State Court Gives Lessons in Bankruptcy Law

State Court Gives Lessons in Bankruptcy Law

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In an unusual reversal of roles, we bankruptcy lawyers can learn some important lessons about the limitations of bankruptcy law from a state court. In Lefever v. K.P. Hovnanian Enterprises Inc., 734 A.2d 290, 160 N.J. 307 (1999), the Supreme Court of New Jersey, in a 4-3 decision, enforced successor liability against a manufacturer who had acquired assets through a "free-and-clear" bankruptcy sale. In doing so, the court held that an intermediate owner's bankruptcy did not preclude successor liability, even though the claim arose before the bankruptcy case was filed.

Lefever involved a forklift operator who suffered injuries when his forklift tipped over. He asserted a "product-line" successor liability claim in state court against a successor corporate manufacturer that had purchased its predecessor's product line through a bankruptcy sale. The purchaser moved to dismiss the claim on the basis that the bankruptcy sale was "free and clear" of any interest in the property, including any successor liability claims. The trial court granted the motion to dismiss. On appeal to the intermediate appellate court, however, the trial court was reversed and the Supreme Court affirmed.

The Lefever court squarely faced the question of whether the product-line successor liability doctrine is applicable when a successor purchases its predecessor's assets at a free-and-clear bankruptcy sale. After reviewing the development of the product-line successor liability doctrine under New Jersey law, the court first examined whether the supremacy of federal bankruptcy law prevents the application of state common law to claims against a successor business enterprise that acquired assets through a bankruptcy sale. Although answering the question in the affirmative, the court nimbly maneuvered around this constitutional impediment by reasoning that the supremacy of federal bankruptcy law applies only if the bankruptcy court had "dealt with" the claim. The justices examined in this context the function of the bankruptcy sale and determined the effect it may have on other principles of law that affect the liability of a successor business enterprise.

The court considered whether either of the two means of selling assets in bankruptcy—by a §363 sale or under a chapter 11 plan—cuts off successor liability claims. It reviewed the distinction between "claims" and "interests" and how the bankruptcy court's power to sell free and clear of claims is coextensive with its power to discharge claims under the Bankruptcy Code. The justices determined that the successor liability claim was not pre-empted because the plaintiff's claim "was simply not dealt with in the bankruptcy proceedings." This conclusion rested on the findings that the plaintiff had not filed a claim (although the debtor had listed the claim on its schedules and, as the dissent pointed out, the plaintiff had the opportunity to file a claim but chose not to) and that his "claim" was not an "interest" in the sense of a lien or encumbrance on the assets sold.

Having determined that federal law permits the application of the product-line successor liability doctrine after a bankruptcy sale, the court then considered whether it should in fact be applied. This involved weighing the competing policies of the Bankruptcy Code (maximizing the value of assets and providing equality of distribution among creditors of equal legal status—each of which would be undermined by enforcing successor liability) against the product-line successor liability doctrine (providing compensation to otherwise remediless victims of defective products and spreading the risk to society at large for the costs of injuries from defective products). In deciding to enforce successor liability against the purchaser of assets at the bankruptcy sale, the court concluded that the policies underlying the product-line successor liability doctrine outweigh those of the Bankruptcy Code (a balancing of interests that was roundly criticized by the three dissenting justices.)

The main lesson of Lefever is not so much its holding; rather, it is what it teaches us about the limitations of bankruptcy law itself. As those loyal members of ABI's Asset Sales Committee and many of our colleagues know all too well, this is certainly not the first instance of a state court enforcing successor liability notwithstanding a free-and-clear bankruptcy sale.

We bankruptcy lawyers must remember that the effectiveness of our work in bankruptcy is often limited by how it is perceived—and enforced—in the real world. It is all too easy to forget that the usual and customary rules of law (along with, it sometimes seems, the very fabric of time and space) are warped by the intense gravitational pull of Planet Bankruptcy. It is also too easy to forget that bankruptcy is an artificial construct—a life-support system for debtors that suspends the harsh reality of our otherwise unforgiving economic system. When we try to effect bankruptcy-like results in a non-bankruptcy forum, we are often strangers in a strange land.

Lefever is instructive for understanding how state courts tend to "think" about bankruptcy and for avoiding the perils of our thinking too narrowly. As with the free-and-clear sale order construed in Lefever, just because we say something in bankruptcy court doesn't necessarily make it so. The Lefever court was willing to sidestep the Supremacy Clause and apply New Jersey law simply based on its (perhaps misguided) view that the plaintiff's claim had not been "dealt with" in the bankruptcy case. It did not hesitate to limit the effect of bankruptcy law to achieve a result more consistent with the way things work in the real world. To the real world, results achieved in bankruptcy are often confusing, counterintuitive and just plain offensive to the mainstream sense of justice and the way things are done. No wonder that state courts like the one in Lefever look for ways to undo what we've often worked so hard to put together.

The Lefever court's willingness to limit the effect of bankruptcy law also teaches an important practical lesson about where a purchaser of assets out of bankruptcy should go to enforce rights it believes it has received by a bankruptcy court order approving a sale free and clear. When a claimant asserts successor liability against a purchaser who assumes there is none, there is a threshold strategic decision to be made: Which court is more likely to enforce the purchaser's expectation of what "free and clear" really means? Although it apparently is not entirely clear from the Lefever opinion, the purchaser adopted a purely defensive strategy in the state court, relying entirely on the sanctity of the "free and clear" language of the bankruptcy sale order. In hindsight, however, this may have been a fatal strategic mistake. As was pointed out by the three dissenting justices, it permitted the Lefever court to undermine the efficacy of a free-and-clear sale by subordinating the narrow bankruptcy law policies to the more broadly based social policies underlying the judicially created state law doctrine of successor liability. A more assertive strategy for seeking injunctive relief from the bankruptcy court that issued the sale order might have been more successful in blunting the plaintiff's claim. As for bankruptcy courts vs. state courts, a purchaser's chances of receiving a more favorable result—strictly on policy grounds, if nothing else—would appear to be better in the former. Bankruptcy courts might be more likely to give effect to and enforce their own orders than a state court with an entirely different constituency, agenda and philosophy.

We bankruptcy lawyers must try to maintain a distant—and defensive—perspective about how our work in bankruptcy will be perceived. Otherwise, as Lefever illustrates, an army of fancy bankruptcy lawyers can be blindsided by a single plaintiff's personal injury lawyer who doesn't know the first thing about the niceties of §363(f) and couldn't care less. That's a tough lesson to learn.

Journal Date: 
Wednesday, December 1, 1999