Restructuring

Contributed by Christopher Hopkins
In In re Emoral, Inc., the Third Circuit addressed whether personal injury claims alleging harms caused by a debtor’s products could be asserted against a prepetition purchaser of the debtor’s assets under a “mere continuation” theory of successor liability.  The court ultimately concluded that the claimants lacked standing to pursue the claims because any successor liability claim against the purchaser constituted property of the bankrupt estate.
Background
As a general matter, after a company files for bankruptcy, creditors lack standing to file claims that constitute property of the estate.  A claim constitutes property of the estate if it (i) arose prepetition, (ii) is general, meaning no particularized injury arose from it, and (iii) could have been asserted by the debtor on its own behalf under state law.
Vesting sole authority to pursue such claims in the trustee (or debtor in possession) promotes the orderly distribution of estate assets and advances the “fundamental bankruptcy policy of equitable distribution to all creditors.”  Permitting individual creditors to pursue such claims against non-debtor third parties outside of bankruptcy would create the proverbial “rush to the courthouse” the Bankruptcy Code endeavors to avoid.  Creditors that would otherwise have a general unsecured claim against the debtor’s estate could “jump the line” by obtaining a recovery from a non-debtor third party in a separate proceeding.  In this scenario, claims that would otherwise inure to the benefit of all of the debtor’s creditors if pursued by the trustee would be diminished by any recovery obtained by an individual creditor outside of the bankruptcy case.  Vesting sole authority to pursue such claims with the trustee, however, avoids this result and ensures that the estate’s assets will be maximized for the benefit of all the debtor’s creditors.
Although it is axiomatic that once a claim is determined to be property of the estate only the trustee may prosecute or defend the claim, it is not always clear from the outset whether a particular claim will qualify as property of the estate.  Whether a claim constitutes property of the estate affects not only the debtor and its creditors, but also purported plaintiffs and potential defendants in such claims.  The Third Circuit’s decision in In re Emoral demonstrates how this determination can affect third parties, as well as the value of a release from the claims of a debtor’s estate.
In re Emoral, Inc.
In August 2010, Aaroma Holdings LLC purchased certain assets and assumed certain liabilities of Emoral, Inc., a manufacturer of the chemical diacetyl.  Both parties knew at the time of the sale that Emoral was facing potential liabilities related to various personal injury claims alleging injuries caused by the claimants’ exposure to diacetyl.  The asset purchase agreement, however, expressly provided that Aaroma was not assuming any of Emoral’s diacetyl-related liabilities.
Within a year of the asset sale, Emoral filed for bankruptcy under chapter 7.  A number of disputes arose postpetition between the chapter 7 trustee and Aaroma, including the trustee’s claim that Emoral’s asset sale constituted a fraudulent transfer.  Aaroma entered into a settlement agreement with the trustee to resolve these claims, which provided, among other things, that Aaroma would pay $500,000 to Emoral’s estate in exchange for a release from any “causes of action . . . that are property of the Debtor’s Estate.”
Once the United States Bankruptcy Court for the District of New Jersey entered an order approving the settlement agreement, a number of plaintiffs brought diacetyl-related personal injury claims against Aaroma under a “mere continuation” theory of successor liability.  In response, Aaroma filed a motion to enforce the bankruptcy court’s order approving the settlement agreement, arguing that the diacetyl plaintiffs’ claims were released by the trustee under the settlement agreement.  The diacetyl plaintiffs countered that the claims were not general claims constituting property of the debtor’s estate because of the personal nature of their injuries, and therefore could not have been released by the settlement agreement.
The bankruptcy court agreed with the diacetyl plaintiffs and denied Aaroma’s motion, holding that the underlying injury asserted by the diacetyl plaintiffs — the personal injuries resulting from diacetyl exposure — were personal harms individual to the plaintiffs, but the United States District Court for the District of New Jersey reversed.  On appeal, the Third Circuit affirmed in a 2‒1 decision, agreeing with the district court that the diacetyl plaintiffs’ emphasis on the personal nature of their injuries was misplaced.  The Third Circuit reasoned that the only theory of liability advanced against Aaroma, a third party that was not alleged to have caused the diacetyl plaintiffs any direct harm, was that “Aaroma constitutes the ‘mere continuation’ of Emoral such that it also succeeded to all of Emoral’s liabilities.”  To prove such a theory under applicable state law, the diacetyl plaintiffs would have to “establish that there is continuity in management, shareholders, personnel, physical location, assets, and general business operation between selling and purchasing corporations following the asset acquisition.”  Although the court acknowledged that the injuries sustained by the diacetyl plaintiffs were indeed personal, the facts underlying the “mere continuation” theory of liability against Aaroma would be common to all of Emoral’s creditors.  Further, if the diacetyl plaintiffs were successful in advancing their theory, Aaroma would become liable for all of Emoral’s liabilities, and therefore the claim must constitute property of the estate.
Although the dissent agreed that the successor liability theory asserted by the diacetyl plaintiffs was “inextricably tied to” their claims, the dissent noted that no other creditor could assert the diacetyl plaintiffs specific successor liability claims.  The dissent reasoned that because none of Emoral’s other creditors could assert successor liability claims against Aaroma alleging liability for injuries suffered as a result of diacetyl exposure, the claims must be considered individual claims belonging to the diacetyl plaintiffs.
Both the majority and the dissent recognized that the diacetyl plaintiffs’ underlying personal injury claims and theory of successor liability could not be viewed in isolation.  Instead, viewing the diacetyl plaintiffs’ claims as being comprised of two inseparable components, the deciding factor in the court’s analysis appears to be whether the court emphasizes the claimant’s underlying cause of action or the legal theory employed to extend liability to the non-debtor third party.  Although the majority’s approach in focusing on the latter results in an admittedly harsh result for the diacetyl plaintiffs, it ensures that the benefits of such claims are preserved for the entire bankrupt estate and promotes the equitable and orderly distribution of estate assets.
Takeaway
The Third Circuit’s Emoral decision clarifies the analysis a court must perform when determining whether a particular claim constitutes property of the estate.  Rather than analyzing whether the alleged injury was particular to the creditor, the Third Circuit looked to the legal theory the claimants relied upon to extend liability to the non-debtor third party.  Where the factual circumstances supporting that theory — whether it be a “mere continuation” theory of successor liability or otherwise — are generally available to the creditors as a whole, the court will deny the claimants standing to assert the claim.  Accordingly, even where a creditor can allege a particularized injury, if the ultimate theory relied upon to assert liability against the non-debtor third party is generally available to all of the debtor’s creditors, the claim will most likely constitute property of the estate.
As the court’s split decision demonstrates, however, it can often be a “close call” as to how the court will classify any particular claim.  Further, the extent to which other circuits will adopt the Third Circuit’s Emoral holding remains to be seen.