By Adam C. Rogoff and Ashland J. Bernard (Kramer Levin)
One feature commonly seen in commercial lending transactions is a waiver of the borrower’s authority to file for bankruptcy without the consent of the lender. While such “blocking” provisions are generally upheld where the equity interest holders are the parties with such rights, they are generally unenforceable as a matter of public policy when such protection is given to a creditor with no meaningful ownership interest in the corporate debtor.
In a recent decision issued in In re Roberson Cartridge Co., LLC, Case No. 22-20192 (RLJ), 2023 Bankr. LEXIS 588 (Bankr. N.D. Tex. March 7, 2023), the Bankruptcy Court for the Northern District of Texas denied a secured creditor’s motion to dismiss the corporate debtor’s Chapter 7 case on the grounds that the petition was filed without the requisite corporate authority. In doing so, the bankruptcy court held void as against public policy a blocking provision in the company’s governing documents, which purported to give the creditor — which held convertible debt of the debtor — the exclusive right to consent to the debtor’s bankruptcy filing. Through an analysis of the company’s governing documents under applicable provisions of the Texas Business Organizations Code, the bankruptcy court concluded that a pledge of equity by the debtor-LLC’s member did not divest the LLC’s manager from corporate authority to file for bankruptcy. Nor was the consent right enforceable with respect to convertible debt where, prior to the bankruptcy filing, the creditor had not exercised its right to convert the debt to equity (and therefore was only a creditor on the petition date). This ruling of a bankruptcy court in the Fifth Circuit joins the growing body of case law from other circuits that holds such bankruptcy-restrictive contractual provisions void as a matter of public policy.
Note: Last week the Roundtable concluded its series on crypto bankruptcies. We will resume our regular posts beginning with this week’s post, featuring an article by attorney Michael L. Cook.
By Michael L. Cook (Schulte Roth & Zabel LLP)
This essay shows why a bankruptcy court preliminary injunction should be reviewable on appeal by an Article III court. District courts are split on the issue, often declining to review these rulings on the grounds that they are not “final” and that review is unwarranted. Although the Third, Seventh and Eighth Circuits hold that the Judicial Code authorizes appellate review, only the Second Circuit disagrees, based on a blinkered reading of the Judicial Code and U.S. Supreme Court precedent.
A district court’s preliminary injunction ruling (granting or denying) is concededly subject to review by a court of appeals under the explicit terms of the Judicial Code. Sound policy reasons, common sense and the obligation of the federal courts to hear cases within their statutory jurisdiction also show that bankruptcy court injunction rulings should not be insulated from appellate review. No sound reason exists for treating these bankruptcy court rulings differently from an identical district court ruling.
This series is being managed by the Bankruptcy Roundtable and Xiao Ma, SJD at Harvard Law School, xma [at] sjd [dot] law [dot] harvard [dot] edu.
Check the HLS Bankruptcy Roundtable periodically for additional contributing posts by academics and practitioners from institutions across the country.
The difference between owning (i.e. having property rights in something) and being owed (i.e. having a right against a person by way of obligation) is at its most stark in bankruptcy. In the wake of multiple bankruptcies of crypto entities last year, the question of whether customers of these entities owned or were merely owed has come into sharp focus, especially when the entity has been engaged in what the industry has coined CeFi (centralized finance), which involves the lending and borrowing of crypto assets. In theory, the same questions are engaged in a DeFi (decentralized finance) transaction, where one of the roles is substituted by a peer (often pseudonymous) rather than a centralized intermediary. Determining whether property in “loaned” crypto assets belongs to a failed borrower (whether centralized intermediary or peer) who simply owes an obligation to the lender or remains with the lender throughout involves a question of characterization. Two recent motions in the Celsius litigation are instructive of how this characterization is undertaken by the courts and although the case involves CeFi rather than DeFi, there is no reason why the same reasoning does not extend to DeFi as well.
The arrangement mirrors exactly the traditional position relating to interest-bearing bank accounts, established since the mid-19th century in the common law world to entail an obligation owing to customers rather than ownership of money by customers. Cases like Thompson v Riggs 72 U.S. 663 (1866) and Foley v Hill (1848) 2 HLC 28, 9 ER 1002 decided that absent any special conditions, money deposited with a bank became the property of the bank, with the customer obtaining a claim to the return of the same amount of money (plus interest) on demand. The obligation is fungible (the bank need not return the same coins and notes deposited) and forms the basis for borrowing short and lending long that is the backbone of modern banking. This characterization is necessary because money, unlike some other property, does not have any inherent utility except by way of alienation. A bank uses deposited money as it pleases (usually by extending loans itself), makes what profit it can, and pays back to its customer the principal and agreed interest. How could a bank generate profits off the money were it otherwise?
However, most crypto assets are not suitable for non-fungible loans since, like money, they can only be enjoyed through alienation. As Warren Buffett famously explained in a CNBC interview, “If you said … for a 1% interest in all the farmland in the United States, pay our group $25 billion, I’ll write you a check this afternoon,” Buffett said. ”[For] $25 billion I now own 1% of the farmland. [If] you offer me 1% of all the apartment houses in the country and you want another $25 billion, I’ll write you a check, it’s very simple. Now if you told me you own all of the bitcoin in the world and you offered it to me for $25 I wouldn’t take it because what would I do with it? I’d have to sell it back to you one way or another. It isn’t going to do anything. The apartments are going to produce rent and the farms are going to produce food.” Without treading on the controversial question of whether all or most crypto assets are thus Ponzi schemes, the point holds that simply holding crypto assets doesn’t generate any returns so, unless a loan of crypto assets is characterized in the same way as a loan of money, it is difficult to see what the point of the loan is (from the borrower’s point of view) and how the borrower is supposed to generate the profits in order to pay the lender the interest it has promised. As a result, it is unsurprising that the court found that the customers had clearly made a “loan” of the fungible rather than non-fungible variety, where ownership of the property passed to Celsius in return for an obligation to return an equivalent sum plus interest.
Editor’s Note: On November 1, 2022, the BRT concluded our eight-part series on the Texas Two-Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies (see below for the full list of posts in the series). On January 30, 2023, the Third Circuit released its opinion dismissing the bankruptcy filing of LTL Management, raising a host of new questions for mass tort bankruptcies. In response, the BRT invited contributors to the prior series, as well as some new voices, to analyze the decision and what it might mean for the future of mass tort bankruptcies.
We will resume our series on crypto bankruptcies next week!
In “The Dismissal of LTL and What Lies Ahead for Mass Tort Bankruptcy,” William Organek (Harvard Law School) summarizes the Third Circuit’s opinion dismissing LTL’s bankruptcy filing. The post then describes key takeaways from the opinion, suggesting how this might impact future mass tort bankruptcy filings, LTL’s tort creditors, and parent company Johnson & Johnson. Finally, it examines questions raised by mass tort bankruptcies that the opinion does not answer, instead leaving them for future cases and debtors.
In “Over-Thinking Ramifications of the Dismissal of LTL Management LLC’s Bankruptcy,” Hon. Judith K. Fitzgerald (ret.) (University of Pittsburgh School of Law and Tucker Arensberg, P.C.) explains how the Third Circuit’s opinion merely applies existing Third Circuit precedent to a single debtor to reach a fact-specific conclusion about the appropriateness of bankruptcy for LTL Management LLC. In doing so, the post argues against concerns that the opinion will make it more difficult for companies facing imminent financial distress to use bankruptcy to resolve their liabilities, even in the mass tort context.
Note: Judge Fitzgerald is a consultant for counsel for certain parties in the LTL bankruptcy, and the opinions expressed herein are solely her own.
In “The Implications of LTL’s Per-Debtor Analysis,” Adam J. Levitin (Georgetown University Law Center and Gordian Crypto Advisors LLC) describes how the LTL decision interacts with the standard entity separateness explanation for much of corporate law. If courts read the opinion strictly to require a debtor-by-debtor analysis of insolvency, this could have major implications for joint administration, venue, and other issues central to bankruptcy administration that stretch far beyond the mass tort context.
Note: Adam Levitin is a consultant for counsel for certain parties in the LTL bankruptcy, and the opinions expressed herein are solely his own.
In “Waltz Across Texas: The Texas Three-Step,” Edward J. Janger (Brooklyn Law School) and John A. E. Pottow (University of Michigan Law School) explore how the seemingly limited decision in the LTL bankruptcy cannot be divorced from wider questions about why bankruptcy is being used to resolve mass tort liability. Focusing on the essential role that third-party releases play in mass tort bankruptcy filings, it suggests that we consider not only whether financial distress is required for good faith, but also what should be required of nondebtors seeking third-party releases and what justifies such extraordinary relief.
In “The Third Circuit’s New One-Step: Good Faith as Purpose in LTL,” Jonathan C. Lipson (Temple University–Beasley School of Law) analyzes the LTL decision by examining how the court understands the concept of good faith. Earlier decisions in the Third Circuit relied on a primarily contractualist, or rules-based approach to good faith–does a debtor face financial trouble or does it have a substantial number of creditors? The LTL decision, however, endorses a more policy-oriented, or standards-based approach to good faith, asking whether the contemplated use of bankruptcy appropriately furthers the policy goals of chapter 11. This could lead to a re-evaluation of whether bankruptcy should be used for resolving mass torts, and some of the tools used by bankruptcy courts to facilitate a deal among the debtor and its creditors. This could have particular ramifications for other mass tort bankruptcies such as that of Purdue Pharma.
A Different Look at Sec. 548 and Concluding Thoughts, by Hon. Judith K. Fitzgerald (University of Pittsburgh School of Law and Tucker Arensberg, P.C.) and Adam J. Levitin (Georgetown University Law Center and Gordian Crypto Advisors LLC); and John A.E. Pottow (University of Michigan School of Law)
By Charles M. Oellermann and Mark G. Douglas (Jones Day)
Courts disagree whether a bankruptcy court, in exercising its broad equitable powers, has the authority to award appellate legal fees as a sanction for contempt. The U.S. Court of Appeals for the Second Circuit recently weighed in on this issue as an apparent matter of first impression. In Law Offices of Francis J. Reilly, Esq. v. Selene Finance, L.P. (In re DiBattista), 33 F.4th 698 (2d Cir. 2022), the Second Circuit held that a bankruptcy court erroneously concluded that it did not have the power to award attorney fees incurred on appeal by a debtor seeking to enforce a contempt order for violations of a bankruptcy discharge order.
The Second Circuit explained that it is well settled that a bankruptcy court, exercising its broad equitable powers under section 105(a), “may compensate a debtor for a creditor’s violation of [a] discharge order” entered under section 524(a). These provisions, the court wrote, which “‘bring with them the old soil that has long governed how courts enforce injunctions,’” authorize a court to impose civil contempt sanctions to coerce compliance with an injunction or to compensate a complainant for losses arising from noncompliance. “[I]n line with long-established practice,” the Ninth Circuit explained, a bankruptcy court’s contempt power includes the authority to compensate a party for damages arising from noncompliance with an injunction, “even if those losses take the form of appellate litigation fees.”
The Second Circuit rejected the argument that the “American Rule” precludes an award of appellate fees “absent explicit statutory authority.” According to the court, an exception to the American Rule has long been recognized that permits a court to award legal fees for willful disobedience of an order entered as part of a fine levied on a contemnor.
By Christopher D. Hampson (University of Florida Levin College of Law)
Social entrepreneurs and lawyers gave birth to the benefit corporation out of frustration with the Delaware law that governs fiduciary duties during insolvency. The benefit corporation statutes require directors to consider general and specific public benefit alongside the interests of shareholders. While legal scholars have grappled with whether the benefit corporation form works well to preserve social commitments, we have not yet explored fully what would happen when a benefit corporation files for bankruptcy.
I attempt to answer that question in Bankruptcy & the Benefit Corporation. As I see it, during good times, the benefit corporation may not improve on traditional corporate forms. After all, wise leaders can balance short-term and long-term goals and weigh the interests of shareholders against stakeholders, within the space provided by the business judgment rule. Whether those leaders are indeed wise is probably more important than the corporate form itself. But during bad times, the law tightens around directors, and that’s where the benefit corporation form provides extra protection for directors committed to both doing well and doing good.
My analysis of duty-based, utility-based, and character-based approaches indicates that we should want commitments to public benefit to persist into bankruptcy. Drawing from Carl E. Schneider’s “channelling” function of law, I argue that the benefit corporation stands as a meaningful “third way” for entrepreneurs, investors, and employees, a corporate form that attracts those interested in pursuing profit while accomplishing some social goal.
When it comes to bankruptcy, some scholars are quite pessimistic about the benefit corporation’s fate. After all, the U.S. Supreme Court has told us that the trustee in bankruptcy has a duty to maximize the value of the estate, and that duty might replace or wash out the fiduciary duties of the directors of a benefit corporation. I am more optimistic. The duty of the trustee in bankruptcy is famously underdefined (what kind of value? value to whom?). Against the Supreme Court’s vague pronouncements, 28 U.S.C. § 959 and the Butner principle suggest that state law innovations, like the benefit corporation, should control.
The remainder of the article explores the complexity of running that argument through the reticulated, multiplayer world of an insolvency case, because — well, this is bankruptcy. Rules like adequate protection and absolute priority serve as guardrails that state law fiduciary duties cannot override.
I might be wrong, and it could be some time before we know one way or the other. By publication, I had found one filing by a benefit corporation, Medolac Laboratories in the District of Nevada, and it didn’t raise the issues I explore in the article. When more data comes in from benefit corporation filings, we may find out what bankruptcy courts think about the newest corporate entities to face financial distress.
The full article has been published in the American Bankruptcy Law Journal (96 Am. Bankr. L.J. 93 (2022)) and is available here.
Note: The Harvard Law School Bankruptcy Roundtable is pleased to resume regular weekly posts for the academic year.
By Douglas G. Baird (University of Chicago Law School)
Negotiations are the lifeblood of Chapter 11, and a large part of the bankruptcy judge’s job is to police them. Bankruptcy judges are not dispensers of Solomonic wisdom. They are referees who ensure a level playing field. They insist that the parties follow the rules, but they do not enforce rules for their own sake nor do they allow their oversight to interfere with the flow of play. Their job is to give parties a chance to work together on equal terms to find a path forward.
Notwithstanding the centrality of negotiations, little of the written law says much about how bankruptcy judges should oversee them. The few explicit statutory mandates are pitched at a high level of abstraction. They require little more than that judges ensure that bargains be proposed in “good faith” and meet certain substantive conditions to be considered “fair and equitable,” without defining how the bargaining process could meet these standards. Precedent is similarly unhelpful. One can exhaust virtually all the guidance the Supreme Court has offered over the last century and a half in a few sentences: The judge cannot be a “silent registrar of agreements.” Nor can the judge approve deals that “alter the balance” of substantive rights set out in the statute. At the same time, the judge should not come to the aid of a creditor who declines a “fair offer.” Lower courts are similarly silent. Among the many hundreds of volumes of reported opinions, few provide much guidance.
Much less is up in the air than it first seems, however. The judge is bound by a coherent set of unwritten principles that derive from the Statute of 13 Elizabeth and fraudulent conveyance law as it was received in this country in the late eighteenth century. Over the course of the nineteenth century, judges drew on this uncodified power to craft an approach to policing negotiations between creditors and a financially distressed debtor. The legal reforms of the 1930s and the 1970s drew again on these same principles. This unwritten law remains central to modern reorganization practice.
The Unwritten Law of Corporate Reorganizations traces this long arc of reorganization law in the United States. It uncovers a history rich with interesting characters, including Founding Father Alexander Hamilton, corporate law giant Paul Cravath, and SEC chairman and Supreme Court justice William O. Douglas. Their stories illuminate the way bankruptcy judges have long used a set of unwritten rules, derived from fraudulent conveyance principles, to oversee the reorganization process.
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.
By Michael J. Cohen, Michael A. Rosenthal & Matthew J. Williams (Gibson Dunn)
The recent decision in In re Purdue Pharma did not uphold the third-party releases in the bankruptcy court’s approved plan. This post discuss the third-party releases issue.
— Harvard Law School Bankruptcy Roundtable Editors
On July 28, 2021, certain Democratic members of Congress, primarily in response to the $4.325 billion contribution made by the Sackler family to fund the settlement underpinning Purdue Pharma’s chapter 11 plan, introduced the Nondebtor Release Prohibition Act of 2021 (the “NRPA”), which proposes to amend the Bankruptcy Code to (i) prohibit the use of non-consensual third party releases in chapter 11 plans, (ii) limit so-called “Section 105” injunctions to stay lawsuits against third parties to a period no greater than 90 days after the commencement of a bankruptcy case, and (iii) provide a ground for dismissing a bankruptcy case commenced by a debtor that was formed within 10 years prior to such case via a divisional merger that separated material assets from liabilities.
When viewed against the backdrop of current complex chapter 11 practice, the NRPA is a flawed remedy for issues for which alternative means of redress already exist. First, the proposed elimination of the important bankruptcy tools of non-consensual third party releases and Section 105 injunctions – each of which is extraordinary in nature and only permitted in the rarest of circumstances – is a blunt force measure that threatens to vitiate the longstanding bankruptcy policy of favoring settlements over interminable value-destructive litigation. Second, the loss of these tools may cause inequitable disruption in currently pending cases and stymie the implementation of critical creditor-supported strategies to resolve the most difficult cases going forward. Moreover, a per se prohibition against non-debtor releases would contravene core bankruptcy principles by elevating the interests of a minority of creditors who would otherwise be bound to the terms of a chapter 11 plan containing such a release that is supported by the requisite majorities required under the Bankruptcy Code. Third, while the disincentive against divisional mergers would affect a far more limited set of cases, it appears that the harm raised by some divisional mergers that are followed by bankruptcy may be adequately addressed through clarifying the applicability of fraudulent transfer law to challenge these transactions.
On November 3, 2021, the House Judiciary Committee sent the NRPA to the House floor for further consideration; the Senate Judiciary Committee has yet to act on the bill. For more detail on the NRPA and our analysis of the bill, please find the full article here.
By Ralph Brubaker (James H.M. Sprayregen Professor of Law, University of Illinois College of Law)
The recent decision in In re Purdue Pharma did not uphold the third-party releases in the bankruptcy court’s approved plan. This post discuss the third-party releases issue.
— Harvard Law School Bankruptcy Roundtable Editors
This response to Professor Lindsey Simon’s Bankruptcy Grifters article challenges the controversial practice at the epicenter of the bankruptcy grifter phenomenon that Simon critiques: so-called nonconsensual nondebtor (or third-party) “releases” and “channeling” injunctions that discharge the mass tort obligations of solvent nondebtor entities who have not themselves filed bankruptcy. These nondebtor releases are an illegitimate and unconstitutional exercise of substantive lawmaking powers by the federal courts that contravenes the separation-of-powers limitations embedded in both the Bankruptcy Clause and Erie’s constitutional holding. The federal courts have manufactured out of whole cloth the unique, extraordinary power to impose mandatory non-opt-out settlement of a nondebtor’s mass tort liability on unconsenting tort victims through the bankruptcy proceedings of a codefendant. The bankruptcy “necessity” that supposedly justifies this astounding and unique settlement power—to mandate nonconsensual non-opt-out “settlements” that are otherwise impermissible and unconstitutional—is (at best) naive credulity or (at worst) specious sophistry.
Nonconsensual nondebtor releases are not “necessary” for the bankruptcy process to facilitate efficient aggregate settlements of the mass tort liability of both bankruptcy debtors and nondebtor codefendants. The bankruptcy jurisdiction, removal, and venue provisions of the Judicial Code already contain the essential architecture for mandatory, universal consolidation of tort victims’ claims against both bankruptcy debtors and nondebtor codefendants. Bankruptcy can be an extremely powerful aggregation process that facilitates efficient (and fair) settlements of the mass tort liability of nondebtors, even (and especially) without nonconsensual nondebtor releases, particularly if the Supreme Court elucidates the full expanse of federal bankruptcy jurisdiction. Nondebtor releases are an illicit and unconstitutional means of forcing mandatory settlement of unconsenting tort victims’ claims against solvent nondebtors, and the Supreme Court should finally resolve the longstanding circuit split over the permissibility of nonconsensual nondebtor releases by categorically renouncing them.
The full article is available here and is forthcoming in the Yale Law Journal Forum.