When Successor Liability and Bankruptcy Principles Collide

Company A manufactures a product that is used by millions of consumers, and it is facing thousands of personal injury claims seeking millions of dollars based on an alleged defect in that product. The financial burden of this litigation, coupled with inadequate liability insurance, pushes Company A into bankruptcy. Even though it has developed a new product design that likely eliminates the defect, Company A is unable to reorganize and seeks to sell its business through the bankruptcy. Company B is interested in acquiring the business but has been cautioned by its lawyers about the risk of possible successor liability for Company A’s liabilities, including possible “future claims” arising from the use of Company A’s old product after the bankruptcy. Can Company B safely make the acquisition?

Generally, a good-faith purchaser of assets does not incur liability for the debts of the seller.¹ However, liability for unpaid debts of the seller may be imposed on the purchaser by statute or under the common law doctrine of “successor liability.” Under common law, the four generally recognized exceptions to the general principle of nonassumption of debt are (1) where the purchaser expressly or impliedly agrees to assume the seller’s debts, (2) where the transaction amounts to a consolidation or de facto merger, (3) where the purchaser is “merely a continuation” of the seller or (4) where the transaction is entered into fraudulently to escape liability.²

There is some disagreement about whether the successor’s liability is dependent on the liability of the seller or is an independent liability of the successor. If the successor’s liability depends on the seller’s liability, then the discharge in bankruptcy of the seller’s liability might shield the successor, and the expiration of the statute of limitations for suing the seller might be invoked as a defense by the purchaser.³ However, there is some support for the view that the purchaser’s liability, while rooted initially in the seller’s liability on the original claim, is an independent liability.⁴

Successor liability, whether imposed by statute or common law, sometimes collides with important goals of bankruptcy policy, including equality of distribution and maximizing the value of an estate. Prior to the 1990s, the ability of an asset purchaser to acquire property in a bankruptcy sale free and clear of successor liability was still somewhat uncertain. By the mid-2000s, however, the case law at the federal court of appeals level began to make it clear that, in a properly structured bankruptcy sale or Chapter 11 reorganization, assets could be acquired free and clear of successor liability.⁵

In a bankruptcy case, assets can be sold in two ways: a sale pursuant to Section 363 of the Bankruptcy Code⁶ or a sale pursuant to a confirmed Chapter 11 plan of reorganization.⁷ Under Section 363, the trustee or debtor-in-possession may sell all of the debtor’s assets out of the ordinary course of business free and clear of “interests.”⁸ Most authorities have held that a properly conducted bankruptcy sale conveys the assets free and clear of not only property interests, such as liens and encumbrances, but also claims, including successor liability claims.⁹ Conveying assets pursuant to a Chapter 11 plan arguably affords greater protection because Section 1141(c) of the Bankruptcy Code provides that property “dealt with” by a confirmed Chapter 11 plan shall be “free and clear of all claims and interests of creditors.”¹⁰

The efficacy of a bankruptcy sale to cut off pre-existing debts and claims will depend, in part, on the adequacy of the notice of the sale given to interested parties.¹¹ As a general rule, the trustee or debtor-in-possession is required to give notice of any proposed sale of property of the estate outside the ordinary course of business to all creditors and, in a Chapter 11 case, to all equity security holders of the debtor.¹² The bankruptcy court often will require that a proposed sale outside the ordinary course of business be appropriately advertised. Notice must be given to the holders of liens.¹³ If a creditor is adequately notified that the assets will be sold free and clear of liens, claims and encumbrances (including successor liability) and does not object, that creditor will be bound under preclusion principles by entry of a valid sale order.¹⁴

Special problems are presented by so-called “future claims” and certain types of environmental liabilities. A future products liability claim arises when (1) a person is harmed prior to the sale by a product introduced into commerce by the seller and the health effects will not be manifested until after the sale or (2) a person is harmed after the sale by a product introduced into commerce by the seller prior to the sale.¹⁵ To insulate the purchaser from successor liability for future claims, the transaction generally will be effectuated under a Chapter 11 plan, a representative of the putative claimants will be appointed and afforded an adequate opportunity to represent their interests in the bankruptcy case, and specific provisions will be made, by way of a trust fund or otherwise, for the fair and equitable treatment of such claimants.¹⁶

Courts have held that injunctions obtained under environmental statutes to abate ongoing pollution are not within the ambit of “claims” under the Bankruptcy Code and, accordingly, are not dischargeable under a Chapter 11 plan.¹⁷ Environmental agencies regularly insist that special measures be taken by the parties to provide funding for the remediation of assets on which there is ongoing pollution generated by the debtor, often by establishing trust funds.¹⁸ Moreover, when a purchaser acquires assets on which contamination created by the seller remains, the purchaser will have liability to address the contamination as the current owner or operator of the property without regard to the doctrine of successor liability.¹⁹

There are currently a number of pending coal company bankruptcies that may give rise to successor liability issues. In a coal company bankruptcy, an asset purchaser will likely confront the risk of being bound by the “successorship” provisions of collective bargaining agreements as well as potential statutory successor liability for retiree health care benefits premiums imposed under the federal Coal Industry Retiree Health Benefit Act.²⁰ A federal district court in the Northern District of Alabama recently affirmed the holdings of a bankruptcy court that the debtors’ liabilities for premiums under the Coal Act were “interests in property” under Section 363(f) of the Bankruptcy Code and that the debtors’ assets could be sold to a purchaser free and clear of such interests under Section 363.²¹ The bankruptcy court also held that the debtors’ collective bargaining agreements could be rejected under Section 1113 of the Bankruptcy Code,²² the debtors’ obligations to their retirees could be terminated under Section 1114,²³ and the purchaser could acquire the debtors’ assets free and clear of any successor employer obligations to the debtors’ employees and retirees under the debtors’ collective bargaining agreements.²⁴

Returning to the hypothetical posed above, Company’s B’s advisers advise it to do the following: (1) acquire the assets pursuant to a confirmed Chapter 11 plan with notice of the plan and the sale being given to all known existing claimants and to a court-designated representative for any future claimants; (2) ensure that the plan provides for the payment or assumption of all present debts and establishes a mechanism to enable future claimants to participate in plan distributions; (3) obtain an injunction channeling the claims of the claimants to assets set aside under the plan and insulating Company B from successor liability; and (4) ensure that the plan proponents present evidence sufficient to enable the court to find that, without the cutoff of successor liability, the plan could not be consummated.²⁵

This article was published on July 1, 2016 in the Bankruptcy, Commercial Contracts, Energy, Environmental, Mergers & Acquisitions and Product Liability sections of Law360.