There has been a growing trend to use the bankruptcy process to effect a quick sale of many or all of a debtor's assets. Where the debtor does not have the time or the money to include the sale in a reorganization plan, the sale is done pursuant to §363 of the Bankruptcy Code, sometimes within weeks of the chapter 11 filing. Section 363(f) permits a bankruptcy court to approve the sale of assets "free and clear of any interest in such property of an entity other than the estate."¹ This provision is highly attractive to purchasers because it "cleanses" the assets, making it more difficult for third parties to assert claims against the assets or the purchaser. These advantages to the purchaser theoretically result in a higher purchase price and thus more value to the estate.

Two recent appeals court decisions reinforce the effectiveness of §363 sale orders to cut off third-party claims against asset purchasers. In In re Trans World Airlines Inc.,² the Third Circuit, following the broad trend throughout the country, held that a §363 sale order may be effective to protect the purchaser against successor liability claims. In ITOFCA Inc. v. Mega Trans Logistics Inc.,³ the Seventh Circuit held that a party that purchases an intellectual property asset pursuant to a §363 order is protected against a third party's claim that it owns the asset, provided that the party was on notice of the proposed sale.

In re Trans World Airlines Inc.

In May 2002, a few months after TWA had filed its third bankruptcy in less than a decade, the airline sold substantially all its assets to American Airlines. The bankruptcy court's sale order included a provision that, pursuant to §363(f), the assets would be delivered to American free and clear of all interests, including "all asserted or unasserted, known or unknown, employment-related claims, payroll taxes, employee contracts, employee seniority accrued while employed with any of the sellers and successorship liability accrued up to the date of closing of such sale." The order also enjoined all persons from seeking to enforce successor liability claims against American.

As a general rule, an asset purchaser is not liable for claims against the seller. But some courts have sanctioned various successor liability theories, including where the purchaser is deemed a "mere continuation" of the seller or for product-liability claims where the purchaser manufactures the same product under the same product names and trades on the seller's goodwill. In an effort to cut off potential successor liability claims, §363 sale orders, like the TWA order, now include boilerplate findings that the buyer would not have purchased the assets but for the protections against successor liability, and that the purchaser's business is not a continuation of the debtor's business; they explicitly provide that the sale is free and clear of any successor liability claims.

These provisions were challenged by the Equal Employment Opportunity Commission (EEOC), which was investigating more than two dozen charges of discrimination against TWA under various federal employment statutes, and by representatives of a class of flight attendants who had received, in settlement of actions challenging TWA's maternity leave-of-absence policy, travel vouchers that were usable indefinitely by the class members and their families. The district court rejected the challenge. It pointed to the bankruptcy court findings that (a) American's offer was the highest and best offer for TWA's assets, (b) it was unlikely that the sale would have been consummated if the appellants' claims were not extinguished, and (c) if the sale did not go forward, TWA would have been liquidated with resulting harm to all constituents including appellants.

The Third Circuit affirmed. The basic issue of statutory construction was whether a successor liability claim constitutes an "interest in such property of an entity other than the estate" within the meaning of §363(f). Some courts have construed the term "interest" to include only liens and similar in rem interests.⁴ Rejecting that approach, and following instead the Fourth Circuit's approach in In re Leckie Smokeless Coal Co.,⁵ the Third Circuit adopted "a more expansive reading of "interests in property' which "encompasses other obligations that may flow from ownership of the property.'"⁶ The court construed the statutory language "to refer to obligations that are connected to, or arise from, the property being sold."⁷ The court held that, since the EEOC and travel voucher claims were connected to or arose from the assets sold, i.e., the TWA business, the bankruptcy court properly extinguished any successor-liability claims and enjoined appellants from pursuing those claims against American.

Although the court purported to decide the case based on statutory construction, it proceeded to explain why this result comported with the Code's distribution scheme: "[I]n the context of a bankruptcy, these claims are, by their nature, general unsecured claims and, as such, are accorded low priority. To allow claimants to assert successor liability claims against American while limiting other creditors' recourse to the proceeds of the asset sale would be inconsistent with the Code's priority scheme."⁸ The court also noted that, absent protections against successor liability, American may have discounted its bid for the assets.⁹

It is hard to argue with the Third Circuit's result. The appellants' claims clearly were pre-petition claims; the claimants enjoyed no privileged status over other general unsecured creditors; they had every right and opportunity to protect their interests in the bankruptcy case and, as the court of appeals pointed out, denial of successor liability protection would have affected the sale process to the detriment of all constituents.

And yet, the Third Circuit's decision, like so many other bankruptcy law decisions, has a results-oriented undertone. Although the court explicitly declined to address the merits of any successor liability claim,¹⁰ it is hard not to infer some hostility to the expansion of successor liability doctrines that might encompass an asset purchaser being held responsible for employment law violations committed long before the sale, and for which the purchaser had no responsibility. One can hardly question that ongoing obligations for travel vouchers entailed a cost that might have required a reduction of the sale price. But is it credible that, as the bankruptcy court found, this was an issue on which the sale would have foundered, resulting in immediate liquidation of the assets?

Where the underlying facts give rise to a more sympathetic successor liability claim, a court may reach a different result. It is interesting to compare this with In re Fairchild Aircraft Corp., where the court held that a §363 sale order did not protect the purchaser of a commuter aircraft business against products-liability claims brought on behalf of persons injured after the sale from the crash of aircraft made long before the sale. Clearly, the court's concern was the adequacy of representation of such claimants, but the court rested its decision on the statutory language, holding that such claimants did not have an "interest in such property" (i.e., the purchased assets) that could be extinguished under §363(f). 184 B.R. at 919. The Fairchild court construed §363(f) to reach only in rem interests that attach to the property, not successor liability claims that, in the court's view, constitute in personam liabilities.¹¹ Along these lines, some courts have held that a sale order may not cut off product liability claims for injuries occurring after the sale (even if the "claim" arose pre-sale within the meaning of the Code) where the claimant was not given notice of the sale.¹²

ITOFCA Inc. v. Mega Trans Logistics Inc.

The ITOFCA case shows how a §363 order can cut off other types of interests in an asset. The issue arose long after the bankruptcy, when the purchaser relied on the §363 order to support a res judicata defense to a copyright infringement claim. The plaintiff, ITOFCA, had sold its assets and operations to a company called ICI, which later filed chapter 11. In its chapter 11, ICI sold all of its "right, title and interest in all patent, copyright and trade secret rights in and to all computer software and corresponding documentation developed or acquired by [ICI]," and the assets ultimately were transferred to the defendant, Mega-Trans. ITOFCA asserted that ITOFCA retained ownership of the copyright on a computer software program, and that MegaTrans was infringing the copyright by making and selling copies of a modified version of the program.

MegaTrans argued that the bankruptcy court's sale order had adjudicated ITOFCA's claim that it owned the copyright. ITOFCA had been on notice of the bankruptcy court sale and had participated in the bankruptcy court proceedings. ITOFCA argued, however, that the sale order transferred only whatever copyright interest the debtor (ICI) had, and that that interest did not include ownership of the copyright or the right to sell modified versions of the programs. The bankruptcy court had not explicitly addressed the ownership issue, and the copyright was not listed as an asset on the debtor's schedules.

Nonetheless, the court rejected ITOFCA's arguments and sustained the defense. Judge Posner, writing for the court, started with the proposition that "when a bankruptcy court approves the sale of an asset of the debtor, a person who has notice of the sale cannot later void it on the ground that he is the asset's owner."¹³ ITOFCA had been on notice of the sale, and so was bound by the order. Because the order stated that the debtor had the right to all additional copies of the software, the court reasoned, the sale order must be construed to include a finding that the debtor owned the copyright.¹⁴

In a long and carefully documented concurring opinion, Judge Ripple agreed that the court should defer to the lower court's findings as to the scope of the bankruptcy court sale order. He said, however, that the case "raises serious concerns about the proper limitations on the use of claim preclusion," given the "imprecision of the bankruptcy court's order [which] leaves unclear exactly what "asset' ICI was selling."¹⁵

This case not only strains the limits of claim preclusion, but illustrates what a powerful tool the debtor wields in moving for approval of a sale. Ironically, the power derives in part from the practical constraints on a bankruptcy court's ability to adjudicate complex substantive rights in the context of an abbreviated §363 hearing. Consider the plight of the bankruptcy judge. In the ordinary course, a dispute regarding ownership of intellectual property would ripen and be resolved through a series of steps that might include both mediation and litigation, and take several years. In a §363 hearing, the process is condensed to a matter of weeks. The debtor brings to bear the threat that, but for the court's approval of the sale, the business will fail, employees will lose their jobs, and creditors will not recover on their claims. The debtor may have neither the time nor resources to develop its factual or legal position, nor the incentive to explain the nuances to the court. The claimant, in turn, will be acting on short notice in a different forum. Under these circumstances, it is hardly surprising that the bankruptcy court may resolve such disputes, as in ITOFCA, through passing language in an "imprecise" sale order.

Conclusion

As these recent cases show, the "cleansing" power of §363 is indeed quite broad. The bankruptcy court has the power not only to sanction the sale of assets free and clear of liens, but to preclude state and federal law claims that would survive a sale effected outside of bankruptcy. These powers make it likely that under appropriate circumstances companies will continue to use §363 to effect sales of substantially all their assets.

Footnotes

¹ 11 U.S.C. §363(f):

The trustee may sell property under subsection (b) or (c) of this section free and clear of any interest in such property of an entity other than the estate, only if—

1. applicable nonbankruptcy law permits sale of such property free and clear of such interest;
2. such entity consents;
3. such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property;
4. such interest is in bona fide dispute; or
5. such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest. Return to article

² 322 F.3d 283, 2003 U.S. App. LEXIS 4530 (3d Cir. Mar. 13, 2003). Return to article

³ 322 F.3d 928, 2003 U.S. App. LEXIS 4024 (7th Cir. Mar. 7, 2003). Return to article

⁴ See, e.g., In re Fairchild Aircraft Corp., 184 B.R. 910, 919 (Bankr. W.D. Tex. 1995); In re White Motor Credit Corp., 75 B.R. 944, 498 (Bankr. N.D. Ohio 1987); In re New England Fish Co., 19 B.R. 323, 326 (Bankr. W.D. Wash. 1982). Return to article

⁵ 99 F.3d 573 (4th Cir. 1996). Return to article

⁶ 2003 U.S. App. LEXIS 4530, at * 14, citing 3 Collier on Bankruptcy, ¶363.06. Return to article

⁷ 2003 U.S. App. LEXIS 4530, at * 17. Return to article

⁸ Id. at *26. Return to article

⁹ Id. at *27. Return to article

¹⁰ Id. at *12, n.4. Return to article

¹¹ Id. at 917-18. Return to article

¹² See, e.g., Western Auto Supply Co. v. Savage Arms Inc. (In re Savage Indus. Inc.), 43 F.3d 714, 721-22 (1st Cir. 1994); Zerand-Bernal Group Inc. v. Cox, 23 F.3d 159, 163-64 (7th Cir. 1994). Return to article

¹³ Id. at *5, citing, inter alia, La Preferida Inc. v. Cerveceria Modelo S.A. de C.V., 914 F.2d 900, 908 (7th Cir. 1990). Return to article

¹⁴ Id. Return to article

¹⁵ Id. at 13. Return to article