By Arvind Ravichandran (Cravath, Swaine & Moore LLP)
Arvind Ravichandran
[Editor’s Note: The following summary is a duplicate of the article’s introduction.]
How should a federal bankruptcy court decide which of a federally regulated thrift or an FDIC controlled bank gets a federal tax refund? The Supreme Court of the United States’ answer in Rodriguez: Look to state law. So unremarkable was this holding that it required approximately six pages of text and attracted no dissent or concurrence.
As the Supreme Court said, the decision was not really about tax refunds, but was instead an opportunity to instruct lower courts on making federal common law. Indeed, the Tenth Circuit on remand reaffirmed its earlier decision almost entirely by citing to its earlier opinion. But the Court’s instructions and analysis cast serious doubt on the validity of a long-standing and critical aspect of many bankruptcy proceedings-the first day net operating loss trading order. It also requires re-evaluation of authorities related to preserving the non-taxpaying status of the debtor; a somewhat less common but related issue.
These authorities have generally analyzed the question of whether net operating losses or the tax status of a bankrupt entity is entitled to protection under the Bankruptcy Code by examining applicable provisions of the Internal Revenue Code (“I.R.C.”) and relying on their own sense of fairness. The result is federal common law, in all but name, that largely protects net operating losses but not tax status. Examining these authorities reveals the precise concern Rodriguez identifies with the improper creation of federal common law – a body of law that is inconsistent and poorly grounded. Following Rodriguez, courts faced with these questions should more comprehensively analyze applicable state law in determining the treatment of net operating losses or the tax status in a bankruptcy proceeding. Moreover, relying on appropriate state law doctrines will allow private parties to rely on contract law to set forth their desired outcomes in bankruptcy. Ideally, this will all result in a firmer approach to these issues in bankruptcy.
That is what this Article is about. First, it discusses the specific issue in Rodriguez and its history-the allocation of tax refunds in bankruptcy and the Bob Richards rule. Second, it discusses the legal history of first day trading orders to preserve net operating losses. Third, it re-examines these authorities in light of Rodriguez. Finally, it concludes by discussing the issues regarding the tax status of the debtor.
Note: This post is the sixth post in a series of posts on bankruptcies of cryptocurrency companies and the emerging issues they pose. Previous posts in the series include:
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.
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The fall of the once mighty crypto exchange FTX is sometimes mythologized, but what led to its bankruptcy may be simpler than you think. In a nutshell, FTX transferred a large amount of its native tokens to a closely affiliated trading firm Alameda Research. Using these tokens as collateral, Alameda borrowed real assets, made risky bets, and lost huge sums of money. Then, to cover up mounting losses, FTX and Alameda arranged obscure transactions between themselves. In the end, they went bankrupt for the same reason many other companies do: assets were insufficient to offset liabilities.
So, what lies at the crux of this mess? Let me start with FTT, which is FTX’s native token. It is not uncommon for a crypto exchange to issue a utility token to provide users with a convenient means of accessing features and benefits on the platform, such as discounted trading fees, early access to token sales, and voting rights. By offering such a token, a crypto exchange can create an integrated ecosystem and promote growth.
While FTT may have proven valuable to platform users as a utility token, it differed from open-source cryptocurrencies especially Bitcoin, being the first and most prominent, in two important aspects. First, FTT was issued and centrally controlled by FTX, while Bitcoin is generated and governed by a decentralized community. This means that FTX—a centralized exchange—could freely move large quantities of FTTs to affiliated entities like Alameda. This also means that FTX and Alameda should not have recognized FTT tokens as assets, just like stock should not be booked as assets by the issuing company or its subsidiaries. Second, supply and demand, which ultimately determine an asset’s value, are distinctly different between the two tokens. With FTT, the demand was tied to the performance and popularity of FTX platform, and the supply was tightly controlled by FTX, through its release of tokens, regular repurchases, and token burning. With Bitcoin, the demand comes from its perceived investment value and other utilities by a broad base of investors and users, while the supply is rigidly set by its open-source algorithm. This difference explains why FTT tended to be much riskier and less liquid than Bitcoin and why the announcement of a block sale by Binance, a competing crypto exchange, triggered a sharp decline in FTT’s price.
Unfortunately, the core issues that resulted in FTX’s bankruptcy—the use of illiquid and complicated financial instruments to inflate assets, excessive risk-taking leading to huge debts and losses, and engagement in shady non-arm’s length transactions with affiliated entities—are nothing new in U.S. corporate history. For example, mortgage-backed securities (MBS), another illiquid and complicated financial instrument that packages mortgage debts into bond-like securities, played a key role in driving the 2007–2008 financial crisis. Major financial institutions’ involvement with MBS made it possible for them to inflate assets and take risks, which fueled a real estate bubble and resulted in the largest corporate bankruptcy in U.S. history (Lehman Brothers). Take Enron as another example. The company was a dominant player in the global market for energy derivatives, which are financial contracts that enable transacting companies to manage exposure to energy prices. This market was highly obscure, and Enron assumed huge risks from its counterparties. When Enron’s energy trading business turned unprofitable, it attempted to cover up by creating a network of special purpose entities (SPEs) to raise debt and hide losses.
There are, of course, unique lessons to learn from every epic corporate downfall. Three aspects of FTX’s bankruptcy warrant emphasis. First, FTX is a case of regulator shopping facilitated by the status quo of the U.S. crypto regulation. The U.S. lacks a workable regulatory framework that guides exchange platforms on how to provide crypto-based financial services and store customer funds in a transparent manner. As such, many crypto exchanges set up operations offshore where regulation and enforcement are weaker, and customer protection is likely compromised. Second, FTX is a case of an accounting scandal facilitated by the lack of crypto accounting and disclosure requirements. In the U.S., the Financial Accounting Standards Board (FASB) is reportedly working on finalizing an authoritative rule that would require the use of fair-value accounting for crypto assets. It, however, remains a question as to how well this approach will apply to illiquid tokens like FTT, the value of which could evaporate overnight. It also remains a challenge as to how to consolidate accounting for deeply intertwined crypto entities. Third, FTX is a case of failed centralized governance in the name of decentralized crypto assets. Bitcoin, which is emblematic of decentralization, was created with the mission to circumvent centralized control. However, when decentralized assets are traded on a centrally controlled platform like FTX, the platform itself is no different from a traditional financial institution. To that end, proper governance measures must be implemented to prevent problems like conflicts of interest, excessive risk-taking, and misappropriation of customer funds.
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!
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William Organek
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.
Adam J. Levitin
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.
Edward J. JangerJohn A. E. Pottow
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 Diane Lourdes Dick and Christopher K. Odinet (University of Iowa)
Diane Lourdes DickChristopher K. Odinet
Note: This post is the third post in a series of posts on bankruptcies of cryptocurrency companies and the emerging issues they pose. Previous posts in the series include:
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.
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Bankruptcy has a public and a private side. The reorganization of a private company in chapter 11 has implications for the public, and, in some reorganizations, the public interest is quite substantial. The recent bankruptcy of the third largest crypto exchange in the world, FTX, represents just the kind of corporate restructuring where the public interest is front and center. Yet the public priority embedded in these proceedings has the potential to be overlooked. In this work, we aim to change that by shining light on the stakes, the costs, and the allocative decisions to be made in what will no doubt be described as one of the most consequential legal proceedings to happen in the world of crypto. Specifically, the outcome of these proceedings will help clear up what it means to hold crypto as a form of property, as well as the custodial v. proprietary nature of the relationship between crypto exchange companies and their customers as to rights in crypto assets. The answers to these questions will not only help resolve this bankruptcy but they will also guide lawmakers and regulators as they seek a way to regulate and police the crypto market in the future. As such, we question whether the private value capturing model that is chapter 11 is the right framework—particularly when it comes to the allocation of who bears the costs—for these largely public-oriented matters.
By Steven Schwarcz (Stanley A. Star Distinguished Professor of Law & Business, Duke University School of Law)
Steven Schwarcz
Bankruptcy-remote structuring, a legal strategy with potential public policy implications, is crucial both to a range of important financial transactions—including securitization, project finance, covered bonds, oil-and-gas and mineral production payments, and other forms of structured financing—and to the ring-fencing of utilities and other publicly essential firms. In finance, the goal is contractually to reallocate risk by structuring securities-issuing entities that, absent the bankruptcy risks inherent to operating businesses, can attract investments based on specified cash flows. In ring-fencing, the goal is contractually to structure firms to minimize bankruptcy risks, thereby assuring their continued business operations.
Parties engaging in bankruptcy-remote structuring usually seek to reallocate risk more optimally, including by reducing information asymmetry and assigning higher risk to yield-seeking investors, thereby enabling firms to diversify and lower their costs of capital. In reality, bankruptcy-remote structuring can sometimes create harmful externalities. Some blame bankruptcy-remote securitization transactions, for example, for triggering the 2007-08 global financial crisis by shifting risk from contracting parties to the public.
This Article undertakes a normative analysis of bankruptcy-remote structuring, examining the extent to which parties should have the right to reallocate bankruptcy risk. It is the first to do so both from the standpoint of public policy—examining how bankruptcy-law policy should limit freedom of contract; and also from the standpoint of cost-benefit analysis (“CBA”)—examining how externalities should limit freedom of contract.
Traditionally, CBA weighs overall costs and benefits regardless of who pays the costs and who receives the benefits. That model makes sense for a neutral governmental assessment of costs and benefits, such as deciding whether to enact new regulation. In bankruptcy-remote structuring, however, the contracting parties both advocate and significantly stand to gain from the project. From a public policy standpoint, an impartial assessment of these private actions should weigh the socially relevant costs and benefits.
In that weighing, the Article explains why the socially relevant benefits of project finance that is used to facilitate the construction of critical infrastructure projects like powerplants and toll roads, as well as the socially relevant benefits of ring-fencing that is used to protect critical utilities, should exceed the socially relevant costs. However, for more generic structured finance transactions, like securitization, the CBA weighing is more difficult. These types of bankruptcy-remote transactions have valuable public benefits that are difficult to quantify. Their social costs are also difficult to quantify. Given these difficulties, the Article merely categorizes the benefits and costs without purporting to conclude how they balance. This approach has important precedent, including for assessing the costs and benefits of the Volcker Rule.
Finally, the Article examines how to reform bankruptcy-remote structuring to reduce its externalities, thereby rebalancing the costs and benefits to try to achieve net positive benefits.
Among other things, it compares the European Union’s regulatory framework that creates incentives for simple, transparent, and standardized (“STS”) securitization transactions and urges U.S. lawmakers to consider similar securitization reforms.
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).
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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.
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.
By Christopher D. Hampson (University of Florida Levin College of Law)
Christopher D. Hampson
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.[1] 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.”[2] Nor can the judge approve deals that “alter the balance” of substantive rights set out in the statute.[3] At the same time, the judge should not come to the aid of a creditor who declines a “fair offer.”[4] 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.
Purdue Pharma, the maker of OxyContin, filed for bankruptcy in 2019 to resolve thousands of opioid-related lawsuits. Two years after filing, a reorganization plan was confirmed: in exchange for a financial contribution of several billion dollars by the Sackler family and relinquishment of their ownership in Purdue, the family would be released from all civil liability associated with their ownership and control of Purdue. Individual claimants, state attorneys general, the United States Trustee, the Department of Justice, Congress, academics, and others criticized the settlement as an abuse of the bankruptcy system. These parties contended that granting this immunity over their objections–known as a third-party release–was an unfair remedy. They stated that such a plan would reduce creditors’ financial recoveries and make it more difficult to achieve their goals of learning about Purdue’s role in the opioid crisis and preventing future corporate malfeasance. Instead, if the Sacklers were to receive immunity, critics suggested that the Sacklers should be required to file for bankruptcy. A Sackler bankruptcy filing, they claimed, would increase creditor recoveries and ensure that creditors’ nonmonetary goals would be met.
This Article argues that these criticisms rely on a deeply problematic assumption: on closer inspection, it is not at all clear that a Sackler bankruptcy filing would result in better monetary or nonmonetary outcomes for creditors, and could actually detract from these goals.
From a monetary perspective, demands for a Sackler bankruptcy filing overlook the factual complexity that this would entail, and the corresponding weaknesses in remedies available to creditors under bankruptcy law. The Sacklers engaged in sophisticated asset protection strategies that limited creditors’ financial recoveries by spreading ownership and control of Purdue, as well as their other holdings, across dozens of domestic and international spendthrift trusts to benefit scores of family members. Demands for a Sackler bankruptcy filing ignore collections issues, the illiquidity of their holdings, the discounts that might be applied to recoveries of minority interests, and the limitations on creditors’ fraudulent transfer remedies. To overcome these problems and maximize financial recoveries, the parties agreed to a “de facto substantive consolidation”: a consensual dissolution of the legal barriers separating the assets of individual members of the Sackler family, their trusts, and Purdue. This ad hoc solution, while effective, depended on Sackler acquiescence.
Achieving creditors’ nonmonetary goals, such as broader disclosure, restrictions on the opioid businesses of Purdue and the Sacklers, and limitations on Sackler charitable donations, would probably have been made more difficult by a Sackler bankruptcy filing. A bankruptcy filing likely would have pitted family members against one another, making disclosure or other consensual resolutions more difficult. Courts also have limited ability to force debtors to divest assets or refrain from participating in business or charitable endeavors. Instead, the Sacklers agreed to these undertakings because it was clear from the commencement of the case that the availability of a third-party release was contingent upon their cooperation. Only by being able to offer what the Sacklers wanted–civil immunity–could creditors and the court cajole the Sacklers into agreement.
This Article demonstrates the institutional limits faced by the bankruptcy system in addressing certain kinds of monetary harms and nonmonetary objectives. It ends by proposing reforms to fraudulent transfer law that would close the international spendthrift trust loophole that was so critical to the strategy pursued by the Sacklers to limit creditors’ monetary recoveries. It also argues that the price of achieving creditors’ nonmonetary goals can be reduced in future mass tort bankruptcy cases by mandating expanded disclosure by parties seeking third-party releases, more consistent appointment of trustees to manage the debtor in mass tort bankruptcies, and appointment of examiners to uncover information about the causes of a mass tort.
The full article is available here. Comments to the author are welcomed: worganek [at] law [dot] harvard [dot] edu.
By Ralph Brubaker (University of Illinois College of Law)
Note: This is the sixth 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.
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), and here (by David Skeel).
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Ralph Brubaker
All of the posts in this series have been incredibly thoughtful and incisive in illuminating what’s at stake with the innovative new Texas Two-Step bankruptcy strategy.
As Professors Casey and Macey point out, by isolating and separating Defendant’s mass-tort liability (in a new BadCo) from its business operations (in a new GoodCo) and subjecting only the former to the bankruptcy process, the value of Defendant’s business (which must ultimately pay the mass-tort obligations, under a funding agreement between GoodCo and BadCo) is enhanced by avoiding all of the direct and indirect costs that a bankruptcy filing would entail. At the same time, though, Defendant can nonetheless take advantage of bankruptcy’s beneficial claims resolution process, which consolidates all of the mass-tort claims, both present and future claims, in one forum—the Bankruptcy Court.
That mandatory, universal consolidation of all mass-tort claims, which is entirely unique to the bankruptcy process, is tremendously powerful and is a huge boon to facilitating an aggregate settlement of Defendant’s mass-tort exposure. Indeed, bankruptcy can produce aggregate settlement of mass tort obligations much more effectively and efficiently than the only available nonbankruptcy alternative, so-called multi-district litigation (MDL) under the federal MDL statute.
Professors Casey and Macey acknowledge that the Texas Two-Step bankruptcy is an unalloyed good, however, only if it does not leave tort victims worse off. I share the fear of many that it will, though, and my concern derives from one of the most fundamental differences between the bankruptcy and nonbankruptcy systems for aggregate resolution of mass torts, giving rise to the vertical forum shopping that Professor Lipson highlights.
The due process clauses of the Constitution give an individual tort victim a property right in a cause of action against Defendant. Consequently, that individual must consent to a settlement of that tort claim (i.e., a voluntary transfer or sale of the claim to Defendant). The only circumstance in which a mandatory “settlement” of a damages claim can be imposed upon a nonconsenting claimant (i.e., the claimant’s property can be involuntarily expropriated) is when there is sufficient danger of a common-pool problem, or so-called “tragedy of the commons,” of the kind extremely familiar to bankruptcy scholars and professionals.
Outside bankruptcy, that common-pool problem is the impetus for a so-called “limited fund” class action, which takes away claimants’ unfettered control over their individual claims (i.e., their property) by allowing a fiduciary representative to assert and settle in the aggregate all of the common claims against a limited fund, whether or not individual claimants consent to that aggregate settlement. As the Supreme Court made clear in its Ortiz v. Fibreboard decision, though, if a mass-tort defendant’s resources do not constitute a limited fund that is insufficient to fully satisfy its mass-tort obligations, individual claimants retain an absolute constitutional right to opt out of any aggregate resolution process, as part of their due process property rights in their individual claims.
Bankruptcy, of course, is also designed to address such a common-pool problem, and the binding distribution scheme effectuated by a confirmed plan of reorganization is functionally identical to the mandatory non-opt-out settlement at issue in Ortiz. Both systems enable a mass-tort defendant to impose a judicially-approved hard cap on their aggregate mass-tort liability, without any opt-outs by nonconsenting claimants. That mandatory non-opt-out settlement power works a dramatic change in a mass-tort defendant’s ultimate aggregate liability and the complex bargaining dynamics by which that ultimate liability is determined.
I thus share the concern expressed by Professor Ellias about the prospect of solvent mass tort defendants using Texas Two-Step bankruptcies to resolve their mass-tort liability. And Professor Skeel is right to point out that Judge Kaplan’s LTL Management decision gives too much encouragement to that strategy, for example, by opining that “[t]here is nothing to fear in the migration of tort litigation out of the tort system and into the bankruptcy system” and “maybe the gates indeed should be opened.” Bankruptcy poses a substantial risk of systematically undercompensating mass-tort claimants relative to a nonbankruptcy baseline, particularly for future claimants. Perhaps that risk is acceptable when the debt overhang from massive disputed obligations presents a clear and present threat to entity viability and full payment of all claimants, problems that bankruptcy is designed to address. Absent that, however, the bankruptcy gates should not simply be swung open wide in an attempt to “fix” the mass-tort system, however “broken” it may or may not be. The mass-tort bankruptcy system itself could use some fixing.
If you would like to receive a copy of my current work-in-progress exploring these issues, email me at rbrubake [at] illinois [dot] edu.
