Important Court Decision Addresses Scope of Successor Liability Releases in Bankruptcy Asset Sales

A new decision from a New York federal district court highlights certain risks faced by persons buying assets out of bankruptcy. Buyers may be subject to successor liability based on the seller's conduct before the bankruptcy if no injury was caused until after the bankruptcy sale. Buyers of bankruptcy assets will need to do additional diligence to ensure that they are not unwittingly acquiring hidden liabilities.
 
In In re Grumman Olson Industries, Inc., the U.S. District Court for the Southern District of New York was asked to decide whether a "free and clear" sale order entered by the bankruptcy court prevented a personal injury plaintiff from suing the acquirer of the assets of a bankrupt manufacturer. The court concluded that the plaintiff's suit could proceed in state court, notwithstanding strong exculpatory language to the contrary in the sale order.
 
The sale order relieved the acquirer from any claims arising from the assets, "whether arising prior to or subsequent to" the bankruptcy, and provided that the acquirer would have no successor liability or responsibility for claims arising from the assets. The district court, however, held that the language in the sale order could not be enforced against a claimant who was uninjured at the time of the sale, and thus never received notice of the bankruptcy. Enforcing the sale order would violate due process since the claimant had no opportunity to object.
 
Grumman Olson Industries manufactured trucks. In 2002, Grumman filed for bankruptcy, and in 2003, Grumman sold some of its assets to the company now known as Morgan Olson. Sometime after the bankruptcy ended, Denise Frederico was injured while driving a truck manufactured by Grumman before the bankruptcy. Ms. Frederico then sued Morgan on the theory that it was liable as a successor to Grumman under applicable state law.
 
Morgan returned to the bankruptcy court and asked the court to enforce the sale order exculpating Morgan from claims. Ms. Frederico protested, arguing that she had not yet been injured when the bankruptcy court entered the sale order and so never received notice or an opportunity to object.
 
In a 2011 opinion, the bankruptcy court declined to enjoin Ms. Frederico's state court suit against Morgan. Morgan then appealed to the district court, prompting the decision described in this update.
 
The district court's decision may reduce the attractiveness of asset sales conducted under the auspices of a bankruptcy court. Asset sales have become an increasingly attractive feature of chapter 11 bankruptcy practice during the last decade. Buyers have been willing to purchase assets out of bankruptcy for good prices because the buyers could rely on sale orders protecting them from the liabilities of the bankrupt sellers. The analysis exemplified by the Grumman decision undermines some of the certainty that bankruptcy buyers have come to expect.
 
The decision serves as a useful reminder that bankruptcy sale orders cannot function as an omnibus injunction against any kind of liability for all purposes. Bankruptcy sale orders are effective against parties who receive notice and an opportunity to object, but a bankruptcy court’s power is subject to the limits of due process. Even where there is adequate notice, the sale order may still be unenforceable with respect to particular classes of claimants. For example, notice alone is probably insufficient if the claimant does not heed the notice because the claimant had not yet suffered an injury, and had no real reason to expect one. In Grumman, even if the debtor-manufacturer had taken the trouble to serve notice of the sale on every person driving one of its trucks, a reasonable, as-yet uninjured person receiving the notice would ignore it. That person would have no cause to pay attention because that person was not yet injured and was never likely to be injured.
 
Bankruptcy courts are also constrained by the language of the federal bankruptcy code, which authorizes bankruptcy courts to address “claims” against a debtor. While that term is construed very broadly, the Grumman decision illustrates its limits. Crucially, the event giving rise to the plaintiff’s claim (the truck accident) had not occurred at the time of the sale. The plaintiff simply did not have a “claim” when the debtor entered bankruptcy, or even when the bankruptcy court entered its sale order. Although a “claim” in bankruptcy may include contingent liabilities, the contingency must not be wholly remote or speculative, as it was here.
 
Buyers should be particularly aware of the limitations of sale orders when dealing with bankrupt product manufacturers or other industrial firms. The Grumman decision specifically concerns product liability, so an unwary buyer of manufacturing assets might find itself responsible for injuries caused by products sold years before the sale. Likewise, a buyer might be saddled with environmental liability for injuries caused by the seller that did not manifest themselves until after the sale.
 
The district court's decision is important because many of the largest bankruptcies are filed in the Southern District of New York. The decision may affect the enforceability of dozens of sale orders entered in that jurisdiction, including, one can imagine, orders entered in the bankruptcy cases of General Motors and Chrysler. The decision is also likely to prove persuasive in other jurisdictions around the country.

DWT regularly advises buyers of distressed assets in bankruptcy transactions.  Please contact any member of our bankruptcy group for more information about this and other services we provide to our business clients.