of-court workouts, liquidations, creditor assignments and Chapter 11 proceedings.