On March 29, 2012, the District Court for the Southern District of New York held in In re Grumman Olson Industries, Inc. that a section 363 sale order under the Bankruptcy Code does not bar a state law tort claim against a purchaser arising from pre-bankruptcy conduct of the debtor that did not cause injury to the claimants until after the bankruptcy closed. The District Court reasoned that the claimants' due process rights would be violated if they could not pursue their claim because they were not and could not have been given notice of the bankruptcy and therefore were unable to participate in the bankruptcy proceedings.

The issue before the District Court was whether a bankruptcy sale order under section 363 of the Bankruptcy Code could bar a successor liability claim by a third party against the purchaser of the assets where the claim arose from pre-bankruptcy conduct of the debtor that did not cause injury to the claimants until after the bankruptcy closed.

Under a section 363(f) of the Bankruptcy Code, the debtor's assets are sold "free and clear of any interests in such property." Courts generally agree that this provision also extinguishes claims that arise from the property being sold. The intent of this provision is to force any potential claimants to file their claims against the estate and not a subsequent purchaser of the assets. If potential claimants were permitted to bring claims against a later purchaser, an unsecured claimant could potentially jump ahead of other more senior creditors, which then violates the Bankruptcy Code's priority scheme. In addition, selling the assets "free and clear" makes the assets more valuable than if they were encumbered by potential claims, which then maximizes the value of the estate. However, courts have rejected the idea that these policies prevail over the due process rights of potential future claimants who were not given notice of the bankruptcy.

The appellant corporation, Morgan Olson L.L.C. (Morgan), bought assets of the debtor, Grumman Olson Industries, Inc. (Grumman), through a section 363 sale. The US Bankruptcy Court of the Southern District of New York's order approving the sale (the Sale Order) contained provisions intended to limit Morgan's potential liability for tort claims based on allegedly defective products manufactured and sold by Grumman before the sale. The provisions provided, in part, that Morgan would not be subject to any successor or vicarious liability claims and that the assets were free and clear of all claims that arose in connection with the debtor's actions.

About three years after Grumman emerged from bankruptcy and five years after the Sale Order was issued, Denise Frederico was injured while she was driving a truck that was manufactured by Grumman nine years before the section 363 sale. The Fredericos then brought a personal injury action against Morgan in New Jersey Superior Court based on New Jersey's successor liability law, which provides a "product line" exception to the general rule against successor liability. This exception provides that a purchaser can be held liable as a successor for defects in a predecessor's products if it purchased a substantial part of the predecessor's assets and continued to market goods in the same product line. In Lefever v. K.P. Hovnanian Enterprises, Inc. the New Jersey Supreme Court held that the product line exception applies to assets transferred pursuant to a sale order in a bankruptcy proceeding (see 160 N.J. 307 (N.J. 1999)).

Morgan brought an adversary proceeding in the Bankruptcy Court, seeking to bar the Fredericos from bringing their claim in state court. The Bankruptcy Court dismissed the adversary action by Morgan and Morgan appealed to the District Court.

The District Court affirmed the Bankruptcy Court's decision and held that the Fredericos' due process rights would be violated if they could not pursue their state law claim because they were not and could not have been given notice of the bankruptcy and therefore were not able to participate in the bankruptcy proceedings.

The District Court found that the Fredericos' claim was not extinguished by the Sale Order because it was a future claim that had not been dealt with by the bankruptcy proceeding. Future claims are claims arising from a debtor's prepetition conduct resulting in an injury to an identifiable claimant that does not manifest until after the conclusion of the bankruptcy proceedings. Although courts have interpreted "claims" broadly, they generally agree that future claims are not "claims" that a confirmed plan of reorganization can deal with and discharge.

Courts have also generally held that due process requires a party to receive adequate notice before it can be bound by any orders issued during the bankruptcy proceeding. The District Court reasoned that not only did the Fredericos not receive adequate notice, they could not have received notice because their claim did not exist when the Sale Order was issued. Therefore, their due process rights would be violated if their claim was extinguished by the Sale Order issued five years before the injury occurred.

This case serves as a reminder that the bankruptcy policy goal of maximizing the value of the estate by selling its assets free and clear of claims cannot override the due process rights of future claimants. Therefore, a purchaser in a section 363 sale should be aware that certain types of successor liability claims cannot be extinguished by the "free and clear" language of section 363(f) of the Bankruptcy Code.

The purchaser may still be liable for prepetition conduct of the debtor if it caused the injury arising after the bankruptcy proceedings were closed, unless these claims can be dealt with by the appointment of a future claims representative and the creation of a special trust to pay these claims (a common practice in mass tort cases involving asbestos). Therefore, potential purchasers of assets in bankruptcy should not take complete comfort in sale orders. Instead, they should consider the risk of successor liability and adjust their offers accordingly to reflect this risk.

For more information on section 363 sales, see Practice Note, Buying Assets in a Section 363 Bankruptcy Sale: Overview and Timeline of a Section 363 Sale.