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Assets May Be Sold in Bankruptcy Free and Clear of Successor Liability

The ability of a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") to sell assets of the bankruptcy estate "free and clear" of "any interest" in the property asserted by a non-debtor is an important tool designed to maximize the value of the estate for the benefit of all stakeholders. The U.S. Bankruptcy Court for the Central District of California recently examined whether such interests include "successor liability" claims that might otherwise be asserted against the purchaser of a debtor's assets. In In re Catalina Sea Ranch, LLC, 2020 WL 1900308 (Bankr. C.D. Cal. Apr. 13, 2020), the court joined the majority of courts in holding that assets can be sold to an insider of a debtor free and clear of successor liability claims within the plain meaning of section 363(f) of the Bankruptcy Code.

Free and Clear Bankruptcy Sales

Section 363(b)(1) of the Bankruptcy Code provides in relevant part that "[t]he trustee, after notice and a hearing, may use, sell, or lease, other than in the ordinary course of business, property of the estate." Courts generally apply some form of a business judgment test in determining whether to approve a proposed use, sale, or lease of estate property under section 363(b)(1). See ASARCO, Inc. v. Elliott Mgmt. (In re ASARCO, L.L.C.), 650 F.3d 593, 601 (5th Cir. 2011); In re Stearns Holdings, LLC, 607 B.R. 781, 792 (Bankr. S.D.N.Y. 2019); In re Friedman's, Inc., 336 B.R. 891, 895 (Bankr. S.D. Ga. 2005); see generally Collier on Bankruptcy ("Collier") ¶ 363.02 (16th ed. 2020). 

Under this deferential standard, a bankruptcy court will generally approve a reasoned decision by a trustee or DIP to use, sell, or lease estate property outside the ordinary course of business. See In re Alpha Nat. Res., Inc., 546 B.R. 348, 356 (Bankr. E.D. Va.), aff'd, 553 B.R. 556 (E.D. Va. 2016). However, when a transaction involves an "insider," courts apply heightened scrutiny to ensure that the transaction does not improperly benefit the insider at the expense of other stakeholders. See In re Alaska Fishing Adventure, LLC, 594 B.R. 883, 887 (Bankr. D. Alaska 2018); In re Family Christian, LLC, 533 B.R. 600, 622, 627 (Bankr. W.D. Mich. 2015). 

Section 363(f) of the Bankruptcy Code authorizes a trustee or DIP to sell property "free and clear of any interest in such property of an entity other than the estate," but only if:

  1. applicable nonbankruptcy law permits sale of such property free and clear of such interest;
  2. such entity consents;
  3. such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property;
  4. such interest is in bona fide dispute; or
  5. such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.

11 U.S.C. § 363(f). A bankruptcy court's power to order sales free and clear of a competing interest without the consent of the party asserting the interest has been recognized for more than a century. See Ray v. Norseworthy, 90 U.S. 128, 131–32 (1875). It promotes the expeditious liquidation of estate assets by avoiding delay caused by sorting out disputes concerning the validity and extent of competing interests, which can later be resolved in a centralized forum. It also facilitates the estate's realization of the maximum value possible from an asset. A prospective buyer would discount its offer significantly if it faced the prospect of protracted litigation to obtain clear title to an asset. See In re WBQ P'ship, 189 B.R. 97, 108 (Bankr. E.D. Va. 1995); accord In re Realia, Inc., 2012 WL 833372, at *10 (B.A.P. 9th Cir. Mar. 13, 2012) (noting that that "the purpose of the 'free and clear' language is to allow the debtor to obtain a maximum recovery on its assets in the marketplace"), aff'd, 569 F. App'x 544 (9th Cir. 2014).

Holders of such competing "interests" are provided with protections by the Bankruptcy Code. Pending the bankruptcy court's resolution of any disputes, the interest holder is entitled to "adequate protection" of its interest. This most commonly takes the form of a replacement lien on the proceeds of the sale. See generally Collier at ¶ 363.06[9].

Courts have sometimes struggled to identify the outer limits of the term "interest," which is not defined in the Bankruptcy Code or its accompanying legislative history. Most courts reject the narrow approach under which the reach of section 363(f) is limited to in rem property interests (such as liens or security interests) or only those claims that have already been asserted at the time the property is sold. Id. at ¶ 363.06[1] (noting that "[o]bviously there must be situations in which the interest is something other than a lien; otherwise, section 363(f)(3) would not need to deal explicitly with the case in which the interest is a lien").

Instead, the majority of courts have construed the term broadly to encompass other obligations that may flow from ownership of property, such as leasehold interests. See Pinnacle Rest. at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holding II, LLC), 872 F.3d 892 (9th Cir. 2017) (notwithstanding the tenant protections set forth in section 365(h)(1), real property can be sold by a debtor-lessor free and clear of a leasehold interest under section 363(f)); Precision Indus., Inc. v. Qualitech Steel SBQ, LLC, 327 F.3d 537 (7th Cir. 2003) (same)).

Many courts have concluded that "successor liability" claims are also included within the scope of section 363(f). See Ind. State Police Pension Trust v. Chrysler LLC (In re Chrysler LLC), 576 F.3d 108 (2d Cir.) (sale of assets to newly formed acquisition entity free and clear of debtor's liability for certain vehicle defects), vacated on other grounds, 558 U.S. 1087 (2009); In re Trans World Airlines, Inc., 322 F.3d 283 (3d Cir. 2003) ("TWA") (employment discrimination claims arising from conduct prior to a section 363 sale and travel vouchers settling same); UMWA 1992 Benefit Plan v. Leckie Smokeless Coal Co. (In re Leckie Smokeless Coal Co.), 99 F.3d 573 (4th Cir. 1996) (debtor coal operators could sell their assets free of successor liability that would otherwise arise under the Coal Industry Retiree Health Benefit Act of 1992); In re K & D Indus. Servs. Holding Co., Inc., 602 B.R. 16 (Bankr. E.D. Mich. 2019) (sale of chapter 11 debtors' assets free and clear of successor liability claims for ERISA withdrawal liability); In re White Motor Credit Corp., 75 B.R. 944, 948, 951 (Bankr. N.D. Ohio 1987) (declining to impose successor liability on an asset purchaser because "[t]he successor liability specter would chill and deleteriously affect sales of corporate assets, forcing debtors to accept less on sales to compensate for this potential liability"); see also Elliott v. Gen. Motors LLC (In re Motors Liquidation Co.), 829 F.3d 135 (2d Cir. 2016) (agreeing that successor liability claims can be "interests" when they flow from a debtor's ownership of transferred assets, but ruling that certain claims were not barred because they had not yet arisen at the time a section 363(f) sale closed and certain other claimants received inadequate notice of the sale); Olson v. Frederico (In re Grumman Olson Indus., Inc.), 445 B.R. 243 (Bankr. S.D.N.Y. 2011) (a section 363 sale order cannot exonerate purchasers from successor liability claims by claimants who, at the time of the sale, had not yet been injured and had no contact or relationship with the debtor or its products).

In Catalina Sea Ranch, the bankruptcy court considered whether a chapter 11 debtor could sell substantially all of its assets to an affiliated company free and clear of successor liability claims arising from a boating accident allegedly caused by one of the debtor's fishing vessels.

Catalina Sea Ranch

Catalina Sea Ranch LLC ("CSR") was a seafood supplier specializing in mussels. After CSR failed to sell its assets by means of an assignment for the benefit of creditors, certain creditors filed an involuntary chapter 7 case against the company, which the bankruptcy court converted to chapter 11 after transferring venue of the case to the Central District of California.

CSR filed a motion to sell substantially all of its assets at auction to Pacific Mariculture, LLC ("Mariculture"), an insider affiliate and a secured creditor, pursuant to sections 363(b) and 363(f). CSR's largest unsecured creditors were the estates of various members of the Poynter family ("Poynters"). They asserted a $10 million wrongful death claim arising from a prepetition shipping accident involving one of CSR's vessels and objected to the sale. They argued that CSR did not provide a sufficient business justification for the sale to an insider at a "bargain basement price" and that the sale should not be free and clear of a "successor liability" claim they intended to pursue against Mariculture.

The Bankruptcy Court's Ruling

Initially, the bankruptcy court found that, even though CSR's unsecured creditors would not receive any distribution from the estate if the proposed sale to Mariculture were approved, there was no evidence of favoritism, bad faith, or inadequate consideration in connection with the sale.

Next, the bankruptcy court noted that neither Mariculture nor any other non-debtor (including CSR's insurers and directors) would be released or discharged from any liability under applicable non-bankruptcy law if the sale were approved. Rather, the court wrote, "[t]he only issue presently before the Court is whether the proposed sale of assets will be free and clear of successor liability." 2020 WL 1900308, at *11.

The bankruptcy court explained that, under applicable non-bankruptcy law (California law), the general rule is that a company that acquires the assets of another company does not assume the selling company's liabilities unless:

(1) there is an express or implied agreement of assumption, (2) the transaction amounts to a consolidation or merger of the two corporations, (3) the purchasing corporation is a mere continuation of the seller, or (4) the transfer of assets to the purchaser is for the fraudulent purpose of escaping liability for the seller's debts.

Id. (quoting Fisher v. Allis-Chalmers Corp. Prod. Liab. Tr., 95 Cal. App. 4th 1182, 1188 (Cal. Ct. App. 2002)). Factors that may be relevant in assessing whether a purchaser is a "mere continuation" of the seller include whether there is inadequate consideration paid or the buyer and the seller have common officers, directors, or stockholders. Id. (citing Ray v. Alad Corp., 560 P.2d 3, 7 (Cal. 1977)).

The bankruptcy court concluded that any liability that would otherwise follow assets sold in bankruptcy is an "interest" in the assets within the meaning of section 363(f), in accordance with the dictionary definition of the term, which includes a "legal share in something" and a "claim, share [or] stake." Because successor liability involves a challenge to the sale of estate property free of a claim, the court reasoned, it fits within the common understanding of an "interest," and a bankruptcy sale can be free and clear of successor liability "under the plain meaning of § 363(f)."

According to the bankruptcy court, this conclusion is consistent with other parts of section 363, which indicate that Congress did not intend to limit the scope of "interests" in section 363(f) to ownership interests, liens, or other "narrow types of 'interests'" Id. at *12 (citing sections 363(f)(3), 363(g) and 363(h)). It also comports with the rulings of numerous courts, including the Fourth Circuit in Leckie and the Third Circuit in TWA, where the court stated that "[t]o allow the claimants to assert successor liability claims against [the purchaser] while limiting other creditors' recourse to the proceeds of the asset sale would be inconsistent with the Bankruptcy Code's priority scheme." TWA, 322 F.3d at 292.

Finally, the bankruptcy court in Catalina Sea Ranch explained, the conclusion that "any interest" within the meaning of section 363(f) includes successor liability is consistent with the broad policy of the Bankruptcy Code to maximize the value of the estate's assets for the benefit of all stakeholders and the important policy considerations underpinning "free and clear" asset sales in bankruptcy. "For all of these reasons," the court wrote, "a sale free and clear of all interests in [a debtor's] property means a sale free and clear of successor liability."

The bankruptcy court accordingly approved the sale to Mariculture under: (i) section 363(f)(1), because California law permitted the sale free and clear of the Poynters' successor liability claim; and (ii) section 363(f)(5), because the claim was "subject to monetary valuation" and the Poynters could be compelled "to accept a money satisfaction" of their claim.

Outlook

The bankruptcy court's rationale in Catalina Sea Ranch regarding the applicability of section 363(f) to successor liability claims aligns with the approach taken by the majority of courts that have considered the issue. To maximize the value of the bankruptcy estate for all stakeholders, the scope of "interests" that can be extinguished (albeit subject to provision of adequate protection) by means of free and clear asset sales under section 363(f) has been broadly construed.

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