Reprinted with permission from the March 18, 2011 issue of The Legal Intelligencer © 2010 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

Over the last couple of years, the predominant goal in many business bankruptcy proceedings has been the sale of substantially all of the estate's assets. Such bankruptcy sales are often favored by buyers under Section 363(f), which enables a "free and clear" transfer of the assets.

From the estate's perspective, these sales typically lead to a higher price in a shorter period of time than might otherwise be obtained. Under the Bankruptcy Code, a "free and clear" sale involves both in rem and in personam relief. The extent of the in personam relief that a court can grant and its impact on the potential successor liability of a buyer under § 363(f) was recently revisited by the U.S. Bankruptcy Court for the Southern District of New York in Grumman Olson Industries v. Frederico (In re Grumman Olson Industries).

In Grumman , much to the buyer's chagrin, the court concluded that while § 363(f) absolves the buyer of in personam liability for pre-confirmation claims in a Chapter 11 case, it does not automatically extinguish exposure for successor liability to future tort claims.

Grumman Olson Industries, the debtor, designed, manufactured and sold truck body products that were mounted on chassis sold by Ford Motor Co. and General Motors Corp. In 2002, the debtor filed a Chapter 11 petition, and in July 2003, the court entered an order approving the sale of the debtor's assets to Morgan Olson LLC (Morgan), pursuant to Bankruptcy Code §§ 363 and 365. The sale order included provisions releasing Morgan from in personam liability for certain tort claims that could arise after the sale, related to allegedly defective products previously manufactured and sold by the debtor.

According to the bankruptcy court's opinion, in October 2009, John and Denise Frederico commenced a personal injury action against Morgan in the Superior Court of New Jersey. Denise Frederico, a FedEx employee, sustained injuries in October 2008 when the FedEx truck she was driving struck a telephone pole. The Fredericos alleged that the FedEx truck involved in the accident was defective and that the truck had been manufactured, designed and sold by the debtor in 1994.

In March 2010, Morgan commenced an action in the bankruptcy court, seeking declaratory and injunctive relief barring the Fredericos from proceeding against Morgan in state court. The sale order protected Morgan from liability for claims against the debtor arising prior to, or as a result of, the purchase and sale. The sale order further provided that Morgan could not be deemed a successor of the debtor or be responsible for "'any liability of the debtor'" as a result of the consummation of the sale, the opinion noted. Morgan contended that the sale order protected it from all tort claims arising from products manufactured and sold prior to the bankruptcy sale, and because the truck involved in the accident was manufactured and sold by the debtor prior to the bankruptcy sale, Morgan could not be liable to the Fredericos.

Section 363(f) of the Bankruptcy Code authorizes the trustee to sell an estate's interest in property "free and clear of any interest in such property." Section 363(f) specifically speaks to in rem relief, which clears the assets themselves of attendant liabilities, and allows the buyer to acquire them without apprehension that a creditor can enforce a claim against those assets. In addition, § 363(f) has been interpreted to authorize the bankruptcy court to grant in personam relief, thus exonerating the buyer from successor liability, including liability for future tort claims.

Morgan argued that the sale order effectively protected it from all successor liability claims. However, the Grumman court disagreed and found that the sale order could only shield Morgan from liability against those plaintiffs who held a "claim" in the bankruptcy case. The sale order protected Morgan from liability for claims arising against the debtor, but it was not a complete protection against all tort liabilities. Whether the claim was one that Morgan was protected from by the sale order depended on the categorization of the future tort liability asserted by the Fredericos.

The court in Grumman explained that future tort claims fall into two categories. The first category, contingent or unmatured claims, include those victims who had pre-petition physical contact with, or exposure to, a debtor's product but have not yet manifested symptoms or discovered their injury. This category of claims is a liability of the debtor that can be protected against by a sale order because these victims hold a "claim" against the estate at the time of the bankruptcy sale. The court noted that Bankruptcy Code § 101 (5)(A) broadly defines a "claim" to mean a "right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, or unsecured."

The second category of future tort claims, potential claims, consists of victims who are injured after the consummation of an asset sale, as a result of a defective product manufactured and sold by the debtor prior to the bankruptcy. Dealing with this second category of future claims in a bankruptcy case raises numerous practical and constitutional issues. In this category of future tort claims, potential victims are not only unidentified, but there is no way to identify them at the time of the bankruptcy sale. Furthermore, in order to satisfy due process and the Bankruptcy Code, a party must receive adequate notice before his or her rights may be adversely affected. It is not possible to provide these potential claimants with proper notice prior to the sale, and even if such a claimant were made aware of the case, the knowledge would be meaningless as he or she could not file a claim based on an accident that had not yet occurred. Therefore, liability for this category of tort claims cannot be shielded by a sale order.

The Grumman court employed the "Piper" test to distinguish between contingent or unmatured claims, which are "claims" within the meaning of § 101 (5), and potential future tort claims, which are not. The "Piper" test provides that: "An individual has a § 101(5) claim against a debtor manufacturer if (i) events occurring before 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. The debtor's prepetition conduct gives rise to a claim to be administered in a case only if there is a relationship established before confirmation between an identifiable claimant or group of claimants and that prepetition conduct."

The Fredericos' claim failed to meet the "Piper" test, and therefore was not a "claim" against the debtor's estate, existing at the time of the bankruptcy sale. The Fredericos did not have contact with the debtor prior to the accident, they had not dealt with the debtor, and the only connection was that Denise Frederico's employer purchased a truck manufactured by the debtor. Accordingly, the court determined the Fredericos held a potential future tort claim, and that the sale order did not affect the Fredericos' rights to sue Morgan.

The Grumman court not surprisingly concluded that Section 363(f) authorizes the court to absolve the buyer of in personam liability for pre-confirmation claims in a Chapter 11 case. However, a person like Denise Frederico, who is injured after a bankruptcy sale by an allegedly defective product manufactured and sold prior to the entry of the sale order, may well not hold a "claim" in the bankruptcy case, but rather represents a potential future liability of the buyer.

The Grumman decision is a well-written reminder that an asset buyer in a Section 363 sale should not be lulled into believing that a "free and clear" order really means that there will be no trailing liabilities. A careful analysis, including a thorough understanding of the products manufactured and sold prior to the entry of the sale order that remain in the stream of commerce is critical. If this situation exists, then a buyer should consider insisting upon the formation by the seller of a trust or some similar vehicle to which those "future claims" can be channeled.