[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] A Different Look at Sec. 548 and Concluding Thoughts

Note: This is the eighth in a series of posts on the Texas Two-Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies. Styled as a coda of sorts, this double-post includes a new view on section 548 by Judge Judith Fitzgerald (ret.) and Adam Levitin, and some commentary on the other posts in the series by John Pottow.

Check the HLS Bankruptcy Roundtable periodically for additional contributing posts by academics and others from institutions across the country.

Earlier posts in this series can be found here (by Jin Lee and Amelia Ricketts), here (by Jonathan C. Lipson), here (by Jared A. Ellias), here (by Anthony Casey and Joshua Macey), here (by David Skeel), here (by Ralph Brubaker), and here (by Mark Roe and William Organek).


Post One: The Texas Two-Step: A Different Look at Bankruptcy Code Section 548

By Hon. Judith K. Fitzgerald (ret.) (Professor in the Practice of Law, University of Pittsburgh School of Law; Shareholder, Tucker Arensberg, P.C.) and Adam J. Levitin (Anne Fleming Research Professor & Professor of Law, Georgetown University Law Center; Principal, Gordian Crypto Advisors LLC)[^]

Hon. Judith K. Fitzgerald (ret.)
Adam J. Levitin

Is the divisive merger in a Texas Two-Step bankruptcy a fraudulent transfer?  To date, much of the analysis has focused on the question of the “transfer” of assets.  From this perspective, the application of fraudulent transfer law is an uncomfortable fit. In a divisive merger, OldCo disposes of assets and liabilities by assigning the valuable assets to GoodCo and dumping the disfavored liabilities on BadCo. Yet the  Texas divisive merger statute provides that “all rights, title and interest” in property are allocated in a divisive merger without “any transfer or assignment having occurred.”[1] If state law deems the divisive merger not to constitute any form of transfer, how can a fraudulent transfer have occurred?

As Roe and Organek rightly contend, the Supremacy Clause mandates use of the Bankruptcy Code  (“Code”) definition of “transfer” to the exclusion of contrary state law. Likewise, the Uniform Fraudulent Transfer Act has its own definition of transfer and indicates that the definitions are “[a]s used in this [Act],” such that even under state law the divisive merger statute’s definition of transfer would not control in a fraudulent transfer, voidable transactions, or § 544(b) action.

The key problem with viewing a divisive merger through the “transfer” lens is that Code § 548 requires the transfer to be one made by the debtor—BadCo—of its property or an interest it held in property. BadCo, however, did not exist at the time of the transfer and had no property at all. The transfer of the assets to GoodCo was not from BadCo, but from OldCo, which no longer exists. These seem to create impediments to attacking a divisive merger as a fraudulent transfer.

In order to bring the divisive merger within the ambit of § 548, a complainant might have to take an additional step, such as establishing that BadCo was the alter ego of the entity that transferred the property (as Roe and Organek note), or substantively consolidating BadCo and GoodCo. Without consolidation of BadCo and GoodCo, or an unwinding of the divisive merger altogether, a court could conclude that BadCo did not transfer property or an interest in property.

There is another part of § 548, however, that is a better fit for attacking a divisive merger.[2] Section 548 also permits the avoidance of an obligation incurred by the debtor, for which the debtor received less than reasonably equivalent value and/or was insolvent at the time or was made insolvent as the result of the obligation.

The Texas divisive merger statute presents no obstacle for this theory. That statute deals with allocation of assets and liabilities under separate provisions. The asset provision deems the allocation of assets not to be a transfer,[3] but there is no equivalent language in the liabilities provision.[4] That is, nothing in the Texas statute states that the allocation of liabilities is not the incurrence of an obligation.

Similarly, § 548 refers to incurrence of an obligation by the debtor, a concept that works much better than a focus on  transferring property of the debtor. Whereas the transfer provision implicitly requires the debtor to have had property to transfer in the first instance, the incurrence provision has no similar implication. All that is required is that the debtor, BadCo, incur an obligation that left it insolvent or insufficiently capitalized,  a description that fits the treatment of BadCo in a divisive merger to a tee.

For example, in the divisive merger that preceded the LTL Management LLC bankruptcy filing, the BadCo, LTL, was saddled with all of the talc liabilities of OldCo (Old JJCI), an unliquidated liability in the billions of dollars. As part of the same transaction, it was given royalty-producing assets worth enough to cover the anticipated professionals’ fees in the bankruptcy, and certain insurance policies. LTL was also allocated a funding agreement by which both GoodCo (New JJCI) and OldCo’s parent (J&J) were to cover talc liabilities inside or outside bankruptcy, up to the value of OldCo on the date of the divisive merger, provided that certain conditions to use are satisfied. All of OldCo’s other assets (valuable brands and the JJCI name) and other liabilities were allocated to New JJCI. If the talc claims against LTL exceed the value of OldCo, then LTL would be insolvent, and the incurrence of the talc liabilities would be avoidable under § 548.

The distinction between transfers and obligations may support a fresh look at § 548, but raises the question of the remedy. The Code’s remedial provision, § 550, deals solely with recovery for the benefit of the bankruptcy estate of any avoided transfers of property; it is not geared toward the incurrence of obligations. But § 550 may not be necessary as a remedial provision regarding incurrence of obligations. Section 548’s language that “[t]he trustee may avoid…any obligation incurred … by the debtor” may itself be all that is necessary.

So what does this mean in practical terms?  The avoiding of the incurrence of an obligation does not mean that the obligation disappears. Instead, its allocation follows normal state law successor liability principles. In the case of LTL, successor liability would likely put the talc liability squarely back on GoodCo through its continuation of OldCo’s business.

Focusing on obligations does not itself answer the valuation question about BadCo’s solvency, but it is a far better fit with fraudulent transfer law than trying to shoe-horn a divisive merger transaction into the definition of a “transfer” by a company that did not exist at the time property was transferred.

[^] Professors Fitzgerald and Levitin are both retained as consultants by certain talc claimants in the LTL bankruptcy; their opinions are their own.

[1] Tex. Bus. Org. Code § 10.008(a)(2).

[2] The authors do not address whether the divisive merger could be attacked as an actual fraudulent transfer under Code §§ 544 or 548.

[3] Tex. Bus. Org. Code § 10.008(a)(2)

[4] Id., § 10.008(a)(3).


Post Two: Concluding Thoughts on the Series

By John A. E. Pottow (University of Michigan)

John A. E. Pottow

A series of excellent posts have probed the recent developments of the infamous Texas Two-Step, and so I have only three additional comments.

First, a threshold issue that hungers for resolution is the idiosyncrasy of Texas law.  As Jonathan Lipson points out, vertical forum shopping has suitors flocking to the bankruptcy court system, but what they specifically want is application of Texas corporate law.  Specifically, mass tort defendants must avail themselves of its Doublespeak divisional merger statute and its “non-transfer transfers.”  The issue is whether a transfer ordinarily susceptible to fraudulent conveyance scrutiny can be statutorily immunized by legislative pronouncement that it is an “un-transfer.”  While this might invite the sort of textualism disquisition that would enthrall some (can the legislature define the black, frequently granulated table spice as “salt” without offending well-socialized legal sensibilities?), I am thematically drawn to Mark Roe and William Organek’s supremacy argument mooting it all out: that the Bankruptcy Code’s definition of “transfer” may supersede Texas’s.  But I don’t think they get all the way there.  My hopefully congenial amendment to their position is that additional work must be done to get the ball over the finish line by making out a Butner argument—which ought not be heavy-lifting—that federal bankruptcy purposes (e.g., preserving all assets for collective creditor treatment) warrant overriding the presumptive deference to state law definitions of property entitlements.

Second, all substantive concern, e.g., expressed as upsetting bankruptcy’s “traditional bargain” in Jared Ellias’ words (and especially so if they are solvent, as Ralph Brubaker reminds), really boils down to this: Are they cheating?  And as Anthony Casey and Joshua Macey have noted, what that really means is: Are there enough assets left for the claimants?  And that, as the road-terminus Rome of so many bankruptcy matters, is ultimately a valuation question—of claims, assets, going-concern surplus…the whole nine yards.  Forests of trees have died in service of bankruptcy scholarship on valuation, and, just to make you, Dear Likely Reader, feel old, recall that North LaSalle well-preceded the birth of most current law students.  My two cents in these hyper-inflationary times is that whenever I distrust valuation, and Ken Ayotte notes elsewhere that we should be extra-distrustful with synthetic analogues to real assets, I revert to my instincts that it’s hard to beat having skin in the game.  Indeed, the elegance of the Code’s section 524(g) is in requiring the backstopping by half the equity of the company.  So a “funding agreement” is fine and dandy, as is an “extraordinarily large” contribution of capital, but it’s no pledging of cold, hard assets.  Third-party releases on demand?  Not so fast!  If debtors want to reap the bankruptcy system efficiencies of speedy aggregate litigation, they should have to backstop that benefit with the internalized risk of real, teethy underwriting.

Finally, and this point segues from the prior observation, the role of the discretion accorded bankruptcy judges stands front and center with the Two-Step.  As the presumable watchdogs of over-reaching-cum-under-endowing BadCo, the bankruptcy judges wield their power to dispatch for lack of good faith or for receiving lack of reasonably equivalent value.  (For the efficacy of bankruptcy judges in valuation matters, see Forests, supra.)  To feel comfortable with them, then, one requires a sense of attunement to the risks and issues at stake.  Yet as David Skeel reminded us, the gushing endorsement of the bankruptcy system dripping in the LTL opinion (or, perhaps by corollary, angst about the state tort system) may augur poorly for a critical eye being cast on these un-mergers.  Unless we see some pushback and demonstrated non-naivete, legislative intervention seems overdetermined, as Jin Lee and Amelia Ricketts have already flagged.

I am broadly sympathetic to modular usages of the bankruptcy system, but I have also been around enough blocks to know that one person’s more efficient resolution is another’s value-extracting cudgel.  To cheerily assume the riskless benefit (low risk, high returns!) of this latest bankruptcy innovation is not just blinkered but is a Siren call for legislative intervention.

Badges of Opportunism: Principles for Policing Restructuring Support Agreements

By Edward J. Janger (Brooklyn Law School) and Adam J. Levitin (Georgetown University Law Center)

Edward J. Janger
Adam J. Levitin

Business reorganizations are corporate control transactions. When a debtor is insolvent or nearly so, control is in play along two different axes. The first axis allocates control within the existing capital structure. The filing of bankruptcy effectuates a change of control from equity to debt. On the second axis, the company itself is on the auction block, meaning that its assets, or even the entire firm, may be transferred to a new owner. Outside investors may wish to buy the company, and the choice among offers implicates serious governance concerns. This article considers the dynamics of control through the lens of restructuring support agreements (“RSAs”)—contractual agreements among creditors, and sometimes the debtor, to support restructuring plans that have certain agreed-upon characteristics. We conclude that RSAs offer a salutary bridge between the efficiencies of a quick “all asset” sale and the procedural protections of a plan of reorganization. However, they also pose a potential avenue for opportunistic abuse. Specifically, we are concerned with provisions in an RSA that hold value maximization hostage to a reordered priority scheme. Thus, we argue that courts should scrutinize RSAs carefully, and prohibit those that lock in opportunistic value reallocation.

Opportunistic behavior can arise on all sides of restructuring negotiations. Insolvency creates opportunities for creditors (and the debtor) to use transactional leverage to influence the allocation of scarce assets: secured creditors may foreclose; banks may engage in setoff; key suppliers may threaten to stop supplying; landlords can threaten to evict; unsecured creditors may get judgments and start grabbing assets; and purchasers may seek to take advantage of a depressed valuation to purchase the company on the cheap. To the extent that the debtor has value as a going concern, individual creditors may have the power to extort value by threatening to force liquidation. Alternatively, fully secured creditors may prefer a quick realization on their collateral, because they do not benefit from increasing the value of the firm.

The Bankruptcy Code seeks to limit these uses of situational leverage in a number of ways: (1) it stays unilateral creditor action (the automatic stay); (2) it allows for the unwinding of certain prepetition transfers (avoidance); (3) it sets a baseline distribution if the firm liquidates, but promises more if the firm can restructure (best interests/adequate protection); (4) it creates a structured bargaining process that ensures adequate information and reduces the ability of a creditor to holdout in the face of a reorganization plan that is supported by key creditor constituencies (supermajority acceptance); and (5) it sets an entitlement baseline if the firm reorganizes (cramdown). Bargaining in bankruptcy is informed by these procedural requirements and substantive entitlements. If a deal is not reached, liquidation follows.

Recently, in Czyzewski v. Jevic Holding Corp., the Supreme Court raised concerns about procedural innovations that might be used to create “end-runs” around the plan process and these procedural protections. In this regard, RSAs can be a useful tool for aiding compliance with the plan process. However, they are also sometimes also referred to as “lockup” agreements. Once an RSA is proposed and supported by key constituencies, the costs of opposing the contemplated plan may be prohibitive for most creditors. The proposal may operate as a fait accompli. If the RSA freight train is being used to stop creditors from developing information or identifying bases for objection, the device becomes problematic.

The difficulty is distinguishing beneficial RSAs from harmful ones. In our view, a fundamental norm of chapter 11 should govern RSAs, all-asset sales, and a range of other transactions: the common interest in value maximization may not be held hostage by a creditor seeking to improve its own priority. The essay begins by describing the practice surrounding restructuring support agreements and identifies some of the anecdotal concerns raised. We then catalogue the good and bad in RSAs. Next, we illustrate how to distinguish the good from the bad by focusing on bargaining in the shadow of entitlements. Finally, we flesh out the concept of an end-run around the plan process in the context of an RSA and identify “badges of opportunism” that should raise an inference that the practice is being abused.

The full article can be found here.

Reports of Equity’s Death Have Been Greatly Exaggerated

posted in: Cramdown and Priority | 0

By Adam J. Levitin, Georgetown University Law Center

Mark Berman is veryLevitin Headshot kind to take notice of my article in his recent analysis of Law v. Siegel, posted on the HLS Bankruptcy Roundtable, here.  We agree on a great deal about the case and scope of equity practice.  A question persists about the scope of Law v. Siegel, though, and what it is proscribing when it reiterates the view that “whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code.”  The question, then, is which non-Code practices are properly characterized as “equity”.  My own view is that very little of modern bankruptcy practice is in fact “equity.”

Law v. Siegel, for example, should not affect such important non-Code practices as judicial interpretation of Bankruptcy Code statutory terms or judicially-created doctrines like substantial consolidation, which are sometimes mistakenly listed among the bankruptcy court’s “equitable powers”.  As I wrote earlier, though, because such practices are interstitial and formed as broad principles, they are, in my view, better understood as part of a federal common law of bankruptcy, and distinguished from equitable powers, which are based on case-by-case specifics, as in Law v. Siegel.  As interstitial powers, these lie outside any widening or narrowing of bankruptcy court’s equitable powers.

Moreover, the uncertainties about when actual equitable practices contradict statutes will continue.  In cases of clear contradiction, the interpretive result will be easy. But cases where it is unclear whether a conflict truly exists will continue to invite negotiation between and among the parties because of the cost and uncertainty of litigation.  Despite the Supreme Court’s best efforts, consideration of the equities will likely remain a part of our bankruptcy system.

For a fuller treatment of this subject, please continue here.

‘Wither’ the Equity Powers of the Bankruptcy Court

posted in: Cramdown and Priority | 0

Author: Mark N. Berman, Nixon Peabody LLP

The United StaMark Bermantes Supreme Court’s Law v. Siegel decision has been explained away as an understandable limitation of a bankruptcy court’s use of Bankruptcy Code Section 105(a)’s expansive authority based on conventional techniques of statutory construction. Bankruptcy courts will not be able to use Section 105(a) to authorize an order that is otherwise prohibited by another section of the Bankruptcy Code.  However, it is also possible to read the decision as yet another stop on the road to limiting the ability of the bankruptcy courts to ‘do equity.’

Revisiting Professor Levitin’s 2006 law review article entitled Toward a Federal Common Law of Bankruptcy: Judicial Lawmaking in a Statutory Regime, 80 Am. Bankr. L.J. 1-87 (2006), I posit that the equity jurisdiction of the bankruptcy courts has already been statutorily restricted and the United States Supreme Court has made it clear that everyone should be prepared for further limitation of what has historically been its power. The Supreme Court’s warning is repeated in this latest decision.

The full alert is available here.

[Editor: The full text of Professor Adam Levitin’s noted article, Toward a Federal Common Law of Bankruptcy: Judicial Lawmaking in a Statutory Regime, can be found here.]