The economic distress ensuing from COVID-19 will likely result in more frequent sales of business assets and real estate under Section 363 of the Bankruptcy Code. Section 363 sales provide an expedited process to raise revenue and are designed to enable an asset purchaser to take assets “free and clear of any interest.” However, the treatment of environmental liabilities in Section 363 sales is far from straightforward and warrants special attention.

In a 363 sale, the debtor must obtain approval from the bankruptcy court of the procedures to auction the assets and then must notify creditors and potential bidders of the upcoming auction. After selecting the winning bidder and negotiating the terms of the sale, the debtor must move for approval of the sale from the bankruptcy court. Creditors and other parties in interest can object to the sale by filing a motion in the Section 363 proceeding. The sale order executed by the judge will set the terms of the sale, including the extent to which the purchaser takes the assets “free and clear of any interest.”

The term interest is not defined in the Bankruptcy Code.  Courts in the Second Circuit look to the definition of a “claim,” which includes not only a right to payment but also a right to an equitable remedy where the government could accept payment in lieu of performance. 11 U.S.C. § 101(4); see Elliot v. GM LLC (In Matter of Motors Liquidation Co.), 829 F.3d 135, 155–56 (2d Cir. 2016). The Bankruptcy Code provides that such rights can be considered claims regardless of whether they are reduced to a judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured. 11 U.S.C. § 101(4).

In the environmental context, there are many ambiguities regarding what constitutes a claim.  For example, the Second Circuit in In re Chateaugay Corp. held that government environmental response costs for pre-bankruptcy petition releases of hazardous substances were unmatured, contingent “claims”—even though the agency had not yet incurred response costs or even understood the full extent of the future costs. In re Chateaugay Corp., 944 F.2d 997 (2d Cir. 1991). As for injunctive obligations, the Chateaugay court held that where an obligation is an alternative to payment (such as an order to remove wastes not currently causing pollution, where the agency could undertake the removal and sue for response costs), then it is likely a claim; however, where the obligation is one to ameliorate current pollution, then it likely does not constitute a claim.  Id.  These distinctions require close factual analysis.  If claimants believe that a sale will leave their claims unfulfilled, then they may object to the sale or otherwise advocate for the court to include language in the sale order passing certain costs or obligations to the purchaser. This may occur, for example, where a claimant has unsecured or contingent remedial costs that, due to a low sale price, may be discharged for only pennies on the dollar in the bankruptcy proceeding—or where ongoing remedial obligations may remain unfulfilled due to the lack of other responsible parties.

The purchaser in a Section 363 sale also must watch for potential liability as a successor to the debtor. Under New York decisional law, a company that purchases the assets of another company generally does not assume the seller’s liabilities. However, there are situations where the purchaser can be liable as a successor to the seller if: (1) the purchaser expressly or impliedly assumed the predecessor’s liability, (2) there was a consolidation or merger of seller and purchaser, (3) the purchasing corporation was a mere continuation of the selling corporation, or (4) the transaction is entered into fraudulently to escape the seller’s obligations.  See New York v. Nat’l Serv. Indus., Inc., 460 F.3d 201, 209 (2d Cir. 2006). Even under these circumstances, New York courts have found that a debtor can sell assets free and clear of successor liability where a claim (1) constitutes a right to payment and arose before the filing of the bankruptcy petition, or (2) is contingent on future events, and results from pre-petition conduct fairly giving rise to that contingent claim. In re Motors Liquidation Co., 568 B.R. 217, 227–28 (Bankr. S.D.N.Y. 2017), aff’d, 590 B.R. 39 (S.D.N.Y. 2018), aff’d, 943 F.3d 125 (2d Cir. 2019). Where there is a risk of successor liability, the parties may decide to negotiate for terms in the sale order stating that the purchaser is not a successor and will not be liable for environmental costs or obligations incurred by the debtor prior to the bankruptcy (or the inverse: that certain claims will pass through to the purchaser).

Even without being deemed a successor to the debtor, a purchaser may still incur environmental liability as the owner or operator of the property it purchases. The Comprehensive Environmental Response, Compensation, and Liability Act (“CERCLA”) can impose liability on a current property owner for historic releases of hazardous materials without regard to fault. A purchaser may have a defense under CERCLA as a bona fide prospective purchaser when it conducts “all appropriate inquiries” into environmental conditions before acquiring the property and takes reasonable steps to stop any continuing release and to prevent any threatened future release.  However, the purchaser may struggle to conduct “all appropriate inquiries” if there is a short timeframe between notice of the sale and the bid deadline.  Furthermore, even when the purchaser constitutes a bona fide prospective purchaser, the U.S. Environmental Protection Agency (“EPA”) may be able to file a windfall lien against the purchaser’s property where EPA funded a remediation of the property that increased its fair market value.

It has become a common real estate business practice to establish single purpose entities (“SPEs”) to hold ownership of individual properties. Where the underlying property asset is burdened with environmental liabilities, efforts by the SPE debtor to sell the asset pursuant to Section 363 could trigger the bankruptcy court to deny the petition for bankruptcy where the court views a proposed 363 sale as an attempted end-run around environmental liability.

In summary, purchasers in Section 363 sales should closely analyze their potential exposure to environmental liability through the sale order, as a potential successor to the debtor, and as a property owner. Purchasers may benefit from obtaining insurance to protect against the risk of claims for environmental liabilities that arose prior to the bankruptcy.