The Fifth Circuit held in October of this year in In re Ultra Petroleum Corp., 51 F.4th 138 (5th Cir. 2022) that a contractual make-whole provision in the debt instruments of certain unsecured creditors was unmatured interest under Section 502(b)(2). In this unusual case, where the debtor became solvent after filing for bankruptcy, the Fifth Circuit also held that the Solvent Debtor-Exception applied to claims for unmatured interest. The Fifth Circuit then determined that the Make-Whole Amount was a valid contractual claim and held that Ultra must pay the contractual Make-Whole Amount under the Solvent Debtor-Exception. Lastly, the Fifth Circuit held that an unimpaired creditor of a solvent debtor is entitled to interest at the bargained-for rate rather than the Federal Judgment Rate. In reaching this conclusion, the Fifth Circuit interpreted Section 726(a)(5)’s interest at the legal rate provision (relevant to a plan under Chapter 11 through Section 1129(a)(7)(A)) as a floor, rather than a ceiling, for interest payable by a solvent debtor.
Several law firms have now written memos summarizing this impactful decision. Weil summarizes the history of the Ultra Petroleum series of cases. Davis Polk suggests that the decision may have far-reaching consequences on the market use of make-whole provisions given the popularity of the Southern District of Texas as a forum for bankruptcy petitions. Proskauer notes that the Fifth Circuit’s decision addressed only the rights of an unsecured creditor with respect to a make-whole provision and suggests that Section 506(b) provides a legal basis for recovery of a make-whole provision by an oversecured creditor.
(This post was authored by Wesley Sheker, J.D. ’23.)
By Steven Schwarcz (Stanley A. Star Distinguished Professor of Law & Business, Duke University School of Law)
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.
By Michael Rosella (Katten Muchin Rosenman LLP) and Dan McElhinney (Stretto)
The crypto winter has arrived! Among many other issues of first impression for bankruptcy courts is the question of how the increased due diligence standards for preference actions set forth in the Small Business Reorganization Act of 2019 (the “SBRA”) will play out in a crypto case. The SBRA raised the bar on the due diligence needed to pursue preference litigation, requiring the debtor or trustee to assess “known or reasonably knowable affirmative defenses” before moving forward.
This article first assesses lingering disagreements related to the “heightened” pleading standard as applied to preference causes of action set forth in In re Valley Media and its progeny. Next, we delve into the cases interpreting the new due diligence standard set forth in the SBRA, as there is already disagreement on how to interpret the SBRA. Certain courts suggest the new due diligence standard constitutes an element of a preference claim that must be specifically pled in a complaint in order to avoid dismissal; others do not. Yet courts in this latter group, while eschewing the idea of a new element, do consider any information regarding pre-complaint due diligence efforts in the complaint, nonetheless. We then consider the issues unique to the opaque world of a cryptocurrency debtor that may impact the debtor or trustee’s ability to satisfy a heightened due diligence standard. Questions relating to the potential differences in assessing cash vs. crypto transfers and whether debtors or trustees will have access to key demographic and transaction data are considered. For example, whereas a debtor dealing in cash transfers would likely have bank statements, canceled checks, and access to accounting systems with basic transferee information, debtors transferring cryptocurrency to the independent digital wallet of a customer or counterparty would be less likely to have access to basic information necessary to satisfy a heightened due diligence standard.
We also provide key takeaways that highlight measures that cryptocurrency debtors should take to comply with the pleading and due diligence requirements. For example, a debtor in a cryptocurrency case should include in the complaint a recitation of its efforts to conduct reasonable due diligence — including efforts to obtain information needed to consider affirmative defenses, as well as reference to demand letters sent inviting the transferee to assert such defenses—to minimize any dismissal risk.
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).
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.
By David Skeel (University of Pennsylvania Carey Law School)
Note: This is the fifth 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), and here (by Anthony Casey and Joshua Macey).
Are Texas Two-Steps ever a proper use of Chapter 11? The argument that they aren’t—a view held by some scholars and reflected in proposed legislation in Washington—isn’t silly. Most current bankruptcy scholars grew up with Thomas Jackson’s creditors’ bargain theory of bankruptcy, which explains bankruptcy as a solution to creditor coordination problems that threaten to jeopardize the going concern value of an otherwise viable firm. The BadCo that files for bankruptcy in a Texas two-step does not have any going concern value. It’s just trying to manage massive liabilities. Why should this be allowed?
In rejecting a challenge to Johnson & Johnson’s recent two-step, the bankruptcy court supplied a forceful rejoinder to the view that preserving going concern value (or otherwise efficiently deploying a distressed company’s assets) is the only proper purpose for Chapter 11. Judge Kaplan points out that bankruptcy is often a superior mechanism for resolving tort liability as compared to the Multidistrict Litigation process or piecemeal litigation outside of bankruptcy. It is more orderly and can give more equitable and consistent treatment to victims. Judge Kaplan’s conclusion that LTL (the BadCo created by the J&J two-step) belongs in bankruptcy, and that a bankruptcy that involves mass tort liabilities but not the ongoing business that caused them is proper, is fully defensible in my view.
Where Judge Kaplan’s opinion goes off the rails is in too cavalierly dismissing the possibility that two-steps will be abused, as when he muses that “open[ing] the floodgates” to two-steps might not be such a bad thing. Those crafting future two-steps will be tempted to leave BadCo with inadequate ability to pay its victims, since nothing in the Texas divisional merger statute prevents this. Bankruptcy supplies two tools for policing these abuses, the good faith requirement [BRT: seethis earlier Roundtable post on good faith and Texas Two-Steps] and fraudulent conveyance law. If courts are vigilant, these tools should be sufficient to discourage abusive two-steps. But if courts are cavalier about the potential abuses, the legislation pending in Washington will begin to seem a lot less ill-advised.
Perhaps the best thing that could happen for Texas two-steps would be for courts to bar the use of non-debtor releases outside of the asbestos context, where they are explicitly authorized by section 524(g) of the Bankruptcy Code. The Second Circuit may be poised to take this step in the Purdue Pharma opioid case, if it upholds the District Court’s conclusion that the releases of nondebtors in that case—most notably, the Sackler family—are not authorized by the Bankruptcy Code. If non-debtor releases were disallowed except where explicitly authorized, Texas two-steps would remain viable in asbestos cases such as J&J, but the floodgates would not open in other contexts, since the maneuver only works if the eventual reorganization includes a non-debtor release for GoodCo.
By Jared A. Ellias (University of California, Hastings College of the Law; Harvard Law School)
Note: This is the third 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) and here (by Jonathan C. Lipson).
In October 2021, Johnson & Johnson (“J&J”) executed a strategy to use the bankruptcy system to resolve a massive flood of personal injury lawsuits. In doing so, J&J found a way to obtain the benefits of Chapter 11 without accepting the burden of operating a business under court oversight. J&J achieved this outcome by executing a corporate law move dubbed the “Texas Two-Step.” The Two-Step split J&J’s consumer division into two entities: (1) LTL Management LLC, which was allocated all of J&J’s baby powder-related tort liability; and (2) a second entity that contained the assets of its consumer businesses. LTL Management subsequently filed for bankruptcy without the assets of the consumer business. In a landmark recent opinion, Judge Michael B. Kaplan of the Bankruptcy Court for the District of New Jersey held that these maneuvers were not a bad faith bankruptcy filing. As I argue below, Judge Kaplan’s ruling, which attempts to use bankruptcy law to ameliorate weaknesses in tort law, may inspire other wealthy firms to emulate J&J’s tactics. It may also feed a potential backlash from higher courts and Congress that may make the bankruptcy system less useful to large firms.
In short, J&J’s bankruptcy strategy upends the traditional bargain that Chapter 11 offers to distressed corporations and their creditors. Congress designed a bankruptcy system that provides companies with powerful protections, such as an automatic stay of non-bankruptcy litigation. In exchange, companies must submit their assets to court oversight. To be sure, a bankruptcy filing always undermines some of the bargaining power that mass tort claimants have outside of bankruptcy, such as the ability to bring many individual lawsuits. However, the burden of court oversight also gives creditors bargaining power, as companies seek to exit bankruptcy quickly to escape the expense and distraction of a bankruptcy proceeding. J&J argues it has found a better way of using the bankruptcy system: J&J would use a contract to make the assets of the consumer division available to pay any amounts owed to tort victims and its procedural machinations meant that those assets would not be depleted by wasteful court oversight.
The “Texas Two-Step” strategy deployed by J&J takes these existing strategies a step further by surgically separating assets from liabilities to create a favorable bargaining environment. In holding that this maneuver was not a bad faith use of the bankruptcy system, Judge Kaplan opens the door to other wealthy firms to engage in similar maneuvering to resolve mass torts problems. For example, will the next company with headline-grabbing tort liability, such as an unexpected oil spill, respond by “spinning off” its liabilities into a bankruptcy filing? In the past, this only would have happened if the resulting liability rendered the polluter insolvent, but now even wealthy and solvent firms may decide that their fiduciary duty requires them to use the bankruptcy system to deal with their liability.
By Sergio J. Campos (University of Miami School of Law) and Samir D. Parikh (Lewis & Clark Law School)
Mass tort defendants have recently begun exiting multi-district litigation (MDL) by filing for bankruptcy. This new strategy ushers defendants into a far more hospitable forum that offers accelerated resolution of all state and federal claims held by both current and future victims.
Bankruptcy’s resolution promise is alluring, but the process relies on a very large assumption: future claimants can be compelled to relinquish property rights – their cause of action against the corporate defendant – without consent or notice. Bankruptcy builds an entire resolution structure on the premise that the Bankruptcy Code’s untested interest representation scheme satisfies Due Process strictures. This Article questions that assumption, and identifies two compromised pillars. Primarily, the process for selecting the fiduciary that represents future victims’ interests (FCR) is broken. Further, the process by which courts estimate the value of thousands of mass tort claims places too much pressure on a jurist unfamiliar with personal injury claims. These compromised pillars raise the risk that the settlement trust will be underfunded and fail prematurely. In this outcome, future victims would have no recourse but to argue that the process did not satisfy Due Process, and the settlement should be unwound.
This Article proposes that the risk of a prematurely insolvent victims’ trust can be reduced considerably by making two adjustments. Our proposal seeks to (i) rebuild the FCR construct in order to ensure that future victims’ interests are effectively represented, and (ii) recalibrate the claim estimation process by facilitating coordination between the bankruptcy court and nonbankruptcy trial courts.
The full article is forthcoming in the Fordham Law Review and is available here.
By Ronald Silverman, John Beck and Katherine Lynn (Hogan Lovells)
The Fifth Circuit recently issued an opinion, Federal Energy Regulatory Commission v. Ultra Resources, Inc., in which it relied on and affirmed its prior 2004 decision — In re Mirant — and held that bankruptcy courts have the authority — at least in many common contexts — to reject filed-rate contracts without the approval of the Federal Energy Regulatory Commission (FERC). The court reasoned that rejection of such contracts only has an indirect effect on the filed-rate and is not a collateral attack, and therefore can be done without FERC’s approval.
Further, the Fifth Circuit held that rejection of a filed-rate contract does not violate 11 U.S.C. § 1129(a)(6) of the Bankruptcy Code because rejection does not change the rate itself, it merely ceases payment of the rate. Thus, the decision further empowers debtors to reject filed-rate contracts in bankruptcy cases, so long as rejection does not amount to a rate change.
However, the court did identify an exception to the general rule. The opinion statesthat if a debtor seeks to reject a filed-rate contract, but still needs the capacity and seeks to secure a lower rate through rejection, such rejection would be impermissible without FERC’s approval, although that was not the situation in Ultra. Left for future cases will be the determination of what particular circumstances will require FERC’s permission to reject a filed-rate contract.
By David H. Sweeney, Jason P. Rubin, and Laura P. Warrick (Akin Gump Strauss Hauer & Feld, LLP), with Practical Law Oil & Gas
Producers of hydrocarbons generally require some level of gathering, processing, and othermidstream services to monetize hydrocarbons. Midstream services are typically securedthrough contracts between the producers and the midstream providers. The fixed facilities thatare required to perform those midstream services require significant investment by themidstream providers and have capacity constraints. To ensure producers’ performance andprotect their investment, midstream providers often include in their contracts a dedication clausestyled as a “covenant running with the land”. This clause purports to dedicate the land orreserves to the midstream infrastructure and is intended to bind third parties, including estates in bankruptcy, as an interest in real property.
Decisions in recent Chapter 11 cases have challenged the notion that midstream servicescontracts containing purported covenants running with the land are not rejectable under section365 of the Bankruptcy Code. The result is that a debtor may be able to reject a midstreamcontract containing a covenant running with the land, repudiate future performance of its duties,and a midstream service provider may find its claims reduced to a pre-petition unsecured claim for monetary damages.
This article explores some recent case law regarding covenants running with the land inbankruptcy and offers practical suggestions for how producers and midstream providers mightnavigate the newly developing reality, including:
Conducting diligence on midstream contracts to identify red flags and address potentialissues before they become problems.
Addressing the shortcomings of covenants running with the land noted by bankruptcycourts.
Replacing covenants running with the land with a substitute, such as a presentlypossessory interest or a lien.