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Purchase of Assets in Bankruptcy Sales Is Not Always ‘Free and Clear’

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A fundamental cornerstone of the modern bankruptcy paradigm involves companies taking the opportunity to restructure through the sale of assets that are “cleansed” by the courts. While bankruptcy law varies from one state to another, the majority of jurisdictions provide broad protections to those who buy assets in bankruptcy proceedings, shielding the buyer from the liabilities of the seller. Generally, these protections apply to all assets with a few exceptions, such as a buyer merging with a seller and fraudulent transactions.

However, even if a buyer has been told by the courts that the assets are “free and clear,” the legal jargon for the cleansing that bankruptcy provides, there are a few limited situations, such as those involving certain liabilities or procedural complexities, that can result in liabilities being transferred with the assets.

While the overwhelming majority of assets can be easily cleansed by the courts, several types of claims create indelible stains, most frequently when the courts have disagreed as to whether a claim qualifies as “in the property” as outlined in Section 363(f) and 1141(c). In general, claims that fail these tests have had a difficult history in the courts. For example, the Third and Seventh Circuit Courts of Appeals have disagreed as to whether employment liability claims were transferred along with the sale of assets, and an increasing number of courts have begun questioning whether product liability claims are always cleansed via free and clear sales. Perhaps the best example of this issue can be seen with environmental issues, such as in the 1992 case of the United States v. Carolina Transformer Co.

The other major roadblock for buyers of assets involves a failure to provide adequate notice of a sale to creditors. Courts have a strong preference to provide as much notice as possible to creditors, and free and clear asset sales can be significantly complicated if creditors can feasibly claim that they were caught unaware by a sale. The easiest way to avoid this issue, of course, is through a Section 363 sale, a cheap and public option that courts routinely view as providing sufficient notice. Chapter 11 proceedings add significant time and expense to that process. However, because these plans require the active votes of creditors and can include provisions handling the possibility of future claimants, they may ultimately be safer, especially when dealing with employment liability, environmental claims, and other matters.

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