[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] Vertical Forum Shopping in Bankruptcy

By Jonathan C. Lipson (Temple University-Beasley School of Law)

Note: This is the second 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.

The first post in this series can be found here.

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Jonathan C. Lipson

Forum shopping has long been an issue in chapter 11 reorganization, chiefly because liberal venue rules permit gamesmanship.  Section 1408 of the Judicial Code allows a corporate debtor to “bootstrap” into the bankruptcy court of any district where at least one entity in the group was formed.  If a forum is chosen “strategically,” Professors Lynn LoPucki and Bill Whitford first warned (in 1991), “the choice can have an important effect on the distribution of the losses emanating from a bankruptcy reorganization.”

They were describing what may be called “horizontal” forum shopping:  picking among the nation’s roughly 200 bankruptcy panels to find the one the debtor considers best for its situation.  Cases such as LTL Management and Purdue Pharma suggest there is another kind to think about, a variation on what proceduralists call “vertical” forum shopping.

Vertical forum shopping typically concerns competition between state and federal courts, and the rule of decision they apply (i.e., Erie v. Tompkins).  Bankruptcy has a similar state-federal dynamic, but also presents the potential for broader, and more problematic, competitions.

LTL involves the chapter 11 reorganization of Johnson & Johnson’s tort-feasing talc subsidiary.  The debtor had been formed shortly before bankruptcy in a controversial “divisive merger,” which many viewed as little more than a fancied-up fraudulent transfer.  Talc plaintiffs moved to dismiss the case on grounds that it was not commenced in good faith.

In a thorough and thoughtful opinion, U.S. Bankruptcy Judge Michael Kaplan denied the motion because he believed the economic benefits of reorganization appeared to outweigh alternatives.  But, the motion to dismiss also raised “a far more significant issue: which judicial system—the state/federal court trial system,” or chapter 11 “serves best the interests of th[e] bankruptcy estate, comprised primarily of present and future tort claimants with serious financial and physical injuries.”

This question—which system?—is bankruptcy’s version of vertical forum shopping.

On one hand, Judge Kaplan is probably right about the economics:  chapter 11 is likely to pay more to more talc claimants than litigation in other courts.  Nonbankruptcy litigation might produce a few outsize winners—billion-dollar verdicts or multi-million-dollar settlements—but there may be little left for most judgment creditors to collect.

On the other hand, chapter 11’s distributive benefits can trade off against what we might call “dignitary” interests, including individual rights to a “day in court” and a jury trial.  Congress intended to preserve some dignitary protections in chapter 11 cases, including the right to a jury trial of contingent and unliquidated personal injury and wrongful death claims.  But the rise of channeling injunctions and nondebtor releases has undermined those protections.

In Purdue Pharma, for example, the debtor’s controversial plan would give personal injury creditors a bare right to a jury trial against the company, and cap recoveries at about $48,000—surely not enough to cover the cost of the trial.  Worse, it would eliminate the right entirely as to the Sackler family, which owned and controlled the company when it committed two sets of confessed drug crimes.  The viability of those releases is pending before the Second Circuit Court of Appeals.

Vertical forum shopping in chapter 11 can threaten not only the role of other courts, but also other branches of government.  Again, while LTL spotted the issue, Purdue crystallized it.

A supplemental injunction at the beginning of Purdue halted administrative and regulatory actions against Purdue and the Sacklers.  While this left the possibility of criminal prosecution, the U.S. Department of Justice negotiated deals with the Sacklers and Purdue that made it practically impossible for states to prosecute (and, of course, many preferred to settle with the Sacklers rather than fight, anyway).

Purdue Pharma and LTL are likely to be very different cases.  The bankruptcy judge and the debtors in Purdue resisted important efforts to vindicate dignitary concerns, such as a bellwether trial of allegations against the Sacklers or a fulsome examination of them.  Tragically, the lack of those efforts may have undercut the Sacklers’ proposed payout, leading the judge to declare himself “bitter.”

In LTL, by contrast, Judge Kaplan and the debtors have signaled a willingness to deploy these types of mechanisms, should the case remain in bankruptcy.

At this point, it is too early to know.  Angered by the brazen nature of the divisive merger, the talc plaintiffs have appealed to the Third Circuit.

I discuss dignitary issues implicated by vertical forum shopping in chapter 11 in a draft paper, The Problem of Social Debt, which I can share if you email me (jlipson [at] temple [dot] edu).

Congressional Committees Propose Changes to Bankruptcy Code Prohibiting Non-Consensual Releases of Third Parties and Limiting Other Important Bankruptcy Tools

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

Michael J. Cohen
Michael A. Rosenthal
Matthew J. Williams

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.

Mandatory Aggregation of Mass Tort Litigation in Bankruptcy

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

Ralph Brubaker

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.

Bankruptcy Grifters

By Lindsey Simon (University of Georgia School 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

Lindsey Simon

Grifters take advantage of situations, latching on to others for benefits they do not deserve. Bankruptcy has many desirable benefits, especially for mass-tort defendants. Bankruptcy provides a centralized proceeding for resolving claims and a forum of last resort for many companies to aggregate and resolve mass-tort liability. For the debtor-defendant, this makes sense. A bankruptcy court’s tremendous power represents a well-considered balance between debtors who have a limited amount of money and many claimants seeking payment.

But courts have also allowed the Bankruptcy Code’s mechanisms to be used by solvent, nondebtor companies and individuals facing mass-litigation exposure. These “bankruptcy grifters” act as parasites, receiving many of the substantive and procedural benefits of a host bankruptcy, but incurring only a fraction of the associated burdens. In exchange for the protections of bankruptcy, a debtor incurs the reputational cost and substantial scrutiny mandated by the bankruptcy process. Bankruptcy grifters do not. This dynamic has become evident in a number of recent, high-profile bankruptcies filed in the wake of pending mass-tort litigation, such as the Purdue Pharma and USA Gymnastics cases.

This Article is the first to call attention to the growing prevalence of bankruptcy grifters in mass-tort cases. By charting the progression of nondebtor relief from asbestos and product-liability bankruptcies to cases arising out of the opioid epidemic and sex-abuse scandals, this Article explains how courts allowed piecemeal expansion to fundamentally change the scope of bankruptcy protections. This Article proposes specific procedural and substantive safeguards that would deter bankruptcy-grifter opportunism and increase transparency, thereby protecting victims as well as the bankruptcy process.

The full article is available here and is forthcoming in the Yale Law Journal.

Do Bankruptcy Courts Have Constitutional Authority to Approve Nonconsensual, Third-Party Releases?

By Shmuel Vasser and Cara Kaplan (Dechert)

Shmuel Vasser
Cara Kaplan

The Third Circuit, applying the Supreme Court’s decision in Stern v. Marshall, recently held that the Bankruptcy Court has the authority to confirm a chapter 11 plan containing nonconsensual, third-party releases when such releases are integral to the debtor’s successful reorganization.

In Stern, the Supreme Court examined the scope of the bankruptcy court’s constitutional authority and found, among other things, that the bankruptcy court can resolve a matter that is integral to the restructuring of the debtor-creditor relationship.  Analyzing Stern, the Third Circuit in In re Millennium held that the Bankruptcy Court could confirm a plan that included non-consensual, third party releases because the releases were the result of “highly adversarial” and “extremely complicated” negotiations and without the releases, the debtor would not have been able to successfully reorganize.

The full article is available here.

The Changing Landscape of Consensual Third-Party Releases in Chapter 11 Plans: Does Silence = Consent?

By Kathrine A. McLendon and Lily Picón (Simpson Thacher & Bartlett LLP)

There has been increasing focus on what evidences implicit consent to a third-party release in a chapter 11 plan.  This article examines the statutory framework underlying consensual third-party releases and then discusses recent cases in which consensual releases have been challenged by the Office of the United States Trustee and by courts sua sponte. Although various forms of implicit consent were often approved in the past with little or no scrutiny, these cases highlight trends toward stronger indicia of consent and greater attention to the factual context of the particular case.  These developments also underscore the importance of making the appropriate evidentiary record to support approval of consensual third-party releases. We conclude with practice pointers to support the case for confirmation of chapter 11 plans containing consensual third-party releases.

The full article can be found here.