United States: Bankruptcy Sales: "Free and Clear" Of An "Interest" May Even Extend To Blocking A Successor Unemployment Insurance Experience Rating

Last Updated: October 29 2013
Article by Vicki Harding

In re USA United Fleet Inc., 496 B.R. 79 (Bankr. E.D.N.Y. 2013) –

A state used the debtors' prepetition unemployment insurance experience rating to determine the unemployment insurance tax liability of a buyer of the debtors' assets.  The buyer objected that it was not subject to any successor liability under the bankruptcy sale order, and sought a bankruptcy court determination that the sale "free and clear" of "interests" meant that the state did not have a right to assess the buyer based on the debtors' experience.

A group of debtors provided New York State school bus transportation services.  The chapter 7 trustee sought expedited court approval for a sale to a buyer of more than 400 buses and related contracts, since otherwise the contracts would rapidly lose their value.

The court approved the sale, and the sale order provided that the buyer would receive the assets "free and clear" of third party "interests" – which included "any and all interests (including any successor, transferee, or similar liability)" and that "[n]o Interests, and no successor, transferee or similar liability claim, shall bear against or attach or otherwise affect the Acquired Assets or the Buyer" except as set forth in the asset purchase agreement.

After the sale, the state department of labor (DOL) informed the buyer that its experience rating account balances had been revised pursuant to a state law that "provides for the transfer of employment and unemployment experience when one employer acquires, in whole or in part, the business of another."  The DOL asserted that this resulted in a negative balance transfer and underpayments totaling almost $3 million.  The buyer sought relief in the bankruptcy court.

As background, the court noted that a chapter 7 trustee has a duty to achieve the highest possible return for creditors.  In pursuing that duty, one available tool is the ability to sell "free and clear" of third party interests in order to maximize the value of the asset, and thus enhance the payment to creditors.  Otherwise, it might be difficult to sell estate assets and the price would be discounted to account for liabilities.

The DOL first contended that the court was being asked to determine the tax liability of a non-debtor, which was beyond its jurisdiction.  The court disagreed.  It viewed the task before it as interpreting and enforcing its own sale order.  It concluded that (1) adopting the DOL position would allow a taxing authority to "sit out" the sale hearing, assess a tax, pursue its claim in another forum, and then contend that the bankruptcy court was barred from adjudication; and (2) the issue before the court was whether the DOL right to transfer the debtors' experience rating to the buyer was an "interest" for purposes of Section 363(f) of the Bankruptcy Code.

In determining whether something is an "interest" that may be subject to a sale "free and clear" of the interests pursuant to Section 363(f), there are no definitions of interest in the Bankruptcy Code.  Some courts have adopted a narrow reading and limited "interests" to in rem property interests – particularly liens.  However, the bankruptcy court was not persuaded that this was proper.  It cited circuit court cases permitting a sale free and clear of successor liability for various types of claims (including employment discrimination and a tenant's right of possession) in support of a broader view.

In effect, the DOL had a contingent right to apply the debtors' experience rating if their property was transferred to a third party who then used it.  The DOL contended that this was only a "computational device."  However, the court emphasized that the reason the DOL assigned the debtors' rating was because the buyer acquired the debtors' assets.  It agreed with the analysis that Section 363(f) "encompasses a wide range of obligations that may flow from the ownership of property" so that the DOL's right to assess buyers based upon the debtors' experience rating is an interest that can be extinguished under Section 363(f).  The court also found support for its holding in the policy to maximize the value of assets for the benefit of the bankruptcy estate.

Since the DOL had an interest that could be extinguished, the only other question was whether it was extinguished.  In addition to the language that the sale would be free and clear of successor, transferee, or similar liabilities, the asset purchase agreement specifically contemplated that buyer would be released from liability for "unemployment compensation" and that any obligation of the debtors to any taxing or other governmental entities would not be included as a liability of the buyer.  So, the DOL, which had notice of the sale hearing, should have been able to anticipate that its application of the debtors' experience rating would be affected.

Consequently, the court found that the DOL's right to transfer the unemployment experience rating of the debtors to the purchaser was extinguished by the sale free and clear of interest.

As illustrated by this case, selling assets free and clear of interests may have an impact that extends beyond traditional claims and liens.  Consequently, anybody that receives notice of a sale should consider whether there is any way that its interests might be affected, and should raise an objection if there is even a possibility that the sale order could be interpreted to affect those interests.  The result in this case might have been different if the DOL had raised an objection at the time of the sale.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Vicki Harding
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