• U.S. Court of Appeals for the Sixth Circuit Bolsters Free and Clear Sales Under Section 363 of the Bankruptcy Code
  • November 19, 2007
  • Law Firm: Bingham McCutchen LLP - Boston Office
  • One of the primary advantages of purchasing assets in a sale under Section 363 of the Bankruptcy Code is that a prospective purchaser can acquire the assets “free and clear of any interest” in the assets if the sale complies with Section 363(f). Purchasers have come to assume, albeit with inconsistent judicial concurrence, that a sale “free and clear of any interest” in the assets sold under Section 363(f) necessarily insulates them from successor liability for pre-petition “claims” against the seller. On September 27, 2007, the U.S. Court of Appeals for the Sixth Circuit issued a decision in Al Perry Enters. v. Appalachian Fuels, LLC,1 that buyers and debtors will applaud for its broad reading of Section 363(f) and resulting limitation on the types of claims that survive a Section 363 sale.

    Background

    Prior to filing for bankruptcy protection, Bowie Resources Limited entered into a sales agency agreement with Al Perry Enterprises pursuant to which Perry agreed to serve as a sales agent for Bowie. Under the sales agency agreement, Perry attempted to procure coal supply contracts for Bowie in exchange for commissions on coal sold under those contracts. Relevant to the instant dispute, Perry secured a supply contract with the Tennessee Valley Authority for Bowie. A dispute arose over Bowie’s obligation to pay commissions to Perry in connection with the TVA contract and Perry filed a lawsuit against Bowie in the U.S. District Court for the Southern District of Indiana. The lawsuit resulted in an agreed judgment that obligated Bowie to continue paying commissions to Perry in connection with the TVA contract. The judgment further required Bowie to assume its contractual obligations to Perry under the sales agency agreement in the event that Bowie filed for bankruptcy.

    Bowie subsequently filed a Chapter 11 petition and, after a false start with one prospective purchaser, proposed a sale of substantially all of its assets to Appalachian Fuels. Bowie provided notice of the proposed sale, along with a copy of the asset purchase agreement, to all its creditors, including Perry. The asset purchase agreement provided, among other things, that (i) the TVA contract was among the assets to be sold to Appalachian Fuels, (ii) the assets were to be delivered “free and clear of all Liens” (except “Permitted Liens”), and (iii) Appalachian Fuels would not assume any of Bowie’s debts other than those specifically set forth in the asset purchase agreement. The asset purchase agreement did not expressly mention the assumption of the obligation to pay commissions due to Perry in connection with the TVA contract.

    Nonetheless, Perry did not object to the proposed sale. Perry took action only after the Bankruptcy Court entered a final order authorizing the sale “free and clear of all liens, claims and encumbrances,” the asset sale closed and Appalachian Fuels did not make further commission payments. At that point, Perry commenced a breach of contract suit against Appalachian Fuels alleging that Appalachian Fuels assumed the obligation to pay commissions owed to Perry in connection with the TVA contract as a result of the agreed judgment between Perry and Bowie. The U.S. District Court for the Eastern District of Kentucky granted summary judgment to Appalachian Fuels, triggering Perry’s appeal to the U.S. Court of Appeals.

    Discussion

    At the outset of its opinion, the Court of Appeals observed that this was a case of “first impression” for the court. It had never previously ruled on the effect of a Section 363 sale order that approved a sale of the debtor’s assets “free and clear of all liens, claims and encumbrances.”2

    As noted at the beginning of this alert, Section 363(f) of the Bankruptcy Code authorizes a debtor or trustee who complies with the requirements of that section to sell assets “free and clear of any interest” in the assets. Thus, the question was whether Perry’s claim for commissions alleged to be due from the sale of coal under the TVA contract was an “interest” in the assets sold to Appalachian Fuels that could be extinguished under Section 363(f).

    The Court of Appeals did not discuss at length whether an unsecured claim is included within the scope of an “interest” in assets for purposes of Section 363(f), other than to quote with approval language from a case decided by the Bankruptcy Court for the Western District of Michigan that equated an unsecured “right to payment” against a debtor with an “interest” in property sold by the debtor.3 Although the Court of Appeals did not expressly determine that Perry’s claim for commissions was an “interest” in the transferred assets, it did not hesitate in holding that Perry’s claim would be extinguished by the Section 363 sale order in this case unless it was expressly assumed in the asset purchase agreement by Appalachian Fuels. In reaching its conclusion, the Court of Appeals stated that Section 363(f) provides a bankruptcy court with the “clear power” to approve assets sales “free and clear of any interest or claims that could be brought” during bankruptcy (emphasis added). The Court of Appeals effectively expanded the scope of Section 363(f) by reading the term “claim” into that provision of the Bankruptcy Code.4

    Perry did not dispute the Court of Appeals’ holding regarding the legal effect of the sale order. However, Perry framed the dispute as a simple matter of contract interpretation and asserted that in the asset purchase agreement Appalachian Fuels assumed “by clear and unambiguous language” Bowie’s obligation to pay commissions to Perry. More specifically, Perry maintained that pursuant to the express terms of the asset purchase agreement, Appalachian Fuels assumed all liabilities “relating to” or “arising in connection with” the TVA contract and that Bowie’s obligation to pay a commission to Perry for coal sales made under the TVA contract necessarily was a liability “relating to” and “arising in connection with” that contract.

    The Court of Appeals rejected Perry’s expansive interpretation of the terms “relating to” and “arising in connection with” in favor of a more restrictive view, finding that “[t]he obligation to pay commissions to Perry is ‘related to’ and ‘arising in connection with’ the separate contract between Bowie and Perry and not from any obligation created by the TVA contract itself.” From the Court of Appeals’ perspective, obligations “relating to” or “arising in connection with” the TVA contract would be spelled out directly in the TVA contract and would encompass such things as the terms and conditions for supplying coal and the prices to be paid for coal.  Perry’s right to commissions related to and arose in connection with “a totally separate contract on a totally different subject matter.”

    Moreover, the Court of Appeals asserted that Perry’s suggested interpretation of the asset purchase agreement could lead to absurd results, saddling a purchaser with obligations that were not explicitly mentioned in the underlying asset purchase agreement or the Bankruptcy Court’s sale order. The Court of Appeals refused to tolerate such a result in this case.

    Comment

    The thrust of the Court of Appeals’ decision, that a purchaser of assets in a Section 363 sale takes such assets free and clear of all claims and interests except for those expressly assumed, will be enthusiastically endorsed by prospective purchasers and debtors alike. Prospective purchasers will applaud the Appalachian Fuels decision for providing some certainty that when purchasing assets in a Section 363 sale, buyers will receive the benefit of their bargain and not a host of unintended and unwanted liabilities (although claims based on product liabilities, environmental laws, mass tort theories and the like may be more difficult to shed than a simple contract claim such as Perry’s). In turn, debtors and creditors will appreciate the relative predictability generated by this decision which should help maximize the values paid for assets purchased out of bankruptcy. Comfort derived from this decision should be somewhat tempered, however. In particular, while Appalachian Fuels offers additional precedent for “free and clear” sales, it remains to be seen whether courts in other circuits will give this decision great deference without detailed analysis from the court of why an unsecured claim is an “interest” for purposes of Section 363(f). 

    Finally, the Court of Appeals’ decision puts creditors and other claimants on notice that it is perilous to simply assume that obligations owing to such parties will be transferred to a purchaser in the context of a Section 363 sale. Based on this decision, unless a party’s claim is expressly assumed in the underlying asset purchase agreement, that party must come forward in the bankruptcy case prior to the entry of any asset sale order in order to protect its interest. Otherwise, much like Perry, such party’s claim can be fully extinguished, leaving the party without recourse or sympathy.

    Endnotes

    1 Al Perry Enters. v. Appalachian Fuels, LLC, No. 06-6505, 2007 U.S. App. LEXIS 22808 (6th Cir. Sept. 27, 2007).

    2 Courts have struggled with the meaning of “free and clear,” particularly in the area of successor liability. Some courts have concluded that Section 363(f) extinguishes valid claims for successor liability. See, e.g., In re White Motor Credit Corp., 75 B.R. 944, 950-51 (Bankr. N.D. Ohio 1987) (refusing to impose successor liability on asset purchaser largely on policy grounds, including that “[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”). Other courts, however, have been less willing to purge successor liability claims under Section 363(f). See, e.g., Zerand-Bernal Group, Inc. v. Cox, 23 F.3d 159, 163 (7th Cir. 1994) (finding that Section 363(f) may extinguish liens on assets being transferred, but not successor product liability claims).

    3 Car-Tec, Inc. v. Venture Industries, Inc. (In re Auto Style Plastics, Inc.), 227 B.R. 797 (Bankr. W.D. Mich. 1998).

    4 While Section 363 does not define the term "interest" as used in Section 363(f), the examples provided in the statute -- liens, dower and curtesy -- sound more in the nature of property interests than unsecured claims.