In 2009, General Motors (“Old GM”) commenced a chapter 11 case and sold the bulk of its business and assets to a new entity (“New GM”) “free and clear” of liabilities against New GM. Notwithstanding the “free and clear” language of the 2009 sale order (the “Sale Order”), a Second Circuit panel recently held that plaintiffs could assert claims against New GM over faulty ignition switches in cars manufactured by Old GM and recalled in early 2014. Because Old GM had knowledge of those claims prior to the sale, the court held that the plaintiffs were entitled, as a matter of procedural due process, to actual notice of the bankruptcy sale and an opportunity to assert their claims and participate in the complex negotiations prior to the sale. As a result, the bankruptcy court could not enforce the sale order to enjoin the plaintiffs’ claims. The decision has important implications for asset sales under section 363 of the Bankruptcy Code, as companies that purchase the assets of debtors in such sales may face unanticipated claims arising from the debtors’ pre-sale acts.

Bankruptcy Case Background

In 2009, Old GM entered chapter 11 with federal backing for a sale of its assets to the majority government-owned New GM. Following exhaustive negotiations and over hundreds of objections asserted by consumer organizations, states attorneys generals, and accident victims, the Bankruptcy Court for the Southern District of New York issued an order approving the section 363 sale of Old GM’s assets.

The Sale Order provided that the sale was “free and clear of all liens, claims, encumbrances, and other interests of any kind or nature whatsoever, including rights or claims based on any successor or transferee liability.” However, New GM expressly assumed certain liabilities for, among other things, post-sale accident repairs and injuries, express car sale warranties, and “Lemon Law” claims under state law. Old GM noticed the proposed sale in major publications and through direct notice to “all parties…known to have asserted any lien, claim, encumbrance, or interest in or on [the to‐be-sold assets].”

Following the sale, Old GM, the chapter 11 debtor-in-possession, retained substantial assets and most liabilities. Upon confirmation of Old GM’s liquidation plan on March 29, 2011, a General Unsecured Claims Trust (“GUC Trust”) was established to provide certain holders of unsecured claims against Old GM with, among other things, warrants to purchase stock in New GM.

Ignition Switch Defect Claims

In February 2014, New GM issued recalls with respect to an ignition switch defect that resulted in some GM cars shutting off while in motion. The GM cars were manufactured by Old GM prior to the bankruptcy case, and the defects resulted in injuries and damages both before and after entry of the Sale Order. Old GM did not provide actual notice of the sale to any parties in connection with the ignition switch defects.

In April 14, 2014, class action plaintiffs filed the first of several class lawsuits against New GM with respect to cars manufactured and sold by Old GM or used GM cars sold secondhand after the Section 363 sale. New GM argued that the claims should be brought against Old GM only because the Sale Order barred claims against New GM (with the exception of post-sale injuries, repairs, and Lemon Law claims). In total, the amount of damages sought for economic losses and amounts arising from pre-sale accidents totaled over $10 billion. The plaintiffs soon filed actions against New GM and claims against the GUC Trust, and related objections, in the Old GM bankruptcy case. New GM sought an order enforcing the Sale Order as a liability shield.

Among several orders, the bankruptcy court held that the Sale Order protected New GM from liability. The court agreed with plaintiffs that Old GM knew or should have known of the ignition switch claims prior to the sale, and procedural due process entitled the plaintiffs to actual notice of the sale to New GM. However, the court found that most plaintiffs were not prejudiced by the absence of actual notice of the sale, because the court would have approved the sale to New GM regardless, given the stakes at the time. The court certified the orders for direct appeal to the Second Circuit.

The Second Circuit’s Decision

On appeal, the Second Circuit panel addressed, among other issues: (1) whether the plaintiffs each asserted “claims” of the kind that could be treated in bankruptcy and enjoined in the Sale Order, and if so, (2) whether enforcement of the Sale Order to bar those claims would violate procedural due process.

First, the Second Circuit held that some of the plaintiffs did not have bankruptcy “claims” at all. Section 363 of the Bankruptcy Code provides that a debtor’s “interests” may be sold “free and clear” of liens. Despite language in a 2009 Second Circuit decision in the Chrysler bankruptcy case suggesting that “interests” includes successor liability claims, the court declined to follow the decision because it was later vacated by the Supreme Court and not controlling precedent. Instead, the court held that whether “claims” are “interests” must be determined on a case-by-case basis by looking to whether they are “claims” for as defined by the Code and in the bankruptcy jurisprudence.

In short, the Second Circuit explained that a “claim” is (1) a right to payment (2) that arose before the filing of the bankruptcy petition. Rights to payment that are contingent on future events are bankruptcy “claims” if they “result from pre-petition conduct fairly giving rise to that contingent claim.” Where pre-petition conduct has not yet resulted in detectable injury, courts require some minimum “contact” or a “relationship” between the debtor and the claimant that allows for identification of the claimant.

The Second Circuit held that the plaintiffs’ pre-Sale accident claims and economic loss claims arising from ignition switch defects were “claims” in the bankruptcy case and for purposes of the Sale Order because they arose before the petition date from Old GM’s production of cars with ignition defects. In contrast, certain other claims related to New GM’s conduct and used car purchaser claims were not “claims” that could be enjoined by the bankruptcy court because they were not based on Old GM’s conduct and had no relation to Old GM prior to the Section 363 sale.

Second, the court held that enforcing the Sale Order to enjoin the pre-Sale ignition switch accident claims and economic loss claims against New GM would deprive the plaintiffs of due process because they did not receive adequate notice of the sale. “Adequate notice” requires actual notice through direct mail, and not merely publication notice, if the debtor “knew about the claim or, with reasonable diligence, should have known.” The Court cited considerations such as federal recordkeeping requirements for vehicle ownership applicable to GM, GM’s knowledge of ignition switch defects as early as May 2009, and GM’s failure to provide any notice of the defects despite extensive complaints.

Next, the court declined to say whether the plaintiffs were required to show, in order to establish a deprivation of due process, that they were prejudiced by the lack of adequate notice. However, the court held that even if required, the claimants showed prejudice because the outcome of negotiations, the section 363 sale proceedings and the Sale Order could have been very different if Old GM had disclosed the ignition switch defect:

Opportunities to negotiate are difficult if not impossible to recreate. We do not know what would have happened in 2009 if counsel representing plaintiffs with billions of dollars in claims had sat across the table from Old GM, New GM, and Treasury. Our lack of confidence, however, is not imputed on plaintiffs denied notice but instead bolsters a conclusion that enforcing the Sale Order would violate procedural due process.

Among other considerations suggesting that adequate notice to Plaintiffs could have affected the outcome of negotiations and the Sale Order, the court cited the business needs of protecting GM’s brand, consumer confidence, and the federal government’s likely interest, as majority owner of New GM at that time, in protecting faultless claimants.

Conclusion

New GM intends to petition for a rehearing by the Second Circuit. If the petition is denied, the Second Circuit’s July 13 ruling will stand as a significant development in bankruptcy law. However, the decision does not bar enforcement of sale orders with respect to claims that were completely unknown and unidentified when the bankruptcy petition was filed and are wholly dependent on future events. Further, the full impact of the decision may be limited due to the unprecedented nature of the GM case: the degree of federal involvement in GM’s restructuring, the detailed record of Old GM’s knowledge of the ignition switch defects, and what the Second Circuit described as a lacking safety culture and a “reckless disregard of the facts.” Purchasers of assets in Section 363 sales may argue that courts should only follow the Second Circuit’s decision where not doing so would “reward debtors who conceal defects.” The decision also leaves open the question of whether plaintiffs asserting successor liability claims and challenging “free and clear” sale orders must show prejudice to establish a violation of due process.

Nevertheless, plaintiffs are now equipped with an important precedent establishing that “free and clear” sale orders do not shield asset purchasers from liability for claims that were known or reasonably known by debtors if the debtors fail to provide actual notice of the asset sale to parties holding the claims.