In a recent decision by the U.S. Court of Appeals for the Second Circuit in the General Motors case, the court held certain claimants were not afforded procedural due process with respect to the § 363 sale of General Motor Corporation’s assets in the bankruptcy case. As a result, the assets were not sold free and clear of these claims, and these claimants may now seek recovery against New GM. The decision found that the claimants were prejudiced by the inadequate notice because the claimants did not have an opportunity to be heard, even though the claimants were unable to articulate any objection to the sale order that had not been made by others and rejected by the bankruptcy court in approving the sale order.

Background

General Motors Corporation (“Old GM”) filed chapter 11 bankruptcy on June 1, 2009 and requested the bankruptcy court approve an immediate § 363 sale of substantially all of its assets free and clear to General Motors LLC (“New GM”).1 The free and clear provision was intended to protect New GM from liability relating to claims against Old GM. After hearing over 850 objections, the bankruptcy court entered the sale order on July 5, 2009, and the sale closed on July 10, 2009. Old GM remained in bankruptcy with some assets to liquidate.

In February of 2014, New GM issued over 60 recalls relating to an ignition switch defect, and the recalls effected over 25 million vehicles. Shortly thereafter, dozens of class action lawsuits were filed asserting that the ignition switch defect caused personal injuries and economic losses before and after the § 363 sale closed. On April 21, 2014, the plaintiffs initiated an adversary proceeding against New GM and asserted claims arising from the ignition switch defect. New GM requested the bankruptcy court enforce the sale order and enjoin the claims brought in the adversary proceeding as well as in the various class actions.

Discussion

Section 363 of the Bankruptcy Code governs the sale of property, and provides that property may be sold free and clear of any interest in such property if certain conditions are met. Sections 363 and 1141(c) of the Code shield debtors from liability for pre-petition claims, so long as the claims are disclosed in the bankruptcy case and the claimants are provided adequate notice.

In the adversary proceeding, the bankruptcy court found that the plaintiffs were entitled to actual notice (i.e notice by mail) rather than notice by publication, because Old GM knew or should have known of the ignition switch defects, but failed to disclose them. The court held that the plaintiffs were not provided notice as required by procedural due process because the plaintiffs only received publication notice. Nevertheless, the bankruptcy court enforced the sale order and enjoined most of the claims because it determined the plaintiffs were not prejudiced by the inadequate notice. The bankruptcy court so held due to plaintiffs’ inability to provide any legal basis on which the court would have sustained an objection to the sale order, other than arguments made and rejected prior to its approval of the sale order.

The plaintiffs appealed the bankruptcy court’s decision and argued enforcing the sale order would violate procedural due process. On appeal, the Second Circuit found no clear error in the bankruptcy court’s finding that the notice provided was inadequate. However, it reversed the bankruptcy court’s holding with respect to prejudice. The Second Circuit was unable to determine “with fair assurance that the outcome of the § 363 sale proceedings would have been the same had Old GM disclosed the ignition switch defect and these plaintiffs voiced their objections to the ‘free and clear’ provision.” The Second Circuit recognized that the bankruptcy court may have been unwilling to withhold approval of the sale and force a liquidation, but explained that the sale order could have accommodated the ignition switch defect claims. The Second Circuit pointed out that other stakeholders objected to the § 363 sale, and that the objections were effective and influenced the § 363 transaction even though the objections were not legal in character. More specifically, New GM assumed liability with respect to state Lemon Law claims after numerous state attorneys general objected to the sale. These objections were effective in bringing GM to the negotiating table even though the state attorneys general were unable to cite any legal support for their objections. According to the opinion, the bankruptcy court failed to recognize that the § 363 “sale was a negotiated deal with input from multiple parties” – and these stakeholders could have included the plaintiffs.

The GM bankruptcy case was unusual because of the involvement of the U.S. Government. The President and Treasury oversaw the affairs of New GM, and the Treasury owned a majority stake in the company after the sale. As the opinion points out, Old GM, New GM, and the United States government were under tremendous pressure to restore consumer confidence in the company by completing the § 363 sale quickly. The Second Circuit concluded that under these circumstances, the ignition switch defect claimants would likely have had negotiating leverage to obtain at least some concessions with respect of their claims, despite having objections that the bankruptcy court overruled in approving the sale.

Implications

The “free and clear” feature of bankruptcy sales is of enormous value and importance to buyers of distressed assets. To the buyer, it provides peace of mind that it will not be liable on account of legacy liabilities; to the debtor-seller and its creditor body it translates into a significant premium over the value that can be obtained had the buyer become liable for the debtor’s legacy liabilities. But, as General Motors reminds us, the protection is only as good as the associated notice given. A party who is required to receive notice of the hearing to approve a sale (because it is a known creditor) and does not get it, is not bound by its terms.

The decision should serve as a reminder that the “free and clear” feature of bankruptcy sales does not eliminate the need for meticulous due-diligence designed to identify all known, significant creditors and giving them actual notice of the sale. A buyer who fails to do so may find itself liable for the seller’s known and undisclosed liabilities.

Read the decision »