Bankruptcy Sales: “Free and Clear” Is Not Necessarily a Free Pass

Encanto Restaurants, Inc. v. Luis S Aquino Vidal (In Re Cousins Int’l. Food Corp.), 553 B.R. 197 (Bankr. D. Puerto Rico 2016)) –

A Chapter 11 debtor sold two restaurants under a bankruptcy sale order that provided that the sale would be “free and clear” of interests. Subsequently judgment creditors sued the purchaser asserting successor liability for labor claims against the debtor arising in connection with the restaurant business. The purchaser and the debtor sought to enforce the sale order and enjoin the judgment creditors.

The debtor was an IHOP-franchise restaurant operator. A little over a year before the debtor filed bankruptcy an ex-employee and his mother (the Aquinos) sued the debtor in a local court for damages relating to labor claims. When the debtor filed schedules in its bankruptcy it did not disclose the local court proceeding and it did not include the Aquinos as creditors.

About a month after the debtor filed bankruptcy, its counsel in the local court proceeding filed an informative motion asking leave to resign and advising that she had learned of the bankruptcy filing from the press. The local court judge directed the debtor to provide proof of its bankruptcy filing and proof that the Aquinas were included in the bankruptcy case as creditors. The debtor failed to comply with the court’s order.

Several months after the bankruptcy filing the debtor sold two restaurants to a purchaser. The sale order provided that the transfer was to be “free and clear” of claims, and the purchaser specifically disclaimed all liability arising from the debtor’s former employees. Neither the debtor nor the purchaser gave notice of the purchase agreement to the Aquinos, nor did they receive notice of the sale.

In the meantime the local court proceeding continued and ultimately the court entered judgment against the debtor. After the Aquinos obtained a judgment against the debtor they sought to enforce it against the purchaser on a theory of successor liability. In response the debtor and purchaser asked the bankruptcy court to find the Aquinos in contempt for violating the automatic stay and the sale order.

The debtor and purchaser argued that the Aquinos had sufficient actual or constructive notice of the bankruptcy proceeding through the informative motion filed by the debtor’s counsel in the local court case. The bankruptcy court disagreed finding that as known creditors the Aquinos were entitled to notice of the bankruptcy sufficient to allow them to participate in matters affecting their interests, such as the sale.

The fact that a creditor may be generally aware of a pending bankruptcy is not sufficient. For example, under the bankruptcy rules at a minimum known creditors must receive (1) notice of deadlines for filing proofs of claims, (2) copy of a reorganization plan, (3) notice of a confirmation hearing and (4) the confirmation order.

Along the same lines, the First Circuit held that known creditors are entitled to notice that includes the claims bar date and the confirmation hearing. The First Circuit has also held that parties in interest must receive adequate notice of any proposed sale so that they will have an opportunity to be heard before their interests are adversely affected.

In this case the informative motion may have provided general awareness, but it did not include any specifics – such as case number, court location and claims bar date. Since the Aquinos did not receive appropriate notice of the sale, the bankruptcy court concluded that the local court claims could not be enjoined or declared void.

The purchaser also argued that the equities of the case supported its requests, noting various provisions in the court approved purchase agreement regarding successor liability. However, since the Aquinos did not have notice of the purchase agreement, these provisions were not effective. The court noted that the purchaser assumed the risk that a known creditor did not receive proper notice. As an aside, the bankruptcy court noted that it did not have to reach the question of whether the Bankruptcy Code authorized a sale free and clear of successor liability given the lack of notice.

In ruling on the Aquinos motion for summary judgment that they did not violate the automatic stay and is one claims were not void, the court reiterated the facts supporting its conclusion that they were known creditors entitled to notice. Not only did the debtor fail to respond to the local court order directing it to provide proof of the bankruptcy, it failed to list the Aquinos as creditors in its bankruptcy so that they did not receive notices in the bankruptcy proceeding.

Since the Aquinos did not receive appropriate notice of the bankruptcy filing or the sale motion they “could not have” violated the automatic stay. Thus, the court held that the Aquinos did not violate the automatic stay or the sale order, and further that their local court claims were not discharged in the bankruptcy proceeding.

In this case the Aquinos lucked out and were able to continue their local court proceeding, obtain a judgment against the debtor and seek to enforce the judgment notwithstanding the pending bankruptcy proceeding. But generally if someone has any information suggesting that a party is a bankruptcy, they ignore that information at their peril. Typically bankruptcy judges do not take kindly to people who ignore their proceedings and have a tendency to be aggressive in enforcing the automatic stay.

Vicki R Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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