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When Successor Liability and Bankruptcy Principles Collide

Author: Michael H. Reed

July 2016 and November 2016
When Successor Liability and Bankruptcy Principles Collide

An edited version of this article was published on November 30, 2016 in Transaction Advisors (full article available with a subscription). This article was published on July 1, 2016 in the Bankruptcy, Commercial Contracts, Energy, Environmental, Mergers & Acquisitions and Product Liability sections of Law360.

Company A manufactures a product that is used by millions of consumers, and it is facing thousands of personal injury claims seeking millions of dollars based on an alleged defect in that product. The financial burden of this litigation, coupled with inadequate liability insurance, pushes Company A into bankruptcy. Even though it has developed a new product design that likely eliminates the defect, Company A is unable to reorganize and seeks to sell its business through the bankruptcy. Company B is interested in acquiring the business but has been cautioned by its lawyers about the risk of possible successor liability for Company A’s liabilities, including possible “future claims” arising from the use of Company A’s old product after the bankruptcy. Can Company B safely make the acquisition?

Generally, a good-faith purchaser of assets does not incur liability for the debts of the seller.1 However, liability for unpaid debts of the seller may be imposed on the purchaser by statute or under the common law doctrine of “successor liability.” Under common law, the four generally recognized exceptions to the general principle of nonassumption of debt are (1) where the purchaser expressly or impliedly agrees to assume the seller’s debts, (2) where the transaction amounts to a consolidation or de facto merger, (3) where the purchaser is “merely a continuation” of the seller or (4) where the transaction is entered into fraudulently to escape liability.2

There is some disagreement about whether the successor’s liability is dependent on the liability of the seller or is an independent liability of the successor. If the successor’s liability depends on the seller’s liability, then the discharge in bankruptcy of the seller’s liability might shield the successor, and the expiration of the statute of limitations for suing the seller might be invoked as a defense by the purchaser.3 However, there is some support for the view that the purchaser’s liability, while rooted initially in the seller’s liability on the original claim, is an independent liability.4

Successor liability, whether imposed by statute or common law, sometimes collides with important goals of bankruptcy policy, including equality of distribution and maximizing the value of an estate. Prior to the 1990s, the ability of an asset purchaser to acquire property in a bankruptcy sale free and clear of successor liability was still somewhat uncertain. By the mid-2000s, however, the case law at the federal court of appeals level began to make it clear that, in a properly structured bankruptcy sale or Chapter 11 reorganization, assets could be acquired free and clear of successor liability.5

In a bankruptcy case, assets can be sold in two ways: a sale pursuant to Section 363 of the Bankruptcy Code6 or a sale pursuant to a confirmed Chapter 11 plan of reorganization.7 Under Section 363, the trustee or debtor-in-possession may sell all of the debtor’s assets out of the ordinary course of business free and clear of “interests.”8 Most authorities have held that a properly conducted bankruptcy sale conveys the assets free and clear of not only property interests, such as liens and encumbrances, but also claims, including successor liability claims.9 Conveying assets pursuant to a Chapter 11 plan arguably affords greater protection because Section 1141(c) of the Bankruptcy Code provides that property “dealt with” by a confirmed Chapter 11 plan shall be “free and clear of all claims and interests of creditors.”10

The efficacy of a bankruptcy sale to cut off pre-existing debts and claims will depend, in part, on the adequacy of the notice of the sale given to interested parties.11 As a general rule, the trustee or debtor-in-possession is required to give notice of any proposed sale of property of the estate outside the ordinary course of business to all creditors and, in a Chapter 11 case, to all equity security holders of the debtor.12 The bankruptcy court often will require that a proposed sale outside the ordinary course of business be appropriately advertised. Notice must be given to the holders of liens.13 If a creditor is adequately notified that the assets will be sold free and clear of liens, claims and encumbrances (including successor liability) and does not object, that creditor will be bound under preclusion principles by entry of a valid sale order.14

Special problems are presented by so-called “future claims” and certain types of environmental liabilities. A future products liability claim arises when (1) a person is harmed prior to the sale by a product introduced into commerce by the seller and the health effects will not be manifested until after the sale or (2) a person is harmed after the sale by a product introduced into commerce by the seller prior to the sale.15 To insulate the purchaser from successor liability for future claims, the transaction generally will be effectuated under a Chapter 11 plan, a representative of the putative claimants will be appointed and afforded an adequate opportunity to represent their interests in the bankruptcy case, and specific provisions will be made, by way of a trust fund or otherwise, for the fair and equitable treatment of such claimants.16

Courts have held that injunctions obtained under environmental statutes to abate ongoing pollution are not within the ambit of “claims” under the Bankruptcy Code and, accordingly, are not dischargeable under a Chapter 11 plan.17 Environmental agencies regularly insist that special measures be taken by the parties to provide funding for the remediation of assets on which there is ongoing pollution generated by the debtor, often by establishing trust funds.18 Moreover, when a purchaser acquires assets on which contamination created by the seller remains, the purchaser will have liability to address the contamination as the current owner or operator of the property without regard to the doctrine of successor liability.19

There are currently a number of pending coal company bankruptcies that may give rise to successor liability issues. In a coal company bankruptcy, an asset purchaser will likely confront the risk of being bound by the “successorship” provisions of collective bargaining agreements as well as potential statutory successor liability for retiree health care benefits premiums imposed under the federal Coal Industry Retiree Health Benefit Act.20 A federal district court in the Northern District of Alabama recently affirmed the holdings of a bankruptcy court that the debtors’ liabilities for premiums under the Coal Act were “interests in property” under Section 363(f) of the Bankruptcy Code and that the debtors’ assets could be sold to a purchaser free and clear of such interests under Section 363.21 The bankruptcy court also held that the debtors’ collective bargaining agreements could be rejected under Section 1113 of the Bankruptcy Code,22 the debtors’ obligations to their retirees could be terminated under Section 1114,23 and the purchaser could acquire the debtors’ assets free and clear of any successor employer obligations to the debtors’ employees and retirees under the debtors’ collective bargaining agreements.24

Returning to the hypothetical posed above, Company’s B’s advisers advise it to do the following: (1) acquire the assets pursuant to a confirmed Chapter 11 plan with notice of the plan and the sale being given to all known existing claimants and to a court-designated representative for any future claimants; (2) ensure that the plan provides for the payment or assumption of all present debts and establishes a mechanism to enable future claimants to participate in plan distributions; (3) obtain an injunction channeling the claims of the claimants to assets set aside under the plan and insulating Company B from successor liability; and (4) ensure that the plan proponents present evidence sufficient to enable the court to find that, without the cutoff of successor liability, the plan could not be consummated.25

Endnotes Example

1 See Brzozowski v. Corr. Physician Servs. Inc., 360 F.3d 173, 177 (3d Cir. 2004); Nat’l Am. Ins. Co. v. Ruppert Landscaping Co., 25 Fed. App’x 116, 120 (4th Cir. 2001).

2 See PCS Nitrogen Inc. v. Ashley II of Charleston LLC, 714 F.3d 161, 173 (4th Cir. 2013); W. Fletcher, Cyclopedia of the Law of Private Corporations § 7122 at 217-18 (Perm. ed. 2008) and Supp. 2015 at 23.

3 See Fairchild Aircraft v. Campbell (In re Fairchild Aircraft Corp.), 184 B.R. 910, 917-921 (Bankr. W.D. Tex. 1995), vacated, 220 B.R. 909 (Bankr. W.D. Tex. 1998) (successor claim is the same as the original claim and subject to same affirmative defenses); Mickowski v. Visi-Trak Worldwide LLC, 321 F. Supp. 2d 885, 888-90 (N.D. Ohio 2004), aff’d, 415 F.3d 501 (6th Cir. 2005) (discharge in bankruptcy of claimant’s claim against debtor precluded successor liability claim against purchaser).

4 See Watson v. Prison Health, 26 A.3d 1207, 2011 Pa. Super. LEXIS 1571 (Pa. Super. Ct. 2011) (unpublished memorandum at 15) (where an action asserting successor liability was filed after the expiration of the statute of limitations on the original claim, the trial court erred in applying the statute of limitations rather than the doctrine of laches in determining the timeliness of the action). See also discussion and cases cited in Michael H. Reed, Insulating Asset Purchasers from Debt Through Bankruptcy Sales, 15 J. Bankr. L. & Prac. 743, 752 and accompanying notes (2006).

5 See 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), cert. denied, 520 U.S. 1118 (1997); In re TWA, 322 F.3d 283 (3d Cir. 2003). See generally Michael H. Reed, Successor Liability and Bankruptcy Sales, 51 Bus. Law. 653 (1996); Michael H. Reed, Successor Liability and Bankruptcy Sales — A New Paradigm, 61 Bus. Law. 179 (2005).

6 11 U.S.C.A. § 363 (2015).

7 11 U.S.C.A. §§ 1123(a)(5)(D), 1141 (2016).

8 11 U.S.C.A. § 363(f) (2015).

9 See In re Old Carco LLC, 538 B.R. 674, 682-88 (Bankr. S.D.N.Y. 2015) and cases cited and discussed therein. See also UMW Combined Ben. Fund v. Walter Energy Inc., 2016 U.S. Dist. LEXIS 14854, *11-16 (N.D. Ala. Feb. 8, 2016).

10 11 U.S.C.A. § 1141(c) (2016).

11 See Mullane v. Cent. Hanover Bank & Trust Co., 339 U.S. 306, 318-20 (1950) (due process required that notice by mail, not merely notice by publication, be given to parties whose interests were to be adjudicated where their identities and whereabouts were known); Nat’l Pipe & Plastics Inc. v. N.P.P. Liquidation Co. (In re Nat’l Pipe & Plastics Inc.), 2000 Bankr. LEXIS 1329, *23-24 (Bankr. D. Del. Sept. 25, 2000) (known creditor who received inadequate notice of sale motion was not bound by findings in the sale order that the purchaser would not be subject to successor liability).

12 See 11 U.S.C.A. § 363(b) (2015); Fed. R. Bankr. P. 2002(a)(2), (d), 6004(a) to (c).

13 The trustee or debtor in possession must serve the sale motion on all parties who hold liens or other interests in the property and notify them of the date of the hearing on the motion and the deadline by which objections to the motion must be filed and served. Fed. R. Bankr. P. 6004(a)-(c).

14 See ITOFCA Inc. v. Mega Trans Logistics Inc., 322 F.3d 928, 930 (7th Cir. 2003) (party claiming to be true owner of property who received notice of bankruptcy sale and failed to object was bound by sale order).

15 See Reed, supra note 5, 51 Bus. Law. at 661, notes 35-43 and accompanying text.

16 See Reed, supra note 5, 61 Bus. Law. at 189-90.

17 See In re Chateaugay Corp., 944 F.2d 997 (2d Cir. 1991); In re Torwico Elecs. Inc., 8 F.3d 146 (3d Cir. 1993), cert. denied, 511 U.S. 1046 (1994); United States v. Apex Oil Co., 579 F.3d 734 (7th Cir. 2009), cert. denied, 562 U.S. 827 (2010).

18 See, e.g., environmental trust established in In re Tronox Inc., No. 09-10156 (ALG) (S.D.N.Y.)

19 See Ohio v. Kovacs, 469 U.S. 274, 285 (1985) (liability for ongoing environmental contamination “runs with the land”).

20 26 U.S.C.A. §§ 9701-9722 (2011 and Supp. 2015).

21 UMW Combined Ben. Fund v. Walter Energy Inc., 2016 U.S. District LEXIS 29097, *19-25 (N.D. Ala. Mar. 8, 2016). The court followed the Fourth Circuit’s similar 1996 holding in Leckie Smokeless, 99 F.3d at 585.

22 11 U.S.C.A. § 1113 (2016).

23 11 U.S.C.A. § 1114 (2016).

24 In re Walter Energy Inc., 542 B.R. 859 (Bankr. N.D. Ala. 2015), aff’d, 2016 U.S. Dist. LEXIS 65166 (N.D. Ala. May 18, 2016). See also In re Alpha Natural Res. Inc., 2016 Bankr. LEXIS 2154 (Bankr. E.D. Va. May 24, 2016).

25 See Reed, supra note 5, 51 Bus. Law. at 674-75.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.