Successor Liability: The Catch Behind "Free and Clear" in Bankruptcy Sales

During a Chapter 11 bankruptcy, the debtor may try to sell one or more of its assets. These sales are often thought of as “free and clear” of old debt, but that doesn’t always mean the buyer is safe from future claims. One key risk is successor liability, a legal doctrine that permits creditors to pursue a buyer of estate assets for debts owed by the debtor-seller under certain circumstances.

Sales under Bankruptcy Code Section 363 are thought to protect purchasers from these claims, but there are exceptions. Specifically, assets are only sold free and clear of claims when those claims are “interests” of assets that can be sold under the Bankruptcy Code. Examples of potential successor liability claims include environmental conditions in a real estate asset; mass tort claims where plaintiffs may have been unknown at the time of the sale; and employment-related claims, such as wage violations, tied to the debtor’s conduct.

The Second Circuit Court of Appeals (encompassing New York, Connecticut, and Vermont) has held that successor liability claims “can be ‘interests’ when they flow from a debtor’s ownership of transferred assets.”¹ To decide whether a claim qualifies, a majority of courts—including those in the Second Circuit—ask whether: 

1. the claim is based on a right to payment that existed before the bankruptcy filing;
2. the claim arises from conduct before the bankruptcy; and 
3. there was some connection between the creditor and the debtor. 

If the answer to any one of these questions is yes, the claim may be barred. A lack of notice, though, also may doom any purported free and clear protections.

In contrast, the Third Circuit Court of Appeals (encompassing Delaware, New Jersey, and Pennsylvania) provides stronger protections for buyers from successor liability claims, holding that these claims can be extinguished in asset sales so long as they arise from the property being sold and can be satisfied with money.² The court has analogized successor liability claims to general unsecured claims, holding that permitting successor liability claims would effectively grant claimants a higher priority and be inconsistent with the Bankruptcy Code’s priority scheme.³ The court added that extinguishing successor liability claims in a Section 363 sale is consistent with Section 363(f)(5), which allows a free and clear sale as long as the interest holder can be compelled to accept money in satisfaction of that interest.⁴

Some other courts take an entirely different approach, holding that successor liability is determined by state law or they have placed other limits on the ability to sell assets free and clear of successor liability.

In bankruptcy courts that do allow assets to be sold free and clear of successor liability, sale orders often expressly block future claims against the buyer or the assets being acquired. Even if the sale order doesn’t mention successor liability, though, creditors must be careful not to violate free and clear language when pursuing claims.

The intersection of bankruptcy law and successor liability is complex, and many courts are still determining how to tackle the issue. The ability to pursue claims against an entity that acquires assets under Section 363 will depend on the facts of the case and the jurisdiction in which the bankruptcy case is pending. In some cases, alternative recourse, such as a channeling injunction redirecting specific claims to a funded trust (originally utilized in mass tort bankruptcies), may be available. While this kind of recovery pool and injunction is considered an extreme measure, it does provide for an alternative route to protect purchasing entities from successor liability claims.

If you are considering purchasing an asset or making a claim against an asset purchaser in a bankruptcy case, it is important to have experienced bankruptcy counsel assess the matter to protect you against potential exposure to successor liability claims.

The Thought Leadership Committee of Barclay Damon’s Restructuring, Bankruptcy & Creditors’ Rights Practice Area issues alerts and blogs on an ongoing basis to keep clients, colleagues, and friends up to date on important developments in the insolvency space. If you have any questions regarding the content of this alert, please contact the authors, Scott Fleischer, partner, and Keyashia Willis, associate, at sfleischer@barclaydamon.com and kwillis@barclaydamon.com; Janice Grubin or Jeff Dove, Restructuring, Bankruptcy & Creditors’ Rights Practices Area co-chairs, at jgrubin@barclaydamon.com and jdove@barclaydamon.com; or Robert Wonneberger, Thought Leadership Committee chair, at rwonneberger@barclaydamon.com.
                                                                                                             
¹Elliott v. Gen. Motors LLC (In re Motors Liquidation Co.), 829 F.3d 135 (2d Cir. 2016).
²In re Trans World Airlines, Inc., 322 F.3d 283, 289 (3d Cir. 2003).
³Id. 
⁴11 U.S.C. § 363(f)(5); In re Trans World Airlines, Inc., 322 F.3d at 289–90.