Bankruptcy Asset Sales: How a “Free and Clear” Section 363 Sale Affects the Purchaser’s Liability

When purchasing assets from a bankruptcy estate, purchasers often rely on the protections of 11 USC 363(f) of the Bankruptcy Code, which allows property to be sold “free and clear of any interest in property” if one of five statutory conditions are met. Those conditions are:

1. Applicable non-bankruptcy law permits a sale free and clear of interests;

2. The interest holder consents to the sale;

3. The interest is a lien and the sale price exceeds the aggregate value of all liens on the property;

4. The interest is in bona fide dispute; or

5. The holder could be compelled in a legal or equitable proceeding to accept money satisfaction of its interest in the property.

The protections contemplated by the statute are geared toward maximizing the value of the bankruptcy estate for the benefit of creditors. That is, the Section 363(f) protections must provide some level of certainty to encourage purchasers to pay top dollar for the assets. After all, a purchaser may not agree to purchase the assets if the purchase is not entirely “free and clear” of all liabilities, or if the purchaser could be liable for claims in the future. On the other hand, the bankruptcy sale procedures also serve to protect creditors of the estate by providing notice to those who may have claims against the seller.

The scope of protection that purchasers can obtain in a bankruptcy asset sale depends on the definition of “interest in property,” a phrase that is not defined in the Bankruptcy Code. While it is clear that Section 363(f) extinguishes all liens against the property, many courts have held that Section 363(f) also extinguishes all claims against the purchaser of the assets. This interpretation of the Bankruptcy Code often affects creditors of the estate, who are precluded from recovering damages through claims against the purchaser of the seller’s assets. Bankruptcy sale orders typically contain broad language approving the sale free and clear from all liens, claims, encumbrances and interests of any and every kind, at law or equity. While such broad language benefits the estate and the purchaser, this language often prompts creditors, faced with limited options to recover pre-petition damages, to inquire as to whether there are any limits to “free and clear” purchases.

Recent bankruptcy cases suggest that the all-encompassing language of sale orders may be inconsistent with the scope of protection afforded to buyers under Section 363. For instance, a broadly drafted sale order may not capture and exclude claims of unidentified or unidentifiable claimants, even if the order expressly limits and excludes successor liability claims. See In re Gruman Olson Ind., Inc., 467 B.R. 694 (S.D.N.Y. 2012).

In Gruman, the debtor manufactured and sold products for the truck body industry. The Bankruptcy Court entered an order approving the sale of certain assets “free and clear of all claims.” Additionally, the sale order protected the purchaser from “any liability for claims against [debtor] or the assets, including, but not limited to, claims of successor or vicarious liability.” Six years later, claimants who sustained injuries in a truck accident sued the purchaser alleging products manufactured by the debtor (prior to the asset sale) were defective. The purchasers asserted the language of the sale order as a defense “free and clear” from pre-petition claims, but the court held that the sale order did not preclude the claims.

The Gruman court held that the language of the sale order does not encompass and preclude claims of unidentified claimants, reasoning that notice and due process, which are the cornerstones of bankruptcy procedures, were not met. In sum, there are limits to the “free and clear” language of bankruptcy sale orders. Accordingly, prospective purchasers should be cognizant of the risks of potential successor liability claims.

Among the assets purchased from the bankruptcy estate, executory contracts can provide substantial value to an asset sale, as the purchaser may pick and choose which contracts are the most favorable. Generally, the contracts to be purchased are specifically identified in the asset purchase agreement (the “APA”). Assumption or rejection of executory contracts for sale must first meet the requirements of Section 365 of the Bankruptcy Code, before the contract may be assigned to the purchaser. If all requirements of Section 365 are met, a purchaser may properly assume the contract and all pre-assumption defaults are precluded by the doctrine of res judicata.

It is incumbent upon a claimant to assert any known pre-assumption defaults to help preserve its rights before the bankruptcy case is closed or the claims will be treated as non-existent after assumption. See NCL Corp. v. Lone Star Building Centers (Eastern) Inc., 144 B.R. 170, 179 (S.D. Fla. 1992); In re Diamond Mfg. Co., Inc., 164 B.R. 189 (S.D. Ga. 1994).

If pre-assumption defaults exist, the court cannot approve the assumption unless the cure requirements of § 365 are met. NCL Corp., 144 at 179. But if a party to a contract fails to assert a pre-assumption default, then “when the bankruptcy court approves an assumption, it necessarily finds that no uncured defaults exist.” Id. After the court approves assumption of the contract, the non-debtor’s contract claims are barred by res judicata. Id. at 179-80.

Purchasers of assets from a bankruptcy estate should take care to conduct due diligence and closely consider all liabilities of the seller, which include all existing and potential claims. Purchasers should examine potential claims beyond the sale order, to determine whether notice due process requirements have been met. Additionally, to reduce the risks associated with assets sales, the sale orders should be carefully drafted with clear and unambiguous language approving the sale of assets “free and clear” of claims and precluding claims of successor liability. The order should make specific references to the various claims a purchaser intends to take “free and clear” with specific reference to which liabilities are assumed and those liabilities that are disclaimed.

Potential claimants should not delay in objecting to the provisions in the bankruptcy “free and clear” order. Likewise, claimants should timely object to the assumption of certain executory contracts to ensure that all the requirements of Section 365 have been met. Failure to timely raise those objections can result in third-parties being bound by the bankruptcy orders. Potential purchasers and claimants should immediately seek qualified counsel to examine the language of the bankruptcy sale order to take advantage of bankruptcy protections in an asset sale.