Buyer Beware: Ruling Saddles ‘New’ GM with Successor Liability

August 29, 2016

One of the principal benefits of purchasing assets out of bankruptcy is that buyers typically are able to acquire the assets “free and clear” of the liabilities of the company in bankruptcy.  This ability allows the purchaser to better estimate value for the assets or business to be acquired by limiting concerns of inheriting problems of the distressed entity, otherwise referred to as “successor liability.”  A recent decision from the U.S. Court of Appeals for the Second Circuit in the General Motors bankruptcy case may establish important limitations on a bankruptcy court’s ability to free such a purchaser from these successor liability claims.

The holding in that case, Elliott v. General Motors, LLC (In re Motors Liquidation Co.), Case No. 15-2844 (2nd Cir. July 13, 2016), was that the bankruptcy sale of GM Motors Corp.’s assets was not “free and clear” of claims belonging to (i) parties prejudiced by the debtor’s failure to provide sufficient notice of the sale, and (ii) parties whose claims did not amount to rights to payment that arose before the filing of the bankruptcy petition.

The facts surrounding the asset sale challenged in Elliott are peculiar. The GM sale occurred only after both a $13.4 billion federal loan to General Motors Corp. and a personal message from the president of the United States to reassure consumers failed to stem the iconic American car company’s descent into Chapter 11.  Further, aside from majority-ownership by the U.S. Treasury, the difference between “new” GM (an entity created to purchase the assets) and “old” GM (the bankrupt seller), was merely a legal fiction.

The dispute in the GM case was whether the sale order’s “free and clear” provision applied to claims arising from what the court found to be a known, pervasive and “potentially lethal” product defect, intentionally concealed from consumers for more than a decade and that didn’t come into public light until four years after the 2009 asset sale: “while in motion, a car’s ignition could accidentally turn off, shutting down the engine, disabling power steering and braking, and deactivating the airbags.”

The court considered two types of liability associated with the ignition switch defects. The first type of liability the court addressed relates to claims of certain parties affected by the defect who didn’t receive notice of the GM asset sale as required by the U.S. Constitution.  In short, the requirement of the Fifth Amendment’s Due Process Clause is to provide “notice, reasonably calculated, under all the circumstances,” to let interested parties know about a proposed court action and provide an opportunity for objections. When a debtor knows or reasonably should have known about a claim belonging to an identifiable party, as the Court found “old” GM did with respect to certain ignition switch plaintiffs, then due process entitles the known potential claimants to receive actual notice of the proceedings before the hearing on the sale. Here, the parties received only “constructive” notice, by newspaper publication, of information about the sale, and that wasn’t good enough. The terms of the GM sale were the result of intense negotiations among multiple constituencies, and the 2nd Circuit found that the plaintiffs might have benefitted from a seat at the table: where “the business circumstances at the time were such that plaintiffs could have had some negotiating leverage,” due to the necessity of restoring consumer confidence in GM vehicles and the sheer numbers of the claimants, among other reasons, “the opportunity to participate in the proceedings would have been meaningful.”  In other words, the Bankruptcy Court could not approve a sale of GM’s assets “free and clear” of claims belonging to claimants who could have benefitted from constitutionally adequate notice that wasn’t provided.

Although the sale order, on its face, released the purchaser from claims of plaintiffs who (i) suffered injury from accidents prior to the sale and/or (ii) suffered economic losses related to the ignition switch defect, the failure to provide proper notice meant those terms could not be enforced.

The second type of liability the 2nd Circuit discussed concerned claims that it found were not rights to payment that arose before the filing of GM’s bankruptcy petition. The power to sell assets “free and clear” of interests under Bankruptcy Code section 363, the court reasoned, cannot exceed the power to release “claims” in a bankruptcy generally. In bankruptcy, claims are generally considered to be rights to payment, even if contingent or not yet matured. Where the right to payment depends on the occurrence of future events, it must result from pre-bankruptcy conduct fairly giving rise to the contingent claim. A sale order, the court explained, cannot sell assets “free and clear” of rights (i) belonging to an entity that had no contact or relationship with the debtor at the time of the filing, or (ii) arising from acts or omissions of a non-debtor party, because in either case the debtor could not have identified the claimant. As applied, this meant that the Bankruptcy Court could not sell “old” GM’s assets free and clear of claims (i) belonging to purchasers who bought used GM cars after the sale closed, without knowledge of the ignition switch defect, since they had no relationship with old GM prior to bankruptcy, or (ii) claims based on “new” GM’s own conduct.

The bankruptcy sale process is designed to provide finality for a buyer by allowing a purchase of assets “free and clear” of encumbrances and lawsuits. This opportunity can assist in maximizing the price for assets sold in such proceedings., because without that security, buyers may discount their offers to account for uncertainties surrounding the specter of old liabilities. The GM decision is a reminder for would-be purchasers of the difficulty in shedding certain types of liabilities. As such, purchasers and their counsel may be well advised to take potential successor liability exposure into account when entering into a sale agreement to buy assets out of bankruptcy.