Under section 363 of the Bankruptcy Code, a trustee or debtor-in-possession may sell property free and clear of “any interest in such property of an entity other than the estate.” Thus, a buyer can generally acquire assets from a bankruptcy estate without subjecting itself to liability or claims based on the seller’s prior actions. In Morgan Olson, LLC v. Frederico (In re Grumman Olson Indus., Inc.), No. 02-16131, 2011 WL 766661 (Bankr. S.D.N.Y. 2011), the Bankruptcy Court for the Southern District of New York recently held, however, that a sale under section 363(f) of the Bankruptcy Code did not absolve a buyer of successor liability claims asserted by individuals who were injured after the sale, but at the time of the bankruptcy petition had no identifiable relationship with the debtor or its conduct.

Background  

Grumman Olson Industries, Inc. (“Grumman” or the “Debtor”) was a designer and manufacturer of parts for the truck body industry. Its products were sold to and incorporated into the products of, among other companies, Ford Motor Company and General Motors Corporation. Grumman filed for chapter 11 on December 9, 2002 in the Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court” or the “Court”). On July 1, 2003 the Court approved the sale of certain of the Debtor’s assets (the “Transferred Assets”) to a predecessor of Morgan Olson LLC (“Morgan”) free and clear of any liens, claims and interests pursuant to section 363 of the Bankruptcy Code.

Among other things, the sale order provided that the Transferred Assets were sold free and clear of any and all claims arising in connection with the acts of the Debtor and holders of such claims were permanently enjoined from proceeding against the Transferred Assets. Additionally, the sale order released Morgan from in personam liability for obligations of or claims against the Debtor arising prior to the sale or related to the Transferred Assets. Following the sale, the Court confirmed a joint liquidating plan and closed the case in 2006. After acquiring the Transferred Assets, Morgan continued to produce and market the product line as that of Grumman.

In 2009, John and Denise Frederico (the “Fredericos”) commenced a lawsuit against Morgan in New Jersey state court. They alleged that they were injured by a product manufactured, designed and/or sold by the Debtor in 1994 — years before the commencement of the Debtor’s bankruptcy case. In particular, Ms. Frederico, a FedEx driver, alleged that she was seriously injured in 2008 when the truck she was driving hit a telephone pole and that Grumman’s product was responsible for her injuries. The Fredericos asserted their claims against Morgan based on theories of successor liability under New Jersey law. According to the Fredericos, Morgan had continued Grumman’s product line following its purchase of the Transferred Assets and was therefore liable for the Fredericos’ damages.

In response, Morgan commenced an adversary proceeding against the Fredericos in the Bankruptcy Court for declaratory and injunctive relief, alleging that the sale order relieved Morgan of any liability stemming from Grumman products manufactured or sold prior to the sale. After finding that the case presented a core proceeding over which it had subject matter jurisdiction, the Court turned to whether section 363(f) absolved a buyer of in personam liability for successor liability claims brought by persons who were injured after the sale but, at the time of the bankruptcy petition had no prior identifiable relationship to the debtor or its products.  

The Scope and Effect of § 363(f)

Section 363(f) of the Bankruptcy Code allows a trustee to sell property of the estate “free and clear of any interest in such property of an entity other than the estate.” The phrase “interest in property” as used in this section includes “claims” that arise from or relate to the property. On its face, section 363(f) grants only in rem relief — that is, relief against the property — and allows a buyer to acquire property of the estate without fear that an estate’s creditor may later enforce its claim against the property. A number of courts have interpreted section 363(f) to extend to in personam relief as well, exonerating not only the transferred property but also the buyer itself. Such relief serves two important policies: (1) it preserves the priority scheme of the Bankruptcy Code and equality of distribution by preventing a plaintiff creditor from asserting claims against the buyer while other creditors are left to satisfy their claims from the sale proceeds; and (2) it maximizes the value of the sale assets insomuch that it induces buyers to enter the transaction.

In the instant case, the Fredericos sought to enforce their claims not against the purchased property, but against Morgan itself. Consequently only the Court’s grant of in personam relief was called into question. Because the claim did not arise “as a result” of the purchase and sale of the Transferred Assets, the Court noted that the sale order could only have released Morgan from claims “arising prior to . . . the purchase and sale of the [Transferred Assets].”

Did the Plaintiffs Hold a “Claim” at the Time of Sale?

Section 101(5)(A) of the Bankruptcy Code defines a claim as a “right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.” This broad definition evinces Congress’ intent that all legal obligations of a debtor — no matter how remote or contingent — can and should be resolved during the bankruptcy case.  

Despite this expansive definition, courts have acknowledged certain limits on claims, particularly in areas dealing with future tort claims. In In re Chateaugay Corp., 944 F.2d 997 (2d Cir. 1991), the Second Circuit identified two categories of future tort claims: (1) those where the claimant has had pre-petition contact with the debtor or its product but has not yet discovered the injury or manifested symptoms (e.g., asbestos cases); and (2) those where the claimant is injured post confirmation by a product manufactured and sold by the debtor before the bankruptcy. The Court noted that the Fredericos’ claim fell within the second category. The second category of future claims poses a number of problems, however, as highlighted by the Second Circuit in the following hypothetical:

[A] company . . . builds bridges around the world. It can estimate that of 10,000 bridges it builds, one will fail, causing 10 deaths. Having built 10,000 bridges, it becomes insolvent and files a petition in bankruptcy. Is there a “claim” on behalf of the 10 people who will be killed when they drive across the one bridge that will fail someday in the future? If the only test is whether the ultimate right to payment will arise out of the debtor’s pre-petition conduct, the future victims have a “claim.” Yet it must be obvious that enormous practical and perhaps constitutional problems would arise from recognition of such a claim. The potential victims are not only unidentified, but there is no way to identify them. Sheer fortuity will determine who will be on that one bridge when it crashes. What notice is to be given to these potential “claimants”?

To address this difficulty, Chateaugay adopted a “fair contemplation” test, which requires a court to determine whether the occurrence of the contingency or future event that would trigger liability was “within the actual or presumed contemplation of the parties at the time the original relationship between the parties was created.” If yes, then there exists a contingent or unmatured “claim” under section 101(5). If no, there is merely a potential future tort claim not encompassed by section 101(5).  

The Eleventh Circuit adopted a modified Chateaugay test in In re Piper Aircraft, 58 F.3d 1573 (11th Cir. 1995). As the following facts demonstrate, the hypothetical posed in Chateaugay became reality in Piper Aircraft. The debtor had manufactured aircraft and spare parts for more than five decades and at the time of its chapter 11 filing between 50,000 and 60,000 Piper aircraft were still operational in the United States. Knowing, as a statistical matter, that some of the planes would crash, the agreement to sell Piper’s assets required the establishment of a fund to compensate future products liability claimants. When the representative of the fund filed a $100 million claim on account of such claims, the creditors’ committee objected, arguing that the future claimants did not hold “claims” under section 101(5).

In Piper Aircraft, the Eleventh Circuit held that a claim fits within section 101(5) only if: “(i) events occurring before the confirmation create a relationship, such as contact, exposure, impact, or privity, between the claimant and the debtor’s product; and (ii) the basis for liability is the debtor’s prepetition conduct in designing, manufacturing and selling the allegedly defective or dangerous product.” Further, the court stressed that the relationship must be between an “identifiable claimant or group of claimants” and the debtor’s prepetition conduct. Applying this test, the Eleventh Circuit held that the fund’s $100 million claim was not a “claim” within section 101(5)’s meaning.

Returning to Grumman, the Bankruptcy Court held that the Fredericos’ right to payment was not a “claim” within the meaning of section 101(5). This situation, explained the Court, fell squarely within the Chateaugay hypothetical and represented an “extreme case of pre-petition conduct that has not yet resulted in any tortious consequence.” The Fredericos had no contact with Grumman prior to the accident and, indeed, their only contact with Grumman was through Mrs. Frederico’s employer. Similarly, at the time of the sale, the Fredericos were not identifiable claimants and could not have been notified of the release of their claims as required by due process and section 363(b). Further, even had the Fredericos received notice, the knowledge would have been meaningless as there would have been nothing for them to do with it. Consequently, the Fredericos did not hold a claim against Grumman at the time of the asset sale and the sale order did not release the rights of the Fredericos to sue Morgan.  

Conclusion

This case should serve as a reminder to potential buyers that “free and clear” are not magic words absolving all types of liability. Purchasers of section 363 assets must still carefully consider the nature of products already in the stream of commerce and how those products may give rise to future liability. How to best account for this risk and whether this ruling will cause future reluctance on the part of potential buyers to enter into section 363 transactions remains to be seen. In the interim, however, buyers should continue to beware.