Asset Dispositions in a Bankruptcy Case PART TWO: The End Game: Maximizing Value For All Constituencies

In the first installment of this article (Trust the Leaders, Fall 2004, page 24), we presented an overview of the basic landscape of asset dispositions in a bankruptcy case, leaving for a subsequent article the "end game" of maximizing the value of the acquired assets for all constituencies.

In the first installment of this article (Trust the Leaders, Fall 2004), we presented an overview of the basic landscape of asset dispositions in a bankruptcy case, leaving for a subsequent article the “end game” of maximizing the value of the acquired assets for all constituencies.

To take a few steps back, upon the filing of a bankruptcy, a debtor who desires to reorganize successfully must frequently sell off some of its assets, which may include one or more business units that will not comprise part of its business when it emerges from bankruptcy. Such sales may be part of the plan of reorganization proposed by the debtor, or alternatively, a debtor may decide to sell substantially all of its assets prior to filing a plan of total or partial liquidation. While a sale pursuant to Bankruptcy Code (the “Code”) Section 363 may be included in a plan of reorganization, Section 363 may also be used on a freestanding basis to authorize a preplan sale “free and clear” through a trustee’s or debtor-in-possession’s motion to sell. Sales conducted prior to the proposal of a plan of reorganization are conducted in accordance with the provisions of Section 363 of the Bankruptcy Code (“Section 363 Sales”).

Value-Added Features of a Section 363 Sale

Section 363 Sales present a win-win situation for many of the constituencies in a case by allowing, among other things, for an efficient and speedy sale. Section 363 Sales present a number of “value-added” features that are available only through the bankruptcy sale process. These value-added features make Section 363 Sales attractive to prospective purchasers and may provide an increased price for assets above that which may be obtained outside of bankruptcy. For example, a Section 363 Sale enables purchasers to acquire assets, or an entire business enterprise, with limited participation in the bankruptcy case. Thus, much of the time and expense necessary to acquire assets through the more traditional confirmation of a plan of reorganization is avoided.

In addition, a Section 363 Sale allows a debtor to bind non-consenting shareholders. In the usual situation, when a corporation desires to divest itself of assets, state law and the corporate governance documents may create hurdles to completing a sale, requiring that a majority of shareholders approve the sale prior to consummation. Compliance with these requirements is not necessary in a Section 363 Sale, so a Section 363 Sale can be accomplished even in the face of significant shareholder opposition.

In conjunction with a Section 363 Sale, the debtor also has the opportunity to assume and assign contracts to the purchaser (including leases) notwithstanding breaches which may have occurred or provisions prohibiting assignment of the contract or lease. Thus, the purchaser can obtain those contracts necessary for the operation of the business and the debtor and creditors can receive value where they may not have been able to do so otherwise. Property that might not otherwise be saleable, such as equipment warranties, may also be sold as executory contracts.

When a sale involves executory contracts or unexpired leases, the transfer of such contracts or leases must comply with Code Section 365, which includes a requirement that monetary defaults be promptly cured or that the debtor or purchaser provide adequate assurance that it will promptly cure any monetary default or that it will promptly cure any default.1 The assignee of the contract or lease must also provide “adequate assurance of future performance” under the contract or lease. A purchaser may realize value in “under market” leases or other contracts that it purchases from the debtor but does not plan to use, by reselling these contracts or leases.

Limiting Claims of Successor Liability

One of the most attractive benefits to a purchaser in a Section 363 Sale (or for that matter, a sale pursuant to a confirmed plan of reorganization) is the ability to acquire assets free and clear of existing liens, claims, encumbrances and interests. A sale free and clear of liens, claims, encumbrances and interests has the potential of maximizing the recovery to creditors of the debtor by increasing the sales price from that associated with a truly distressed asset. Prospective purchasers are more likely to bid higher if they can be assured that there are no claims against the property to be purchased. While a buyer of assets generally does not become liable to the seller’s creditors by purchasing its assets, there are certain circumstances under state or federal law pursuant to which a buyer, as successor to the assets, may be held liable for the claims of third parties against the seller. As a result, one of the primary objectives in obtaining an order of the bankruptcy court finding that the assets were purchased “free and clear” pursuant to Section 363 of the Code is to cut off, or at least minimize, successor liability to the purchaser.

**The Doctrine of Successor Liability **

Generally, under ordinary principles of state corporate law, a corporation that buys assets from another corporation is not responsible for the liabilities of the seller. The exception to this rule is the judicially created “doctrine of successor liability.”

The doctrine of successor liability differs from jurisdiction to jurisdiction, but generally imposes liability upon the purchaser if:
(i) there is an express or implied agreement of assumption;
(ii) there is effectively a consolidation or merger of the two corporations;
(iii) the purchase of the corporation is a mere continuation of the seller; or
(iv) the sale of assets is for the fraudulent purpose of escaping liability on the selling corporation’s debts.

If the purchaser either expressly or impliedly assumes certain liabilities of the seller, the purchaser will be responsible for that which it assumes. This is easy enough to spot when the assumption is expressed, but when it is implied, the purchaser may be exposed to liability if there is ambiguous language in the purchase agreement or the post-acquisition conduct of the purchaser indicates an intention to assume the liabilities of the seller.

In the situation of consolidation or “merger in fact” (while not formal), the purchaser cannot be distinguished from the seller. In this situation, the courts will generally look for certain indicia of a de facto merger including:
– continuity of the business enterprise,
– continuity of shareholders, and
– the buyer’s assumption of those liabilities of the seller that are necessary for the continued operation of the seller’s business enterprise.

There is similarity between a de facto merger and the mere continuation of the seller’s business enterprise. The critical factor is in the ownership of the enterprise and whether there is continuity of ownership. The weight that courts afford the various indicia of merger or continuity varies widely from court to court and the weight afforded each factor can affect whether a court will find that a defacto merger has occurred and the purchaser is liable for the debts of the seller.

In the case of a potential fraudulent transfer of assets by the seller, the key question is whether the consideration received for the sale is sufficient. This test for successor liability is applied less frequently than those dealing with defacto mergers and continuity of business enterprises.

Finally, a few states have recognized an additional test for successor liability, known as the “product line exception.” In the product line exception, the focus is on the buyer’s continued manufacturing or distribution of the same product line under the same name as the seller.

Limiting Successor Liability — When Does a Claim Arise

As mentioned above, bankruptcy courts can order assets of the bankruptcy estate sold free and clear of successor liability claims, either pursuant to a Section 363 Sale or as part of a Chapter 11 plan. In either case, the critical question is whether the purchaser can eliminate, or at least minimize, its exposure to successor liability claims, in particular those claims that have not yet arisen or that may be owed to claimants who are unknown at the time of the sale.

The issue of when a claim arises is critical to determine the level of protection a purchaser may expect to receive through a Section 363 Sale. While there exists no universal standard, there are four general standards that have been developed by the courts:
(i) the accrued state law test,
(ii) the debtor’s conduct test,
(iii) the pre-petition relationship test, and
(iv) the fair contemplation test.

Under the accrued state law test, a claim arises at the time the cause of action accrues under applicable state law. This standard is somewhat controversial because it leads to a narrow interpretation of the law and very limited protection from successor liability.

Under the debtor’s conduct test, the claim is determined to arise at the precise moment that the pre-petition conduct of the debtor, necessary to give rise to the alleged liability, occurred, even if the actual injury is not suffered until later. This is a theory which has been adapted in a number of mass tort cases and is more favorable to the debtor, because if the conduct necessary for the claim has occurred but the claimant has not yet suffered an injury, the claimant is barred from asserting its claim even though its injury does not occur until after the debtor has received its discharge.

The pre-petition relationship test requires that there be some pre-petition relationship such as contract, exposure, impact or privity between the debtor’s pre-petition conduct and the claimant. As with the debtor’s conduct test, the pre-petition relationship test is more favorable to the debtor for the same reason.

Bankruptcy courts can order assets of the bankruptcy estate sold free and clear of successor liability claims.

Lastly, under the fair contemplation theory, the claim must have been fairly contemplated by the parties prior to the bankruptcy. Here, the existence of a pre-petition relationship alone is insufficient to give rise to a claim, even if the conduct resulting in a claim occurred pre-petition.

Authority of the Bankruptcy Court to Limit Successor Liability

All of this brings us to the question of whether a bankruptcy court in a Section 363 Sale can enter a valid order protecting the purchaser from successor liability claims. In this context, courts have struggled with the issue of the meaning of the term “interest” as used in Bankruptcy Code Section 363(f). The term “interest” in property, in order to permit the conveyance of assets free and clear of successor liability, must include not only obligations secured by the property, but pre-petition unsecured claims against the debtor as well. While some courts have construed the term narrowly, the trend seems to be toward a more expansive interpretation which includes the liens, encumbrances and unsecured obligations that may flow from ownership of the property.

Bankruptcy courts generally protect a purchaser from “current” claimants who have had notice of the bankruptcy case and either are actually participating in the bankruptcy case or have had the opportunity to participate in the case. In such cases, the issue is much easier because, to state the obvious, the claimant is known and is able to protect its rights in the case through participation. Thus, elimination of successor liability for known claimants is generally available in a Section 363 Sale.

The elimination of successor liability as to future and unknown claims presents different considerations. The ability to eliminate liability to those claimants who may have future claims is doubtful, at least where there is no plan providing for such claims and no opportunity for the claimant to file a proof of claim during the case. Where the claimants are unknown, the only manner to provide notice to them is perhaps through publication. However, that begs the question regarding potential claimants who have not yet been injured, or are not aware that they may be at risk of injury in the future, and their ability to participate in the case. Absent notice of the bankruptcy case and the opportunity to participate therein, a Section 363 Sale will not effectively insulate a purchaser against this type of successor liability.

That is not to say that there are not methods for dealing with future and unknown claimants through a Chapter 11 plan of reorganization, but such protection is not available in the context of a Section 363 Sale. In such a situation, the ability of the debtor to sustain its business operations through the Chapter 11 process to the confirmation of a plan of reorganization becomes an issue, and if it is not possible for the debtor to sustain its business, a Section 363 Sale may be the only practical alternative to preserve the value of the assets to be sold. Along with the other criteria, when the debtor moves the court for a preplan sale of assets, the court must balance the viability, both long and short term, of the debtor, the ability of the debtor to propose a feasible plan of reorganization which has a possibility of being confirmed, and the rights of the different claimant constituencies.

Most often, the issue of future and unknown claimants arises in product liability or mass tort cases where the claimant does not know of the sale and at the time of the sale has not suffered an injury (where the act giving rise to the injury occurs pre-sale but the injury does not occur until after the conveyance of the assets). In such cases, the challenge is to minimize the purchaser’s potential liability by providing meaningful notice to possible claimants so that they have an opportunity to make a claim in the bankruptcy case, thereby affording a bankruptcy court the ability to enter an order free and clear of these interests.

The extent to which successor liability may be eliminated in a Section 363 Sale varies from jurisdiction to jurisdiction.

While most of the discussion in this article has dealt with Section 363 Sales, many of the same problems exist in the context of a sale of assets through a plan of reorganization, with the possible exception of notice. As discussed above, there are many criteria, which influence a court’s decision whether to enter an order confirming a plan of reorganization which provides in part for the sale of assets free and clear of interests. The primary issue in divesting “interests” from assets which are to be conveyed, is that of notice. In the context of a plan of reorganization which includes provisions to sell assets free and clear of interests, the opportunity for notice to the possible universe of claimants discussed above is enhanced because of the other safeguards that are enjoyed in the confirmation process. The notice of the plan to all creditors, whether by mailing or through publication calculated to reach the greatest number of potential claimants, along with the disclosure statement, provide greater potential for effective notice than the comparatively perfunctory notice of a Section 363 Sale. Of course, the practical problems of getting to a plan of reorganization before assets are divested pose significant obstacles in many cases.


What we have tried to do in this installment is to set out those “value added” features of a sale of assets within the context of a bankruptcy case which bring value to a debtor’s assets over and above that which might be commanded in a non-bankruptcy sale. Whether assets are sold in a Section 363 Sale or through a plan of reorganization, there is no real consensus among the courts as to the meaning and scope of the term “interest” in property as applied to successor liability claims. The extent to which successor liability may be eliminated in a Section 363 Sale varies from jurisdiction to jurisdiction and may depend upon the particular jurisdiction, the nature of the claims, the relationship of the claim to the assets being sold and the overall impact of the sale upon the administration of the case. This is even more prevalent in the context of a stand-alone Section 363 Sale than a plan confirmation process. In a Section 363 Sale, the consideration of what effect the sale may have on the ability of the debtor to ultimately confirm a plan is very different as compared to the sale through a plan of reorganization, where creditors should have a clear understanding of the direction of the case. The extent of insulation from successor liability in particular situations is a matter of debate from court to court and it is important to understand the law of the jurisdiction in which the conveyance is to occur.


  1. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, S. 256, which was passed by the Senate on March 10, 2005 and by the House of Representatives on April 14, 2005, includes in Section 365(b)(1)(A) new provisions with regard to unexpired leases. These new provisions provide that debtors need not cure nonmonetary defaults under such leases to the extent that such defaults are incurable, except that defaults arising from a failure to operate in accordance with a lease of nonresidential real property must be cured through performance at and after assumption, such that the lease terms must be complied with going forward and pecuniary losses resulting from such defaults prior to assumption must be quantified and compensated. 

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