Is a Purchase in Bankruptcy Really Free and Clear of Liability During COVID-19?

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Seyfarth Synopsis: In acquiring a company in bankruptcy, there is often a tendency to think this guarantees the purchaser will be “free and clear” of any liability (including so-called “successor liability”). This is not necessarily so with wage and hour liability, particularly if the purchaser merely continues to operate virtually the same business that was acquired.

Ordinarily, a bankruptcy debtor’s sale of property ‘free and clear’ of interests under Bankruptcy Code section 363(f) excises from the sold assets any claims made on a theory of successor liability. The purchaser is shielded from successor liability claims in accord with public policy underlying the Bankruptcy Code, including the inequality of allowing one creditor to pursue a purchaser of assets for successor liability while other creditors’ recourse is limited to the proceeds of the asset sale. However, although rarely applied, some bankruptcy courts have found exceptions to this ‘free and clear’ transfer where: (1) the successor expressly or impliedly assumes the liabilities; (2) there is an actual or de facto consolidation or merger of the two companies; (3) the purchaser is a mere continuation of the seller; or (4) the transaction was entered into fraudulently to escape liability. This not-often-discussed and rarely-applied exception is similar to that which has developed in connection with asset purchase sales (which was first recognized under the FLSA and has recently continued to develop in state statutes), as we previously wrote about here.

Moreover, in a post-COVID-19 world, it is foreseeable that public policy concerns may continue to further shift away from protecting the purchaser or employer and in favor of protecting the creditor or employee—making the application of such exceptions more common. Although some of the COVID-19 legislation passed has benefited employers—for example, California’s relaxation of Cal-WARN notification requirements—much of the legislation and the public policy discussion has focused on protection of employees and even independent contractors. As one example, legislators have enacted additional paid sick leave requirements at the federal, state, and local level and job protection for employees who could not, or did not, work for COVID-19-related reasons. And uncertainty remains on significant issues such as California’s final pay requirements for employers in the context of furloughs.

The COVID-19 pandemic will likely lead to more distressed businesses and bankruptcies in the near future. COVID-19‑related legislative efforts may then pivot to focus on the bankruptcy arena. For example, the City of Los Angeles has implemented a citywide worker retention ordinance which requires any purchaser of a business to give priority in hiring to the seller’s employees for the first six months and prohibits discharge of the seller’s employees without cause for the first 90 days. It is unclear whether this ordinance would apply to a bankruptcy sale, but arguably, Bankruptcy Code section 363(f) would preempt any such municipal or state legislation and relieve a purchaser in bankruptcy of these obligations. The pandemic has also greatly increased legal compliance risks to businesses. The seemingly constant modifications to federal, state, and local laws and executive orders regarding everything from requirements for businesses to remain open to sick leave for employees has created a dizzying maze of regulations complete with the bear traps and trip wires of steep monetary penalties and class action litigation exposure. With the primary focus seemingly on employee protection, it is foreseeable that courts may more frequently utilize the previously rare “exceptions” allowing successor liability in the bankruptcy context.

Thus, inheriting successor liability should be kept in mind when considering distressed asset purchases. The risk that the purchased asset will not be ‘free and clear’ of such claims should be factored into the purchase price, making due diligence for labor and employment compliance (and considering putting aside monies for potential liability including potential litigation) all the more important. Further, representations and warranties insurance should be considered, as we previously explained at length here. That said, section 363 purchasers also should be aware that some insurers have implemented exclusions for COVID-19-related exposure.

Conclusion

Along with the increased number of bankruptcies and distressed asset sales on the horizon comes the possibility that asset sales may carry hidden risk. As such, it is now more important than ever that purchasers conduct thorough and competent labor and employment due diligence that contemplates COVID-19‑related developments and previously remote possibilities, such as successor liability following a ‘free and clear’ bankruptcy purchase.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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