Section 363 Sales Let the Buyer Beware

Section 363 Sales Let the Buyer Beware

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A debtor's assets may be sold free and clear of liens, encumbrances and interests, with those liens, encumberances and interests attaching to the proceeds of the sale. 11 U.S.C. §363. Indeed, the "§363 sale" has become common in today's commercial bankruptcies, particularly in the telecommunications area. In fact, certain courts have commented on the desire to hear fewer "chapter 3" cases and more chapter 11 cases.

Nonetheless, a §363 sale is sometimes the best and/or only exit strategy, as some debtors have absolutely no ability to reorganize, yet the value of their assets as a going concern exceeds the shut-down value. Additionally, a §363 sale is often attractive to a potential purchaser of assets because of the ability to buy such assets free and clear of all liens, encumbrances and interests, thereby taking the assets without the liabilities.

Despite §363's provisions, §363 sales do not necessarily protect a purchaser of assets in bankruptcy. In fact, certain courts have held that §363 sales do not insulate a purchaser from future claims under the theory of successor liability. Fairchild Aircraft Inc. v. Cambell (In re Fairchild Aircraft Corp.), 184 B.R. 910 (Bankr. W.D. Tex. 1995); vacated, 220 B.R. 909 (Bankr. W.D. Tex. 1998). It is important, therefore, for a buyer of assets from a §363 sale to know what they are buying and the risks associated with such purchases.

Fairchild Aircraft Inc. v. Campbell

In Fairchild, the debtor manufactured and sold commuter aircraft, the last sale of which occurred in 1985. In 1990, the debtor filed a voluntary petition under chapter 11. Subsequently, the court appointed a chapter 11 trustee, who sought and located a purchaser for the debtor's assets. Instead of a §363 sale, the trustee formulated and filed a liquidating plan via the sale of the debtor's assets to the purchaser for $5 million, plus the assumption of certain secured debt, pursuant to an executed asset purchase agreement. The asset purchase agreement expressly provided that the purchaser would not be responsible for the debtor's other obligations or liabilities regardless of when they occurred.

The court confirmed the plan and approved the asset purchase agreement in its confirmation order. Pursuant to the confirmation order, the debtor's assets were sold free and clear of all liens, claims and interests, and the purchaser was not responsible for any liabilities or debts of the debtor. Additionally, the confirmation order contained an injunction prohibiting all creditors and other persons from pursuing claims against the purchaser, along with a finding of fact that notice of the plan was reasonable and adequate.

Nearly three years later, after an aircraft manufactured by the debtor crashed and killed four people, several plaintiffs brought a wrongful death action against the purchaser under the theory of successor liability. In response, the purchaser initiated an adversary proceeding against the plaintiffs in bankruptcy court, seeking both injunctive and declaratory relief to the extent that (i) the confirmation order authorized the sale of the debtor's assets "free and clear," (ii) the provisions of the Asset Purchase Agreement "cleansed" the assets acquired by the purchaser of any future liability and (iii) the plaintiffs' wrongful death action violated the permanent injunction set forth in the confirmation order.

Ultimately, the court found that it lacked subject matter jurisdiction to enjoin the plaintiffs from bringing claims against the purchaser because the confirmation order did not enjoin or otherwise affect the plaintiffs' wrongful death action against the purchaser. Fairchild, 184 B.R. at 934. Specifically, while the confirmation order provided for the sale of the debtor's assets free and clear of all liens, encumbrances and interests, there was no provision for treatment of future claimants, nor were current owners and operators of aircraft manufactured by the debtor given notice, even though the debtor was aware of many of those owners and operators. Id. at 914.

More specifically, the court held that the term "any interest" was limited to sales free and clear of in rem (i.e., property) interests, but did not include sales free and clear of in personam liabilities such as those presented by the plaintiffs. Fairchild, 184 B.R. at 917-18; citing In re Wolverine Radio Co., 930 F.2d 1132, 1147 (6th Cir. 1991), cert. dism'd., 503 U.S. 978 (1992); In re Fleishman, 138 B.R. 641, 647 (Bankr. D. Mass. 1992); In re Dartmouth Audio Inc., 42 B.R. 871 (Bankr. D. N.H. 1984); Jandel v. Precision Colors Inc., 19 B.R. 415 (Bankr. S.D. Ohio 1982). The court noted that perhaps bankruptcy courts should have the power to sell free and clear of "trailing liability" for future claims, but that a policy decision of this nature must be made by Congress, not the courts. Fairchild, 184 B.R. at 918-19. Thus, while in rem interests are extinguished, in personam interests such as successor liability are not. Id.

Fairchild's Reasoning

The theory of successor liability is an exception to the general rule that the transfer of assets does not pass on the liabilities of the seller to the purchaser, similar to where there is (1) an express or implied assumption of liabilities, (2) a consolidation or merger, (3) a "mere continuation" of the seller, and/or (4) a fraudulent transfer to avoid creditors. Id. at 920, citing Upholsterers' International Union Pension Fund v. Artistic Furniture of Pontiac, 920 F.2d 1323, 1326 (7th Cir. 1990). More importantly, the theory of successor liability does not create a new or independent cause of action. Instead, successor liability is based on the transfer of the seller's liability arising from the assets sold to the purchaser. Id., citing Golden State Bottling Co. Inc. v. NLRB, 414 U.S. 168 (1973); Northern Ins. Co. of New York v. Allied Mut. Ins., 955 F.2d 1353, 1357 (9th Cir. 1992), cert. den'd., 505 U.S. 1221 (1992); Clark Equipment Co. v. Dial Corp., 25 F.3d 1384, 1387 (7th Cir. 1994).

Since a claim under the theory of successor liability is not a new claim, one must examine whether the claimant has a "claim" dischargeable in bankruptcy and/or extinguishable by a §363 sale. Fairchild, 184 B.R. at 920-21, n.11. The Fairchild court examined the various tests of what constitutes a "claim," such as the accrual test, citing Avellino & Bienes v. M. Frenville Co. (Matter of Frenville Co. Inc.), 744 F.2d 332, 335-36 (3rd Cir. 1984); cert. den'd., 469 U.S. 1160 (1985); the conduct test, citing S.S. Corp. v. Aguilar (In re S.S. Waterman Corp.), 141 B.R. 552 (Bankr. S.D.N.Y. 1992), vacated on other grounds, 157 B.R. 220 (S.D.N.Y. 1993); the relationship test or conduct plus test, citing Epstein v. Official Committee of Unsecured Creditors of Estate of Piper Aircraft Corp. (In re Piper Aircraft Corp.), 58 F.3d 1573, 1577 (11th Cir. 1995); and the Fifth Circuit's version of the "relationship" or "conduct plus" test, citing Lemelle v. Universal Mfg. Corp., 18 F.3d 1268 (5th Cir. 1994).

Upon examining the various tests, the court held that although the concept of a bankruptcy claim should be as broadly defined as possible, the overriding limitation would be whether the bankruptcy process for dealing with the future claimant had been fundamentally fair. Fairchild, 184 B.R. at 924-25. To comport with the statutory definition of "claims" and assure fundamental fairness for future claimants, (a) the future claims must be based on the pre-bankruptcy conduct of the debtor, (b) the debtor must be able to identify the type of future claim so that it can be "fairly anticipated" that they could arise in the future, and (c) the debtor must provide for "fair representation and treatment" of that type of future claim, including some form of notice, representation and/or treatment. Id. at 922-23.

For example, since the Fairchild plaintiffs' causes of action arose out of pre-petition conduct of the debtor, the debtor had enough information to know and reasonably anticipate that these types of causes of action could arise in the future, and since there was no provision for representation and/or treatment of these future claimants' interests during the bankruptcy case, such future claims could not be treated as "bankruptcy claims." Id. at 932-33. Thus, since the future claims could not be treated as bankruptcy claims, they could not be discharged in bankruptcy, or extinguished pursuant to a §363 sale.

Subsequently, the plaintiffs and the purchaser settled, and the purchaser requested that the court vacate its opinion. Though reluctant, the court found that the purchaser had equitable entitlement to the extraordinary remedy of vacatur and vacated its opinion. Fairchild Aircraft Inc. v. Cambell (In re Fairchild Aircraft Corp.), 220 B.R. 909 (Bankr. W.D. Tex. 1998).

Despite the subsequent vacatur, several courts and commentators have analyzed and relied on Fairchild, due in no small part to its thorough analysis. More important than its thorough analysis is the instruction that Fairchild gave to practitioners regarding the inclusion of future claims as bankruptcy claims, which subsequent courts have adopted. See In re Williams v. Todd Shipyards Corp., 1997 U.S. Dist. Lexis 23 961 (S.D. Tex. 1997) (where a district court declined to grant summary judgment based on the lack of evidence that the Fairchild standards for assuring fundamental fairness for the treatment of future claims was met); UNR Industries Inc. v. Walker (In re UNR Industries Inc.), 224 B.R. 664, 669-72 (Bankr. N.D. Ill. 1998) (where a bankruptcy court held that for the trust fund mechanism in the confirmed plan to cover a future claim, such future claim must be specifically described); Kewanee Boiler Corp. v. Smith (In re Kewanee Boiler Corp.), 198 B.R. 519, 534-36 (Bankr. N.D. Ill. 1996) (where a bankruptcy court, relying on Fairchild, concluded that procedural due process and the requirements of meaningful notice are a limitation on what could constitute a "claim" that could be dealt with in bankruptcy, and, since the debtor had made no provision for identifying, notifying or treating future claimants, future claims were not discharged).

Conclusion

In addition to holding that §363 sales do not necessarily insulate a purchaser of assets from all potential liabilities, Fairchild also gave direction as to how to further insulate a §363 sale purchaser from future claims. However, Fairchild left certain details unanswered: What type of notice must be given to assure fundamental fairness for future claimants? Is it necessary to actually appoint a legal representative for future claimants? How does the Fairchild analysis differ in the chapter 7 context? Does fundamental fairness require asset sales through a plan, or can such assurances be made in the context of a §363 sale motion and order?

Indeed, these issues are pertinent for the practitioner, particularly those representing buyers of assets in bankruptcy, to consider when contemplating a §363 sale. After all, §363 sales are only attractive to purchasers because of the "protections" afforded under §363. Without those protections, the additional time and expense of participating in a chapter 11 removes the incentive of a potential purchaser, thereby diminishing value to the bankruptcy estate. Consequently, complying with the Fairchild standards is not only in the best interests of the potential purchaser, but the bankruptcy estate as a whole.

Journal Date: 
Monday, July 1, 2002