[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] Introduction to LTL Management’s Bankruptcy

By Jin Lee and Amelia Ricketts (Harvard Law School)

Note: This is the first in a series of posts on the Texas Two Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies.  Check the HLS Bankruptcy Roundtable throughout the summer for additional contributing posts by academics from institutions across the country.

Jin Lee
Amelia Ricketts

Judge Kaplan’s recent decision not to dismiss the LTL Management (LTL)/Johnson & Johnson (J&J) bankruptcy has further stirred controversy about the hotly debated Texas Two-Step Maneuver, and put an end to speculation on how the bankruptcy court would rule on J&J’s Texas Two-Step bankruptcy filing.  (The decision has been appealed directly to the Third Circuit).

The court rejected tort claimants’ arguments that LTL’s filing violated the good faith requirement for Chapter 11 filings or warranted “for cause” dismissal under Section 1112.  Judge Kaplan held that the filing was an appropriate use of the Bankruptcy Code to maximize value available to creditors, commenting that the bankruptcy court would be the “optimal” venue to resolve tort claimants’ treatment.  The judge emphasized compliance with the terms of the Texas divisional merger statute as evidence of J&J’s good faith.  He also viewed the funding agreement among LTL, J&J, and J&J’s consumer division subsidiary as providing LTL with appropriate capitalization to meet the talc claimants’ needs.  As a result, Judge Kaplan concluded that the talc claimants’ interests would be best served by the bankruptcy process and denied their motion to dismiss.

The full post discussing the case is available here: Introduction to LTL Management’s Bankruptcy.

 

Due Process Alignment in Mass Restructurings

By Sergio J. Campos (University of Miami School of Law) and Samir D. Parikh (Lewis & Clark Law School)

Sergio J. Campos
Samir D. Parikh

Mass tort defendants have recently begun exiting multi-district litigation (MDL) by filing for bankruptcy. This new strategy ushers defendants into a far more hospitable forum that offers accelerated resolution of all state and federal claims held by both current and future victims.

Bankruptcy’s resolution promise is alluring, but the process relies on a very large assumption: future claimants can be compelled to relinquish property rights – their cause of action against the corporate defendant – without consent or notice. Bankruptcy builds an entire resolution structure on the premise that the Bankruptcy Code’s untested interest representation scheme satisfies Due Process strictures. This Article questions that assumption, and identifies two compromised pillars. Primarily, the process for selecting the fiduciary that represents future victims’ interests (FCR) is broken. Further, the process by which courts estimate the value of thousands of mass tort claims places too much pressure on a jurist unfamiliar with personal injury claims. These compromised pillars raise the risk that the settlement trust will be underfunded and fail prematurely. In this outcome, future victims would have no recourse but to argue that the process did not satisfy Due Process, and the settlement should be unwound.

This Article proposes that the risk of a prematurely insolvent victims’ trust can be reduced considerably by making two adjustments. Our proposal seeks to (i) rebuild the FCR construct in order to ensure that future victims’ interests are effectively represented, and (ii) recalibrate the claim estimation process by facilitating coordination between the bankruptcy court and nonbankruptcy trial courts.

The full article is forthcoming in the Fordham Law Review and is available here.

 

Holdout Panic

By Stephen J. Lubben (Seton Hall Law School)

Stephen J. Lubben

It has been recognized that corporations themselves are designed to promote collective action, and thus “a primary function of corporate law is to coordinate and constrain individual behavior – even profit-motivated behavior.”  Given that corporate debt instruments largely serve a governance function amongst creditors, it is not surprising that they, like corporations themselves, tend to quash individual action in favor of the group.  But the divergence between individual and group interests comes to the fore in times of stress.

An individual creditor can be either an oppressed minority investor or a holdout.  Majority holders can be either the group seeking an efficient and beneficial restructuring, or effectively an insider group that collaborates with more formal insiders to extract value from minority creditors.  Which reality is genuine is highly dependent on the particular facts of the case at hand, and may be quite difficult for an outsider to discern.

Restructuring law attempts to balance this uncertainty by providing a series of checks and balances.  In general, restructuring law begins with a preference for the collective, but encircles the collective with a series of rules that protect individual creditors from abuse.  

Some of the balance comes from the agreements that create the creditor relationship or duties related to those agreements; however, other aspects of balance are external and come from outside structures like the Bankruptcy Code or the Trust Indenture Act.  In general, the basic challenge here is to find the point at which the illegitimate power of holdouts is reduced without trampling on the legitimate rights of minority creditors.  It is very easy to avoid holdouts if the majority always wins.

My paper explores the ways in which modern restructuring practice has moved toward that “majority always wins” extreme.  This change was not part of some grand plan, but rather the result of a series of incremental decisions, each reacting to perceived abuses by holdouts.  But in indulging our fears of holdouts, we have lost the essential balance of the system.

Take the example of the RSA – or restructuring support agreement – that, in a variety of ways, can represent a generalized assault on the requirement in section 1123(a)(4) that a chapter 11 plan must “provide the same treatment for each claim or interest of a particular class.”  RSAs achieve this end by providing for backstop fees paid to a select group that will never have to backstop anything or DIP loans that the debtor does not really need.

In one recent case, pre-bankruptcy the debtor contracted with a sub-group of its secured noteholders to have those noteholders make an interest payment on the notes.   That is, some of the secured noteholders paid the interest payment due to all the secured noteholders.

In exchange, these distinctive noteholders received new “super-priority secured notes” secured by a lien that surpassed the old secured notes’ liens, while also carrying a hefty 10% coupon.  When the debtor filed for chapter 11 later that same year, to implement its own RSA-driven plan, the new super-priority notes were paid in full, with interest and “make whole call” fees.  In short, the select lenders made a small, six-month loan for a very high return at low risk.  This opportunity was not available to everyone in the original class of noteholders.

In short, I conclude that the modern American restructuring system has evolved to favor the interests of the majority to the point where a debtor and a majority of its lenders can inflict serious harm on minority creditors.  At some point, this reality is bound to have consequences for both the debt markets and the utility of chapter 11.

The full article is available here.

Texas Two-Stepping Out of Bankruptcy

By Michael A. Francus (Harvard Law School)

Michael Francus

Johnson & Johnson’s use of the Texas Two-Step to manage its talc liabilities has put the company, and the Two-Step, front and center in the roiling debates over aggressive uses of the bankruptcy system. Those debates have led to scholarly criticism, congressional hearings, and proposed legislation that would curtail debtors’ ability to so use the bankruptcy courts.

My Essay details the mechanics of the Two-Step. Beginning with the Texas divisive merger, the funding agreement, and forum shopping for the Fourth Circuit, the Essay fleshes out precisely how the Two-Step boxes in tort claimants. Like other scholarship, this Essay identifies the risk that such maneuvering effects a fraudulent transfer. It also goes a step further, arguing that the point of the Two-Step is not to succeed, but to delay. Fraudulent-transfer litigation in a bankruptcy consumes time because it requires an adversary proceeding, and that delay pressures tort claimants to settle. So the Two-Step can succeed as long as claimants cannot wait out the course of the bankruptcy, even if a court never declares the particular Two-Step to be a proper use of divisive merger law rather than an improper fraudulent transfer.

Instead of playing into this delay game, this Essay argues, courts should evaluate the Texas Two-Step for good faith. Tort claimants can raise such challenges as a motion to dismiss (as some have) and thus avoid the need for a fraudulent-transfer adversary proceeding. And under current doctrine, the Two-Step likely qualifies as a bad-faith filing: In most cases, the Two-Step is a litigation tactic. And the Two-Step, invariably, is filed by an entity created solely to file for bankruptcy. Both of those are doctrinal hallmarks of bad-faith bankruptcies.

More broadly, the Essay explains, the Two-Step and good-faith challenges to it underscore the continuing role of common law in bankruptcy. The Code does not define good-faith filing, so courts have developed the doctrine case by case. They may yet find an acceptable form of Two-Step, one which yields tort claimants the rights they would receive in, say, a Johnson & Johnson bankruptcy, without hurting Johnson & Johnson’s ability to do business by forcing the whole company into bankruptcy. Along the way, though, a vigilant common-law gatekeeping is warranted, and judges should not hesitate to dismiss Two-Steps thinking that a later ruling on a fraudulent-transfer adversary proceeding can adequately safeguard tort claimants from an improper use of the bankruptcy system.

The full essay will be available at 121 Mich. L. Rev. Online __ (forthcoming 2022) and can be accessed here.

Mitigating Rejection of Midstream Agreements in Bankruptcy

By David H. Sweeney, Jason P. Rubin, and Laura P. Warrick (Akin Gump Strauss Hauer & Feld, LLP), with Practical Law Oil & Gas

Producers of hydrocarbons generally require some level of gathering, processing, and other midstream services to monetize hydrocarbons. Midstream services are typically secured through contracts between the producers and the midstream providers. The fixed facilities that are required to perform those midstream services require significant investment by the midstream providers and have capacity constraints. To ensure producers’ performance and protect their investment, midstream providers often include in their contracts a dedication clause styled as a “covenant running with the land”. This clause purports to dedicate the land or reserves to the midstream infrastructure and is intended to bind third parties, including estates in bankruptcy, as an interest in real property. 

Decisions in recent Chapter 11 cases have challenged the notion that midstream services contracts containing purported covenants running with the land are not rejectable under section 365 of the Bankruptcy Code. The result is that a debtor may be able to reject a midstream contract containing a covenant running with the land, repudiate future performance of its duties, and a midstream service provider may find its claims reduced to a pre-petition unsecured claim for monetary damages. 

This article explores some recent case law regarding covenants running with the land in bankruptcy and offers practical suggestions for how producers and midstream providers might navigate the newly developing reality, including: 

  • Conducting diligence on midstream contracts to identify red flags and address potential issues before they become problems.
  • Addressing the shortcomings of covenants running with the land noted by bankruptcy courts.
  • Replacing covenants running with the land with a substitute, such as a presently possessory interest or a lien.

The full article is available here.

Are Judges Randomly Assigned to Chapter 11 Bankruptcies? Not According to Hedge Funds

By Niklas Hüther (Indiana University) and Kristoph Kleiner (Indiana University)

Niklas Hüther
Kristoph Kleiner

”The bankruptcy system is supposed to work for everyone, but in many cases it works only for the powerful.”  – House Judiciary Committee Chairman Jerrold Nadler, July 28th, 2021

Researchers have long recognized that judicial outcomes are subject to the biases of the ruling judge. To alleviate concerns of fairness, courts in both the U.S. and abroad claim to assign judges to individual court cases randomly. From a policy perspective, randomization promotes public confidence in the judicial process by limiting forum shopping and the individual influence of any individual judge. From an academic perspective, recent empirical research in economics and finance exploits the random assignment of judges to causally identify of a wide range of legal outcomes.

This paper revisits the claim of randomized judicial assignment in the context of U.S. Bankruptcy Court. Our research is motivated by legal scholarship arguing that debtors in recent cases are influencing judicial assignments (Levitin, 2021), as well as renewed interest in these issues from policy makers and the public (Merle and Bernstein, 2019; Randles 2020). Despite these arguments, there are reasons to believe assignment is random. For instance, after contacting all U.S. Bankruptcy Courts, Iverson et al. (2017) found that only one court (the Eastern District of Wisconsin) reports assigning cases to judges non-randomly. In addition, a range of research including Bernstein et al. (2019) provides convincing evidence that debtor characteristics fail to predict judicial assignments. Missing from this literature is any large-scale empirical evidence of non-random assignment.

Analyzing U.S. corporate bankruptcy filings between 2010 and 2020, we provide new evidence that assignment is not random, but predicted by the lending decisions of hedge funds. By focusing on investments made before the assignment of a bankruptcy judge, our technique is not suspect to standard critiques that predictability is merely an outcome of ex-post data mining; instead, in order for investors to systemically invest in firms that are later assigned a preferred judge, it must be possible to infer future judicial assignments. In addition, we focus on hedge funds, as they routinely influence a wide range of bankruptcy outcomes including emergence and debt restructurings.  The prevalence of these investors allows us to explore a new channel of activism in the distress debt market: activist influence in judicial assignment process prior to filing.

In our setting, judges can decide whether to convert a Chapter 11 bankruptcy to a Chapter 7 liquidation; while secured creditors may have a preference for liquidation, unsecured creditors recover more under reorganization.  Exploiting this distinction, we confirm unsecured hedge fund creditors (relative to secured hedge funds) are significantly less likely to be assigned a judge with a tendency to convert Chapter 11 cases.  We also extend our analysis to an alternate bankruptcy outcome measure: the unsecured creditor recovery rate according to the confirmed plan. We find unsecured hedge funds are far more likely to be assigned a judge with a high past unsecured recovery rate.

We next test whether these estimates differ across the filings in our sample. First, we find that unsecured hedge fund claimants are assigned a preferable judge more commonly when the hedge fund invested shortly before the bankruptcy filing, suggesting hedge funds choose to invest explicitly to influence the filing. Second, we show the effects are greatest when the hedge fund is on the board of directors of the debtor at the time of filing, providing further support for the role of communication between debtor and creditor.

Finally, we conduct three robustness tests. First, we find no evidence that a judge’s future conversion rate (after controlling for the past conversion rate) is predicted by hedge fund investment, suggesting hedge funds are explicitly influencing judicial assignment based on information regarding past information. Second, focusing on the subset of districts that explicitly state random assignment within their district, we continue to find hedge fund investments predict assignment. Third, we include district-office-year fixed effects in our analysis and continue to find a relationship between hedge fund investments and assignment.

Moving forward, we believe there are two potential policies that can alleviate these issues. The first, and simplest, is for policy makers to develop a truly randomized process. Alternatively, policy makers can instead increase the number of bankruptcy judges, leading to lower predictability even if assignment is not fully randomized. Policy makers intent on a fairer judicial system should consider both proposals.

The full article is available here.

This piece previously appeared on the Oxford Business Law Blog.

The Importance of Being Bound: Bondholders’ Vote and Workouts in the U.S. and in Italy

By Francesca Prenestini (Bocconi University, Milan)

Francesca Prenestini

Most legal systems follow one of two rules for regulating the capacity of an issuer to renegotiate the terms of the bond loan to avoid insolvency or to accommodate changing capital needs. The first rule requires the individual consent of every bondholder while the second one permits the proposed agreement to be approved upon a majority decision which also binds dissenting bondholders.

This article analyzes the desirability of adopting a regulatory approach that allows a binding vote of bondholders on amendments of the core terms of the loan and other restructuring measures, including the conversion of bonds into shares. In doing so, this article examines the drawbacks of the prohibitive approach, which requires consent from all bondholders, with particular regard to the judicial cases and business practices of two major legal systems (the U.S. and Italy).

In the U.S., the Marblegate and Caesars cases have reignited the debate on out-of-bankruptcy restructurings of bond issues. In 2015, the U.S. District Court for the Southern District of New York reaffirmed that coercive exit consent transactions which force bondholders into questionable restructurings are prohibited by § 316(b) of the Trust Indenture Act of 1939 (“TIA”). Then, in January 2017, the U.S. Court of Appeal for the Second Circuit adopted a narrower interpretation, holding that § 316(b) only prohibits formal non-consensual modifications of an indenture’s core payment terms.
The district court’s interpretation, though broad, is more coherent with the text, the legislative history, and the purpose of the TIA. Section 316(b) provides that the individual right of each bondholder to receive payment of the principal of and interest on their indenture security on the due dates cannot (with a few minor exceptions) be impaired without the bondholder’s consent. This section was enacted to protect bondholders from insider abuses by giving individual bondholders the power to veto proposed amendments in an out-of-court restructuring. However, this individual veto power often precludes even fair renegotiation agreements between the issuer and the bondholders.

Under Italian law, the meeting of bondholders may approve “amendments of the terms of the loan” by majority vote. Nevertheless, in the light of quite restrictive interpretations of such a rule, those modifications may not change the structural characteristics of the bond loan.

This article suggests that governments should adopt rules that allow a majority bondholders’ vote to accept out-of-bankruptcy restructurings of bond issues. Currently two different solutions may be implemented in the U.S. and Italy: in the U.S., until § 316(b) can be reformed, the Securities and Exchange Commission could exercise its power to grant exemptions to authorize transactions and agreements otherwise banned; and in Italy, in the absence of a statutory prohibition, the contract governing the loan could include a provision allowing the meeting of bondholders to vote upon amendments of the core terms of the loan and other restructuring measures, such as the conversion of bonds into shares.

This article first examines the two different approaches to bond loans restructuring in various legal systems and in the context of sovereign debt, and considers why allowing a binding vote of the bondholders in workouts is so important given the rationales for and against this rule. Then it focuses on the U.S. legal system, and discusses the statutory provision that bans the majority rule, how the jurisprudence and business practices have evolved, and recent proposals for reform. The article also considers the Italian system, its rules and business practices, and how to overcome its limits. In the end, this article suggests an alternative rule and proposes interim solutions to the problem while awaiting statutory reform.

The full article is available here.

For previous Roundtable posts on § 316(b) of the TIA and Marblegate, see William W. Bratton, The New Bond Workouts; Out-of-Court Restructurings After Marblegate: Trust Indenture Act Section 316(b) and Beyond; Benjamin Liu, Exit Consents in Debt Restructurings; Second Circuit Rules on § 316(b) in Marblegate; Mark Roe, The Trust Indenture Act of 1939 in Congress and the Courts in 2016: Bringing the SEC to the Table; National Bankruptcy Conference Proposed Amendments to Bankruptcy Code to Facilitate Restructuring of Bond and Credit Agreement Debt; David A. Brittenham, Matthew E. Kaplan, M. Natasha Labovitz, Peter J. Loughran, Jeffrey E. Ross, and My Chi To, 28 Law Firms Publish White Paper Addressing Trust Indenture Act Complications In Debt Restructurings; Carlos Berdejó, Revisiting the Voting Prohibition in Bond Workouts (providing evidence related to argument made in Mark Roe, The Voting Prohibition in Bond Workouts, 97 Yale L.J. 232 (1987)).

Senate Judiciary Committee Subcommittee Hearing on the “Texas Two-Step”: A Recap

By Amelia S. Ricketts (Harvard Law School) and Jin Lee (Harvard Law School)

Amelia Ricketts
Jin Lee

On February 8, 2022, the Senate Subcommittee on Federal Courts, Oversight, Agency Action, and Federal Rights held a hearing on the process through which corporations allegedly side-step accountability through divisive mergers undertaken immediately prior to bankruptcy, commonly known as the “Texas Two-Step.”

Companies have used the Two-Step when they have incurred significant liabilities in mass tort cases. The company first changes its state of incorporation to Texas or Delaware. It then carries out a divisive merger, splitting into GoodCo and BadCo. GoodCo retains all of the company assets and the non-tort liabilities, while BadCo retains the mass tort liabilities. BadCo then files for bankruptcy, while GoodCo continues business in the ordinary course. BadCo requests that the automatic stay be extended to GoodCo, preventing tort victims from seeking relief from GoodCo.

Typically, as part of the divisive merger, GoodCo and BadCo execute a funding agreement whereby GoodCo agrees to fund any victims’ trust established in bankruptcy, but usually specifying an amount far below the potential liability. One witness argued that these agreements should assuage concerns about divisive merger bankruptcies, while others argued that they did not offer tort victims real recourse.

Certain witnesses objected to using the Texas Two-Step to obtain the benefits of bankruptcy without the burdens and urged legislative reform to prevent divisive merger bankruptcies. Others argued that the current bankruptcy protections, such as bad faith dismissal and fraudulent transfer law, were sufficient to guard against abuse. However, courts are generally reluctant to dismiss a case for bad faith. Moreover, fraudulent transfer law’s usefulness is also uncertain, because the Texas state law treats the divisive merger transaction as though no transfer has occurred. The witnesses also discussed Johnson & Johnson’s use of the Two-Step as an example and test case for existing protections against abuse.

The full post is available here.

For previous Roundtable posts on the Texas Two-Step, see Samir D. Parikh, Mass Exploitation.

Scarlet-Lettered Bankruptcy: A Public Benefit Proposal for Mass Tort Villains

By Samir D. Parikh (Lewis & Clark Law School)

Samir D. Parikh

Financially distressed companies often seek refuge in federal bankruptcy court to auction valuable assets and pay creditor claims. Mass tort defendants – including Purdue Pharma, Johnson & Johnson, Boy Scouts of America, and USA Gymnastics – introduce new complexities to customary chapter 11 dynamics. Many mass tort defendants engage in criminality that inflicts widescale harm. These debtors fuel public scorn and earn a scarlet letter that can ultimately destroy the value of an otherwise profitable business. Scarlet-lettered companies could file for bankruptcy and quickly sell their assets to fund victims’ settlement trusts. This Article argues, however, that this traditional resolution option would eviscerate victim recoveries. Harsh public scrutiny has diminished the value of the resources necessary to satisfy claims, creating a discount that must be borne by victims.

My public benefit proposal charts a new course. Instead of accepting fire sale prices and an underfunded settlement trust, the scarlet-lettered company emerges from bankruptcy as a corporation for the public benefit. This modified reorganization offers victims the greatest recovery. The continued operation preserves value during a transition period, after which the going concern can be sold efficiently. Further, assets that have been tainted by corporate criminality are cleansed behind a philanthropy shield and sold to capture the value rebound. The victims’ collective is the owner of the new company and can participate in a shareholder windfall if the reorganized company experiences strong post-bankruptcy performance.

At the forefront of a new trend in aggregate litigation, this Article proposes a public benefit alternative to traditional resolution mechanisms. This approach delivers utility that will support application in a variety of contexts, assuming certain governance safeguards are maintained. In our new age of greater personal and corporate accountability, more scarlet-lettered companies will emerge and ultimately land in bankruptcy. The need to address the disposition of tainted assets will be paramount in compensating mass tort victims trying to reassemble fractured pieces. This Article explains a new phenomenon and reconceptualizes resolution dynamics in a way that will have policy implications that transcend aggregate litigation.

The full article will be available at 117 Nw. U. L. Rev. ___ (forthcoming 2022) and can be accessed here.

Creditor Rights, Corporate Leverage and Investments, and the Firm Type

By Aras Canipek (University of Konstanz), Axel H. Kind (University of Konstanz), and Sabine Wende (University of Cologne – Faculty of Management, Economics and Social Sciences)

Aras Canipek
Axel Kind
Sabine Wende

Stronger creditor rights reduce credit costs and thus may allow firms to increase leverage and investments, but also increase distress costs and thus may prompt firms to lower leverage and undertake risk-reducing but unprofitable investments. Using a German bankruptcy reform, we find evidence on average consistent with the latter hypothesis. We also hypothesize and find evidence that the effect of creditor rights on corporate leverage and investments depends on the firm type, as it influences the effect creditor rights have on credit costs and distress costs and thus which effect dominates. For example, our findings suggest that stronger creditor rights are costly for large firms, for which the effect of creditor rights on distress costs should outweigh the effect on credit costs, but beneficial for small firms, for which the effect on credit costs should outweigh the effect on distress costs. Our understanding not only reconciles the mixed empirical evidence of existing studies, but also has important implications for optimal bankruptcy design. In particular, our findings are contrary to a widely held opinion that bankruptcy law should be uniform and balance the effect of creditor rights on credit costs and distress costs. Rather, they point to a menu of procedures in which a debtor-friendly and creditor-friendly procedure co-exist and thus allow different types of firms to utilize the procedure that suits them best. If such a menu is not possible, our analysis suggests that countries should choose a debtor-friendly or creditor-friendly procedure, depending on the most important firm type in the country.

The full article is available here.

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