On March 27, 2013, the US Bankruptcy Court for the Northern District of New York in In re Tougher Industries, Inc. followed Second Circuit precedent and held that the term "interests" must be defined broadly under section 363(f) of the Bankruptcy Code to include a state-assessed unemployment tax rate, of which the debtor's assets could be sold free and clear.

Tougher Industries, Inc. and Tougher Mechanical, Inc. (Debtors), filed Chapter 11 petitions on November 3, 2006 and January 3, 2007, respectively. On March 6, 2007, the Bankruptcy Court ordered the joint administration of the cases.

The Bankruptcy Court appointed a trustee, who, on November 20, 2007 and with court approval, sold substantially all of the Debtors' assets in a section 363 sale free and clear of all liens, claims, encumbrances and interests. The sale order specifically stated that these interests included "those relating to taxes arising under or out of, in connection with, or in any way relating to the operation of the Assets prior to the Closing."

The State of New York Department of Labor (DoL) filed a priority claim of $160,629.17 for unpaid unemployment insurance taxes against the Debtors. The DoL also notified the purchaser that it was a successor employer under state law, and therefore it inherited the Debtors' experience rating (used to calculate unemployment insurance tax premiums). This resulted in a significantly higher rating than the purchaser would have otherwise had if the rating had been based on new employer status.

The purchaser filed a motion asking the Bankruptcy Court to clarify that its purchase of the Debtors' assets did not make it a successor to the Debtors, and that the DoL therefore could not transfer the Debtors' experience rating to it.

At issue is whether the debtor's experience rating is an interest within the meaning of section 363(f) of the Bankruptcy Code. The outcome depended on whether the Bankruptcy Court embraced the broader definition of "interest" adopted by the Second, Third, Fourth and Seventh Circuits, and the US Bankruptcy Appellate Panel of the First Circuit, or a narrow definition meaning only in rem interests in property.

Under section 363(f), a trustee may sell property free and clear of any entity's interest in the property only if at least one of the following conditions is met:

The Bankruptcy Code does not define "interest" and courts have addressed the scope of the term on a case-by-case basis.

The Bankruptcy Court adopted a broad interpretation of the term interest and held that a debtor's experience rating is an interest in property within the meaning of section 363(f).

The Bankruptcy Court followed the US Court of Appeals for the Second Circuit's decision in In re Chrysler, LLC, which endorsed a broad definition of interest in section 363(f), allowing the debtor to sell its manufacturing assets free and clear of claims arising from the sale, including tort claims. The Bankruptcy Court also followed the First Circuit BAP decision in In re PBBPC, Inc., which held that a debtor's experience rating fell within the definition of "any interest" of which the debtor's assets could be sold free and clear (see Legal Update, In re PBBPC: First Circuit BAP Adopts Expansive Definition of "Interests" Excluded from Successor Liability in a Section 363 Sale).

The Bankruptcy Court noted that its holding was consistent with the purpose of bankruptcy sales. Bankruptcy sales are meant to maximize the value of assets available for distribution to creditors, which is achieved by allowing assets to pass to purchasers free of all interests, not solely in rem interests. The purchaser would presumably have paid a lesser amount for the assets if the sale had not been free and clear.

There is a split of authority on this issue. The Bankruptcy Court rejected the US Court of Appeals for the Sixth Circuit's decision in In re Wolverine Radio Co., in which the Sixth Circuit defined an interest as something that attaches "to the property so as to cloud its title." The Bankruptcy Court disagreed, explaining that the higher experience rating was imputed to the purchaser as a direct result of the sale and subsequent ownership of the Debtors' assets. Additionally, in this case, the sale order specifically provided that the purchaser would not be deemed a successor within the meaning of all federal, state and local taxes and labor laws.

This decision follows the trend adopted by several circuit courts towards applying an expansive definition of the term "interest" as used in section 363(f) of the Bankruptcy Code. This interpretation maximizes the purchase price for assets sold in bankruptcy, which ultimately benefits all creditors.