The decision of the United States Court of Appeals for the Second Circuit in In re Motors Liquidation Company is yet the latest case to show the difficulty in using the bankruptcy process to resolve tort claims.[1]

The Background Basics

Shortly after Old GM commenced its chapter 11 bankruptcy case, it sold substantially all of its assets to New GM, an acquisition vehicle funded by the U.S. Department of Treasury. The sale occurred under section 363(f) of the Bankruptcy Code[2] and purported to be free and clear of liens, claims, and interests. Although New GM expressly assumed liability for accidents occurring after the closing date and for repairs arising from express warranties on vehicles sold by Old GM, the sale purported to be free and clear of all other claims relating to vehicles sold by Old GM.

Old GM gave publication notice of the proposed sale in various national publications but did not give any direct mail notice to vehicle purchasers. The parties consummated the sale within 40 days after the petition date.

Almost five years later, New GM announced that it would be recalling certain vehicles manufactured by Old GM because a defect in the ignition switch could prevent airbags from deploying.

The Second Circuit’s decision revolved around whether certain classes of vehicle owners could assert claims against New GM or could assert late claims against the bankruptcy trust established to pay prepetition claims against New GM: (i) vehicle purchasers who had suffered prepetition injuries as a result of the ignition switch defect, (ii) prepetition purchasers of vehicles manufactured by Old GM who claimed economic damages as a result of the ignition switch defect or other defects, and (iii) postpetition purchasers of used vehicles manufactured by Old GM who claimed economic damages as a result of the ignition switch defect.

The Good News for Debtors with Unknown Claims

Certain claimants argued that the bankruptcy court lacked jurisdiction to interpret and enforce the 363 sale order for their “independent” claims against New GM. The Second Circuit, however, found that the interpretation and enforcement of a bankruptcy court’s 363 sale order is a core matter “arising under” the Bankruptcy Code because the sale order would not exist but for the Bankruptcy Code. This jurisdiction extends to a determination of whether the sale order enjoins so-called independent claims. Moreover, an order determining that a 363 sale order covers certain claims is not a new injunction, but merely enforces an existing injunction.

Can a 363 sale protect against successor liability claims? Here, Second Circuit came down squarely on the side of the majority of courts that have held that an “interest” in property may include any rights that travel with the ownership of the property, including successor liability claims.

The Perhaps Obvious (But Often Overlooked) Part

To sell “free and clear” of certain claims, though, the holders must actually have “claims” that are capable of being treated in the bankruptcy case. For several years now, the Second Circuit has been consistent in its approach to “independent” claims against non-debtors. Because the bankruptcy court only has the power to address “claims” against a debtor, the Second Circuit previously has allowed claims that have been crafted as “independent” claims to proceed against non-debtors.[3] As a result, claims that alleged wrongful conduct, such as a failure to warn, by New GM, were not covered by the 363 sale order. The Second Circuit’s approach continues to leave the door open for creative plaintiffs’ lawyers as they attempt to construct independent claims against non-debtors.

What continues to be overlooked – and has not been addressed for some time by the Second Circuit – is how this line of reasoning affects one of the seemingly de rigueur plan provisions – the third party release. If a third party has a claim against a non-debtor that is wholly independent and not derivative of the debtor’s conduct, can that be released under the Second Circuit’s logic?

The Not So Good News for Debtors with Unknown Claims

In determining when “claims” arise, the Second Circuit applied its earlier reasoning in the Chateaugay line of cases,[4] in which the Second Circuit determined that a claim arises when the conduct that gives rise to that claim (i.e., construction defect, manufacture or sale of asbestos-containing product, or deposit of hazardous waste) occurs, coupled with some minimum “contact” or “relationship” (i.e., collapse of a defective bridge, exposure, or release) such that the rights do not “depend entirely on the fortuity of future occurrences.”[5] In GM, the Second Circuit characterized this second prong as requiring “some contact or relationship between the debtor and the claimant such that the claimant is identifiable.”

Applying this test, the Second Circuit characterized the GM claims as follows:

    • Pre-closing accident claims are “claims” because they are prepetition tort claims.
    • Economic loss claims by prepetition purchasers of vehicles also are prepetition claims because the owners had “come into contact with GM” prior to the petition date.
    • Postpetition purchasers of used vehicles, however, did not have claims as they did not have a prepetition “contact or relationship” with GM.

Although the first two holdings are straightforward (that is, until the Second Circuit later applies its additional layer of due process gloss), the treatment of used car claims seems troubling. Having concluded that a claim against a purchaser in a 363 sale can be barred to the extent it “travels” with the sold property, the Second Circuit switches its logic when it comes to the claimant who essentially inherits what the Second Circuit held was a prepetition claim. The rationale has its roots in some of the tests used by other jurisdictions (e.g., “fair contemplation” and relationship), but does it make sense in this context? If a prepetition purchaser of a defective vehicle (and, therefore, holder of a prepetition claim) sells her car and with it any latent claims associated with the car to someone postpetition, does her prepetition claim magically convert into a postpetition claim? Certainly, if the question arose solely in the context of claims purchases, no court would hold that the character of the claim would change in this way as a result of the claims sale. Why, then, does it change when the claim is attached to prepetition property that is sold postpetition?

The Second Circuit’s famous bridge analogy in Chateaugay is not exactly on point here. In Chateaugay, the court discussed the problem of what happens when a bridge built prepetition contains a structural defect and then collapses postpetition. The persons on the collapsing bridge had no way to protect themselves. The same, however, cannot be said of persons who purchase products manufactured by a debtor prepetition. To the extent that a claim “rides with the product,” any purchaser can and should be on notice that any claims against the debtor manufacturer or the purchaser of the debtor’s assets are no longer viable once the manufacturer files for bankruptcy protection and then sells its assets “free and clear.” The Second Circuit unnecessarily wove due process considerations into its definition of “claim,” thereby creating uncertainty about when a “claim” actually arises.

If the Second Circuit had stopped there, its decision may have been a little off course but generally in line with other courts’ treatment of unknown claims. In determining whether the 363 sale was free and clear of the admittedly prepetition claims, though, the Second Circuit added a layer of due process onto a test that already contained a due process qualification. That’s where the decision went off track.

The issue the Second Circuit had to address was what notice is due to an unknown claimant when the debtor has some level of knowledge that the prepetition claim exists. In other words, the asbestos debtor knows that people were exposed to its products, but it doesn’t know who was exposed. An organization knows that an employee has a history of sexual abuse of minors, but it doesn’t know who those individuals are. Claims are made that a component part of a product is defective, but the manufacturer of that part does not know the identity of the end users. What form of notice complies with due process in these circumstances?

Historically, following the principles of Mullane v. Cent. Hanover Bank & Tr. Co., 339 U.S. 306, 314 (1950), courts have reasoned that publication notice suffices when the identity of a claimant is unknown. Indeed, the Second Circuit in GM quotes from the U.S. Supreme Court’s decision in Schroeder v. City of New York, 371 U.S. 208, 212-13 (1962), which focuses on publication notice as being insufficient “with respect to a person whose name and address are known or very easily ascertainable.” The Second Circuit turns these established principles of focusing on whether a claimant is known into whether the debtor “knew or reasonably should have known about the claims.” Only if the “claims” are unknown, the Second Circuit reasons, is publication notice sufficient.

What then, does it really mean for a debtor to “know” or “reasonably should know” about a claim? The Second Circuit upheld the bankruptcy court’s finding that Old GM knew or reasonably should have known about the ignition switch defect and, therefore, given actual notice to consumers. The central issue, though, is whose knowledge is relevant? Although the Second Circuit likens the response of unnamed “GM personnel”[6] as willful blindness, it does not specifically address what diligence GM should have done, and what diligence future debtors could do.

The Second Circuit focuses on a “corporate culture that sought to pin responsibility on others” and even goes so far as to say that, even if GM had not known about the precise linkage between the ignition defect and the consequences of the defect, it had “enough knowledge” and should have revealed the facts it knew in bankruptcy. Although this requirement of full disclosure of facts that may give rise to claims is unprecedented, the Second Circuit characterized the request to discharge contingent claims based upon general notice to the public as a “request to reward debtors who conceal claims against potential creditors.”

Is the Second Circuit requiring actual notice or a confession from debtors?

The GM decision does little to establish a road map for addressing what might constitute a “known” or (new category) “knowable” claim in future cases, and courts will be left to develop the standard on an ad hoc basis. This lack of clear guidance may leave future debtors and purchasers of their assets stranded on the virtual bankruptcy swale waiting for assistance that never comes.

For purposes of due process, is it more important that the claim be unknown to the claimant, to the debtor, or both? Victims of sex abuse claims may know they have a claim while the debtor does not know their identity. A debtor may know that it conducted manufacturing operations at a former location, but may not know whether it released hazardous substances as a result of those operations. And, if we focus on the debtor’s knowledge, what knowledge is relevant and whose? Is the knowledge of an individual priest in an archdiocese relevant? Is the knowledge of former management relevant? How high up the chain must the knowledge or “potential knowledge” go?

Although the bankruptcy court had concluded that the unknown claimants had not received appropriate notice of the 363 sale, it nevertheless upheld the sale order with respect to their claims because it found that the claimants had not been prejudiced by the lack of actual notice. The Second Circuit, however, disagreed. The Second Circuit did not reach the issue of whether a showing of prejudice is even necessary once a finding of inadequate due process is made because it found that the GM claimants had demonstrated prejudice. Among other things, the Second Circuit considered that objections raised by other parties afforded those parties the opportunity to negotiate more favorable treatment even if such treatment was not technically

required by the Bankruptcy Code. “Opportunities to negotiate are difficult if not impossible to recreate.” The Second Circuit went on to say that “the business circumstances at the time were such that plaintiffs could have had some negotiating leverage, and the opportunity to participate in the proceedings would have been meaningful.”

What Options Remain for Debtors with Potential Unknown Claims?

Outside of the asbestos personal injury and wrongful death context,[7] the Bankruptcy Code provides no specific authority for debtors to address issues relating to unknown claims or unknown claimants. So, how should future debtors address the treatment of unknown claims and claimants in light of the GM decision?

One focus may be on giving notice to past and present customers. Does the company have a list of all customers? The Second Circuit states that individual GM claimants “were entitled to notice by direct mail or some equivalent.” Direct mail notice would seem to be overwhelmingly expensive. But what about e-mail notice? To the extent that a company collects e-mail addresses from customers, is this one way of providing notice of potential claims? We also need to consider whether notions of actual notice, rooted in Supreme Court decisions from the last century, are archaic given today’s methods of communications.

GM shows that in bankruptcy cases we continue to be rather limited in our thinking of how to give effective publication notice. In this day and age, even when publication notice is accepted, does a small ad in the back of USA Today and The Wall Street Journal really do the trick? Perhaps debtors should take a page from class action settlements and adopt a broader notice program designed to alert parties, particularly consumers, of the need to file a proof of claim or object to a 363 sale that is free of their existing and latent claims. To what extent should effective use of traditional media and social media replace traditional publication notice? Should a debtor post a notice on its Facebook page? How many Twitter followers does a debtor have? Among other things, debtors may want to consider how they can use newer forms of media, such as sending emails to addresses on record and posting notices on their Facebook pages, as a way of providing notice.

Although the Second Circuit suggests that its decision may have been different if GM had given actual notice of the sale and the claims bar date to original owners of cars, what should that notice have said? Would it have been sufficient if GM had given actual notice to all purchasers and stated, “We do not know if any defect exists with respect to the car you purchased from us, but if there is, you need to come forward and state a claim.”?

This relates directly to the conflict between unknown claimants and unknown claims. The GM decision raises questions about the extent to which a debtor must examine its books and records, the “knowledge” of its employees to determine where potential liabilities may arise, and the extent to which a debtor must disclose the nature of potential claims against it. Underlying the

GM decision is the Second Circuit’s frustration with “a corporate culture that sought to pin responsibility on others and a Sisyphean search for the ‘root cause.’” Bankruptcy is a one-time “Get out of jail free” card, so debtors need to consider what the price should be for a discharge, how much of an investigation they should conduct, and what they should disclose.

For present claims that are truly unknown and unknowable, what kind of due process can a debtor provide? Can an “unknown claimants’ representative” substitute for actual notice to holders of prepetition claims if the identity of those holders is uncertain? Nothing in the Bankruptcy Code actually recognizes the appointment of such a representative outside of the asbestos personal injury context, but courts have embraced the notion of an “unknown claimants’ representative” as a means of skirting difficult issues about binding prepetition claimants, such as in the sexual abuse claims. Moreover, does appointment of an “unknown claimants’ representative” put the cart before the horse? How effective will that solution be if the debtor is not forthcoming about its potential liabilities? Will the “unknown claimants’ representative” become a quasi-examiner with the power to investigate latent claims against the debtor? Finally, does the “unknown claimants’ representative” concept even work legally for latent claims? GM suggests that some kind of privity or injury is still required for a latent tort claim to be considered a “claim” at all. So, who may even be included within the group bound by the due process provided by having a representative appointed on behalf of an unknown claimant?

Conclusion

GM leaves open a number of questions and places some obstacles along the way of a debtor seeking to discharge latent claims. One point is crystal clear, though: “Due process applies even in a company’s moment of crisis.”