The power of a bankruptcy court to authorize the sale of assets “free-and-clear” of liens and any other interests is a powerful tool that is used to realize value from distressed businesses. Indeed, purchasers will occasionally insist that sellers file a chapter 11 case in order to “cleanse the assets” by conducting their sale under Bankruptcy Code § 363(b). But how far does this power reach? Can bankruptcy be used to protect the purchaser from potential successor liability claims? A recent decision from the United States Court of Appeals for the Second Circuit avoided answering the first question and gave a nuanced answer to the second.

Background

In a decision emanating from the government sponsored Chapter 11 case of General Motors, the Second Circuit held that a sale under section 363(b) could not shield the purchaser from liability to a known category of claimants that had not been given actual notice of the proposed sale. In re Motors Liquidation Company, No. 15-2844 (2d Cir. July 13, 2016). In doing so, the Second Circuit reversed a decision by the Bankruptcy Court for the Southern District of New York enforcing the free-and-clear provision of a sale order to enjoin ignition switch defect claims against General Motors Corporation’s (“Old GM”) successor (“New GM”).

In June 2009, as part of a federal government rescue plan for the automobile industry, Old GM commenced a Chapter 11 case and immediately filed a motion to sell its assets to New GM free-and-clear under section 363 of the Bankruptcy Code. The Bankruptcy Court ordered Old GM to give notice of the proposed sale, requiring direct mail notice to numerous interested parties, including “all parties who are known to have asserted any lien, claim, encumbrance, or interest in or on, the to-be-sold assets.” It also required publication notice. Despite knowing about ignition switch defects and the possibility of future claims arising from the defects, Old GM did not provide direct mail notice to vehicle owners. To the extent that vehicle owners had actual notice, it came by way of the publication notice. Shortly thereafter, the Bankruptcy Court approved the sale and entered an order (“Sale Order”) authorizing the sale with the requested free-and-clear provision.

Several years later, in February 2014, New GM began recalling cars due to the ignition switch defect. The recall was followed by dozens of class actions against New GM asserting successor liability claims and seeking damages. Commencing in April 2014, New GM and several of the plaintiffs filed motions with the Bankruptcy Court seeking, respectively, enforcement of, or a determination that the Bankruptcy Court lacked jurisdiction to enforce, the Sale Order. In each case, New GM argued that because of the free-and-clear provision in the Sale Order, the ignition switch claims could not be asserted against New GM.

In deciding these motions, the Bankruptcy Court found that the claims were known to, or reasonably ascertainable by, Old GM prior to the sale and therefore the plaintiffs had been entitled to actual notice, as opposed to mere publication notice. Nevertheless, the Bankruptcy Court concluded that — with the exception of claims relating to New GM’s post-sale failure to disclose the defect — the plaintiffs had not been prejudiced by the lack of proper notice. As a result, New GM could not be sued for ignition switch claims that otherwise could have been brought against Old GM. The only surviving claims would be claims arising from New GM’s wrongful conduct after the sale.

The Second Circuit’s Ruling

On appeal, the Second Circuit affirmed in part and reversed in part, while making rulings that will impact future reliance on the Bankruptcy Code’s free-and-clear provisions.

First, the Second Court concluded that a section 363 sale could be free-and-clear of successor liability claims, but only if the claims (i) “flow from the debtor’s ownership of the sold assets” and (ii) arose before the bankruptcy filing or resulted from pre‐petition conduct. In addition, however, it said that the claimant must be identifiable. Applying these principles, the Court ruled that section 363(b) would shield the purchaser from (i) claims from accidents involving Old GM cars occurring before the sale, and (ii) economic losses resulting from ignition defects in vehicles sold by Old GM. However, it also ruled that the Sale Order did not shield New GM from claims of persons who did not own Old GM vehicles at the time of the asset sale (i.e., purchasers of used cars who made their purchase after the closing), because there was no contact or relationship until after the asset sale.

Second, the Court of Appeals agreed with the Bankruptcy Court’s ruling that vehicle owners were entitled to actual notice but reversed its holding that had no been prejudiced by the lack of notice. The Second Circuit held that they had been prejudiced by the loss of a meaningful opportunity to participate in the proceedings. In doing so, the Court declined to decide whether prejudice must be demonstrated to obtain relief because it found that the claimant had been prejudiced. The Second Circuit said it could not determine “with fair assurance that the outcome of the § 363 sale proceedings would have been the same” if claimants had been able to voice their objections to the free-and-clear provision. Pointing to the manner in which the terms of the sale had been modified in response to other objections, the Court said that the Bankruptcy Court should have recognized that the sale was a negotiated transaction with input from many parties. Because the Second Circuit could not “say with any confidence that no accommodation would have been made” it reversed the Bankruptcy Court’s decision.

The Take Away

The Motors Liquidation decision should give some pause about over reliance on free-and-clear treatment. First, purchasers in a section 363 sale must understand the limits of protection afforded under section 363(b), at least as interpreted by the Second Circuit. Second, the decision underscores the importance of meticulous diligence and adequate notice to all potentially affected parties. Notice to an overly expansive universe of possible creditors may present logistical and timing hurdles, but expediency may come at a heavy price.