Editor’s Note: On November 1, 2022, the BRT concluded our eight-part series on the Texas Two-Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies (see below for the full list of posts in the series). On January 30, 2023, the Third Circuit released its opinion dismissing the bankruptcy filing of LTL Management, raising a host of new questions for mass tort bankruptcies. In response, the BRT invited contributors to the prior series, as well as some new voices, to analyze the decision and what it might mean for the future of mass tort bankruptcies.
We will resume our series on crypto bankruptcies next week!
In “The Dismissal of LTL and What Lies Ahead for Mass Tort Bankruptcy,” William Organek (Harvard Law School) summarizes the Third Circuit’s opinion dismissing LTL’s bankruptcy filing. The post then describes key takeaways from the opinion, suggesting how this might impact future mass tort bankruptcy filings, LTL’s tort creditors, and parent company Johnson & Johnson. Finally, it examines questions raised by mass tort bankruptcies that the opinion does not answer, instead leaving them for future cases and debtors.
In “Over-Thinking Ramifications of the Dismissal of LTL Management LLC’s Bankruptcy,” Hon. Judith K. Fitzgerald (ret.) (University of Pittsburgh School of Law and Tucker Arensberg, P.C.) explains how the Third Circuit’s opinion merely applies existing Third Circuit precedent to a single debtor to reach a fact-specific conclusion about the appropriateness of bankruptcy for LTL Management LLC. In doing so, the post argues against concerns that the opinion will make it more difficult for companies facing imminent financial distress to use bankruptcy to resolve their liabilities, even in the mass tort context.
Note: Judge Fitzgerald is a consultant for counsel for certain parties in the LTL bankruptcy, and the opinions expressed herein are solely her own.
In “The Implications of LTL’s Per-Debtor Analysis,” Adam J. Levitin (Georgetown University Law Center and Gordian Crypto Advisors LLC) describes how the LTL decision interacts with the standard entity separateness explanation for much of corporate law. If courts read the opinion strictly to require a debtor-by-debtor analysis of insolvency, this could have major implications for joint administration, venue, and other issues central to bankruptcy administration that stretch far beyond the mass tort context.
Note: Adam Levitin is a consultant for counsel for certain parties in the LTL bankruptcy, and the opinions expressed herein are solely his own.
In “Waltz Across Texas: The Texas Three-Step,” Edward J. Janger (Brooklyn Law School) and John A. E. Pottow (University of Michigan Law School) explore how the seemingly limited decision in the LTL bankruptcy cannot be divorced from wider questions about why bankruptcy is being used to resolve mass tort liability. Focusing on the essential role that third-party releases play in mass tort bankruptcy filings, it suggests that we consider not only whether financial distress is required for good faith, but also what should be required of nondebtors seeking third-party releases and what justifies such extraordinary relief.
In “The Third Circuit’s New One-Step: Good Faith as Purpose in LTL,” Jonathan C. Lipson (Temple University–Beasley School of Law) analyzes the LTL decision by examining how the court understands the concept of good faith. Earlier decisions in the Third Circuit relied on a primarily contractualist, or rules-based approach to good faith–does a debtor face financial trouble or does it have a substantial number of creditors? The LTL decision, however, endorses a more policy-oriented, or standards-based approach to good faith, asking whether the contemplated use of bankruptcy appropriately furthers the policy goals of chapter 11. This could lead to a re-evaluation of whether bankruptcy should be used for resolving mass torts, and some of the tools used by bankruptcy courts to facilitate a deal among the debtor and its creditors. This could have particular ramifications for other mass tort bankruptcies such as that of Purdue Pharma.
A Different Look at Sec. 548 and Concluding Thoughts, by Hon. Judith K. Fitzgerald (University of Pittsburgh School of Law and Tucker Arensberg, P.C.) and Adam J. Levitin (Georgetown University Law Center and Gordian Crypto Advisors LLC); and John A.E. Pottow (University of Michigan School of Law)
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)[^]
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.” 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. 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, but there is no equivalent language in the liabilities provision. 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.
Note: The Harvard Law School Bankruptcy Roundtable is pleased to resume regular weekly posts for the academic year.
By Douglas G. Baird (University of Chicago Law School)
Negotiations are the lifeblood of Chapter 11, and a large part of the bankruptcy judge’s job is to police them. Bankruptcy judges are not dispensers of Solomonic wisdom. They are referees who ensure a level playing field. They insist that the parties follow the rules, but they do not enforce rules for their own sake nor do they allow their oversight to interfere with the flow of play. Their job is to give parties a chance to work together on equal terms to find a path forward.
Notwithstanding the centrality of negotiations, little of the written law says much about how bankruptcy judges should oversee them. The few explicit statutory mandates are pitched at a high level of abstraction. They require little more than that judges ensure that bargains be proposed in “good faith” and meet certain substantive conditions to be considered “fair and equitable,” without defining how the bargaining process could meet these standards. Precedent is similarly unhelpful. One can exhaust virtually all the guidance the Supreme Court has offered over the last century and a half in a few sentences: The judge cannot be a “silent registrar of agreements.” Nor can the judge approve deals that “alter the balance” of substantive rights set out in the statute. At the same time, the judge should not come to the aid of a creditor who declines a “fair offer.” Lower courts are similarly silent. Among the many hundreds of volumes of reported opinions, few provide much guidance.
Much less is up in the air than it first seems, however. The judge is bound by a coherent set of unwritten principles that derive from the Statute of 13 Elizabeth and fraudulent conveyance law as it was received in this country in the late eighteenth century. Over the course of the nineteenth century, judges drew on this uncodified power to craft an approach to policing negotiations between creditors and a financially distressed debtor. The legal reforms of the 1930s and the 1970s drew again on these same principles. This unwritten law remains central to modern reorganization practice.
The Unwritten Law of Corporate Reorganizations traces this long arc of reorganization law in the United States. It uncovers a history rich with interesting characters, including Founding Father Alexander Hamilton, corporate law giant Paul Cravath, and SEC chairman and Supreme Court justice William O. Douglas. Their stories illuminate the way bankruptcy judges have long used a set of unwritten rules, derived from fraudulent conveyance principles, to oversee the reorganization process.
By Mark Roe and William Organek (Harvard Law School)
Note: This is the seventh 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), here (by David Skeel), and here (by Ralph Brubaker).
Considerable attention is now being paid to the Texas Two-Step in bankruptcy. The Two-Step anticipates the movement of assets and liabilities from one corporate entity to another, via a divisive merger that splits the assets and liabilities of the original entity. After the movement of the assets and liabilities, the liabilities sit in one entity (often a subsidiary of a larger enterprise). Meanwhile, the liabilities are separated from many of the assets (in the most controversial form of the Two-Steps), which sit in another entity. The entity with the bulk of the liabilities then files for bankruptcy. The Two-Step is central to the Johnson & Johnson (“J&J”) bankruptcy of a subsidiary, aiming to separate the talc liabilities from J&J’s extensive assets.
When assets are transferred from a firm that is thereby rendered insolvent, or when the assets are transferred with actual intent to hinder, delay or defraud creditors, the transferred assets can, of course, be recovered by the transferring firm as a fraudulent transfer. Bankr. Code § 548. Similar transactions are regularly accomplished under corporate structures as spinoffs: the firm moves assets into a subsidiary, for example, and then “spins” off the subsidiary’s stock to the firm’s stockholders. After the spinoff the old stockholders own two companies, one with the assets (and possibly some of the liabilities of the just-created subsidiary) and the other with the liabilities (and any remaining assets) of the original company.
The Texas divisive merger statute creates a fraudulent transfer conundrum, because it says movements of assets pursuant to a divisive merger are not transfers. If there’s no transfer, there’s no fraudulent transfer liability, as there must first be a transfer for there to be liability.
If the bankruptcy process were ousted of power to control fraudulent transfers, then the debtor firm would have more freedom to move assets and liabilities in ways that would allow the firm to escape liability. No judge would get to the meaty issues (e.g., was the transferring firm insolvent? were the transfers done with intent to hinder, delay, or defraud creditors? is the bankrupt firm with the bulk of the liabilities an alter ego or successor of the original firm?) because there’d never have been a triggering transfer.
The Texas statute itself is clear on its face that there’s no transfer under Texas law:
When a merger takes effect . . . all rights, title and interests to all . . . property owned by each . . . party to the merger is allocated . . . as provided in the plan of merger without . . . any transfer or assignment having occurred . . .
Commentatorshavenoted that a Two-Stepping debtor might make such an argument. While it has not yet been explicitly raised in the LTL bankruptcy, the commentators anticipated correctly that such an argument was coming. In another pending Texas Two-Step bankruptcy, In re DBMP, the debtor made this argument at length. In an oral ruling1 delivered a little more than a week ago, on July 7, Judge Craig Whitley agreed with the key plain meaning premises of the Two-Step argument but ultimately rejected it as facilitating “wholesale fraud.”
The court began by accepting the debtor’s interpretation that, under a plain meaning reading of the Texas statute, no transfer occurred; and under a plain meaning reading of section 548 of the Bankruptcy Code, a transfer is a necessary predicate for a fraudulent transfer to have occurred. Hence, a plain meaning construction of section 548 and the Texas statute means no fraudulent transfer exposure.
Judge Whitley saw where such a plain meaning reading led, but refused to go there, rejecting the debtor’s conclusion. Going down the plain meaning route would, he said, lead to absurd results, leaving plaintiffs with “no recourse whatsoever.” And such a reading would contradict another provision of the Texas statute, which states that a divisive merger is not meant to “abridge any . . . rights of any creditor under existing law,” Tex. Bus. Orgs. Code § 10.901. Finally, Judge Whitley went deep: such a plain language reading of the Texas statute would run contrary to longstanding general principles of Anglo-American fraudulent transfer law.
Judge Whitley’s conclusion was in our view correct. But the conclusion can be reached more directly—by a plain meaning reading of the Bankruptcy Code.
The bankruptcy courts have already been instructed by Congress not to pay attention to the Texas statute, even when the state statute declares that an asset disposition in a divisive merger is not a transfer. True, considerable policy issues (e.g., supremacy of federal law, the extent to which state property and contract law is incorporated into the bankruptcy process) could well be brought to bear if the Bankruptcy Code were unclear here. But the most straightforward way to answer the question raised in DBMP comes from a parsimonious textual analysis of the Code.
Here’s the Bankruptcy Code’s two-step ouster of the Texas Two-Step:
The text of the fraudulent transfer statute, section 548, begins: “The trustee may avoid any transfer . . . of an interest of the debtor in property . . . ” (emphasis added). If we stop there, a basis might be had for examining state law for whether a transfer cognizable under the Bankruptcy Code has taken place. Property is, after all, transferred under state law.
But the Code does not say that state law governs whether a movement of property is a bankruptcy transfer. The Code itself defines the term “transfer” and does so independently of state laws’ appellations, leading to Step 2 of the ouster.
Section 101(54) defines what a “transfer” is for bankruptcy purposes, such as section 548 (governing fraudulent transfers). It states: “The term ‘transfer’ means . . . each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with (i) property; or (ii) an interest in property.”
The Code thereby instructs bankruptcy courts to conclude that a transfer has occurred for each “mode . . . of disposing of . . . property . . . .” A divisive merger under Texas law is surely a “mode . . . of disposing of . . . property. . . .” As a result, for bankruptcy purposes a Texas two-step is a transfer, whatever the Texas authorities decide to call it. And, therefore, the Texas Two-Step should have no import in bankruptcy for determining whether there’s been a transfer for bankruptcy purposes. Property has been disposed of. Thus, for Code purposes there is a “transfer.” The first statutory predicate to considering whether there has been a fraudulent transfer has been satisfied and the court could then go on to the other, meaty fraudulent transfer issues. The Texas Two-Step is a transfer because the Bankruptcy Code says it is.
While we reach an identical conclusion to that of Judge Whitley, and we do not fault his reasoning from the bench, our analytic path is better in the long run for bankruptcy decisionmaking. The court’s reliance upon the best way to interpret the potential contradictions of the Texas Business Organizations Code is a precarious foundation for the ruling. One could imagine another bankruptcy court, faced with the Texas statute’s contradictions (“it’s not a transfer” vs. “it’s not in derogation of any other right”), interpreting and concluding differently.2Another judge might not consider such a result as absurd as Judge Whitley and we do. And yet another bankruptcy court could feel compelled to certify questions to the Texas Supreme Court on how to interpret the Texas divisive merger statute and its impact.
The new mass tort bankruptcies present major issues of policy and statutory construction for which answers will not be assured and apparent. But the question of whether there is a transfer for bankruptcy purposes is clear. A divisive merger is a disposition of property and, hence, the Code says it’s a transfer, thereby triggering the opening prerequisite to there being a fraudulent transfer.
The Code says so. Plainly.
1: A recording of the hearing is embedded in the linked PDF, which PDF may need to be downloaded in order to access the recording; the relevant portion of the hearing begins around 20:15 in the recording.
2: See Curtis W. Huff, The New Texas Business Corporation Act Merger Provisions, 21 St. Mary’s L.J. 109, 122-25 (1989).
Johnson & Johnson’s use of the Texas Two-Step to manage its talc liabilities has put the company, and the Two-Step, front and center in the roiling debates over aggressive uses of the bankruptcy system. Those debates have led to scholarly criticism, congressional hearings, and proposed legislation that would curtail debtors’ ability to so use the bankruptcy courts.
My Essay details the mechanics of the Two-Step. Beginning with the Texas divisive merger, the funding agreement, and forum shopping for the Fourth Circuit, the Essay fleshes out precisely how the Two-Step boxes in tort claimants. Like other scholarship, this Essay identifies the risk that such maneuvering effects a fraudulent transfer. It also goes a step further, arguing that the point of the Two-Step is not to succeed, but to delay. Fraudulent-transfer litigation in a bankruptcy consumes time because it requires an adversary proceeding, and that delay pressures tort claimants to settle. So the Two-Step can succeed as long as claimants cannot wait out the course of the bankruptcy, even if a court never declares the particular Two-Step to be a proper use of divisive merger law rather than an improper fraudulent transfer.
Instead of playing into this delay game, this Essay argues, courts should evaluate the Texas Two-Step for good faith. Tort claimants can raise such challenges as a motion to dismiss (as some have) and thus avoid the need for a fraudulent-transfer adversary proceeding. And under current doctrine, the Two-Step likely qualifies as a bad-faith filing: In most cases, the Two-Step is a litigation tactic. And the Two-Step, invariably, is filed by an entity created solely to file for bankruptcy. Both of those are doctrinal hallmarks of bad-faith bankruptcies.
More broadly, the Essay explains, the Two-Step and good-faith challenges to it underscore the continuing role of common law in bankruptcy. The Code does not define good-faith filing, so courts have developed the doctrine case by case. They may yet find an acceptable form of Two-Step, one which yields tort claimants the rights they would receive in, say, a Johnson & Johnson bankruptcy, without hurting Johnson & Johnson’s ability to do business by forcing the whole company into bankruptcy. Along the way, though, a vigilant common-law gatekeeping is warranted, and judges should not hesitate to dismiss Two-Steps thinking that a later ruling on a fraudulent-transfer adversary proceeding can adequately safeguard tort claimants from an improper use of the bankruptcy system.
The full essay will be available at 121 Mich. L. Rev. Online __ (forthcoming 2022) and can be accessed here.
By Jeffrey Cohen, Michael A. Kaplan, and Colleen M. Maker (Lowenstein Sandler)
InLoan Forgiveness as Basis for Fraudulent Transfer Claims, authors Jeffrey Cohen, Michael A. Kaplan, and Colleen M. Maker address fraudulent transfer litigation as a valuable weapon in the bankruptcy code arsenal, to target assets transferred or disposed of prior to bankruptcy with the potential to provide at least some recovery to creditors of the debtor’s estate. The article examines debt cancellation as an overlooked, but still potentially viable and valuable, basis for a fraudulent transfer cause of action.
Avoidance actions may include not only transfers with fraudulent intent, but also constructive fraud through loan forgiveness or debt cancellation. For example, if a company makes loans to subsidiaries and then formally or informally either writes off, forgives and cancels the loan prior to bankruptcy, that action has the same impact as a fraudulent transfer: creditors are left holding the bag while the beneficiary is unaffected and may even receive a windfall at the expense of the creditors.
Intercompany transfers are often considered within the ordinary course of business in a complex corporate structure, and loans to directors and officers are not rare. However, avoidance actions regarding forgiveness of debt are seldom brought due of issues of standing, resources, discovery, and cost weighed against the viability of the claim. Parties must assess whether the possibility of recovery outweighs the risks or if limited resources are better used elsewhere, perhaps through direct distribution to creditors.
By Daniel J. Merrett (Jones Day) and Mark G. Douglas (Jones Day)
The ability of a bankruptcy trustee or chapter 11 debtor-in-possession (“DIP”) to avoid fraudulent transfers is an important tool promoting the bankruptcy policies of equality of distribution among creditors and maximizing the property included in the estate. One limitation on this avoidance power is the statutory “look-back” period during which an allegedly fraudulent transfer can be avoided—two years for fraudulent transfer avoidance actions under section 548 of the Bankruptcy Code and, as generally understood, three to six years if the trustee or DIP seeks to avoid a fraudulent transfer under section 544(b) and state law by stepping into the shoes of a “triggering” creditor plaintiff.
The longer look-back periods governing avoidance actions under various state laws significantly expand the universe of transactions that may be subject to fraudulent transfer avoidance. Indeed, under a ruling recently handed down by the U.S. Bankruptcy Court for the Western District of North Carolina, the look-back period in avoidance actions under section 544(b) may be much longer—10 years—in bankruptcy cases where the Internal Revenue Service (“IRS”) or another governmental entity is the triggering creditor. In Mitchell v. Zagaroli (In re Zagaroli), 2020 WL 6495156 (Bankr. W.D.N.C. Nov. 3, 2020), the court, adopting the majority approach, held that a chapter 7 trustee could effectively circumvent North Carolina’s four-year statute of limitations for fraudulent transfer actions by stepping into the shoes of the IRS, which is bound not by North Carolina law but by the 10-year statute of limitations for collecting taxes specified in the Internal Revenue Code.
Zagaroli does not break new ground on the power of a bankruptcy trustee or DIP to bring avoidance actions under section 544(b) of the Bankruptcy Code. Nevertheless, the court’s endorsement of the majority approach on the availability of a longer look-back period in cases in which the IRS is a creditor is notable. Widespread adoption of this approach could significantly augment estate avoidance action recoveries.
by Charles M. Oellermann and Mark G. Douglas (Jones Day).
The ability to avoid fraudulent or preferential transfers is a fundamental part of U.S. bankruptcy law. However, when a transfer by a U.S. entity takes place outside the U.S. to a non-U.S. transferee—as is increasingly common in the global economy—courts disagree as to whether the Bankruptcy Code’s avoidance provisions apply extraterritorially to avoid the transfer and recover the transferred assets. Several bankruptcy courts have addressed this issue in recent years, with inconsistent results.
In a recent example, in In re CIL Limited, 582 B.R. 46 (Bankr. S.D.N.Y. 2018), the U.S. Bankruptcy Court for the Southern District of New York, disagreeing with other courts both within and outside its own district, ruled that the “transfer of an equity interest in a U.K. entity to a Marshall Islands entity was a foreign transfer” and that the Bankruptcy Code’s avoidance provisions do not apply extraterritorially because “[n]othing in the language of sections 544, 548 and 550 of the Bankruptcy Code suggests that Congress intended those provisions to apply to foreign transfers.”
The decision further muddies the waters on an issue that has become increasingly prominent as the volume of cross-border bankruptcy cases continues to grow and cross-border transactions become ubiquitous. The split on this issue exists not merely between courts in different jurisdictions, but also among courts in the Southern District of New York, where the majority of cross-border bankruptcy cases have traditionally been filed.
By Jane Rue Wittstein and Mark G. Douglas (Jones Day)
Courts disagree as to whether the amount that a bankruptcy trustee or chapter 11 debtor-in-possession can recover in fraudulent transfer avoidance litigation should be capped at the total amount of unsecured claims against the estate. The U.S. Bankruptcy Court for the District of Delaware recently weighed in on this issue in PAH Litigation Trust v. Water Street Healthcare Partners, L.P. (In re Physiotherapy Holdings, Inc.), 2017 WL 5054308 (Bankr. D. Del. Nov. 1, 2017). Noting the absence of any guidance on the question from the U.S. Court of Appeals for the Third Circuit, the bankruptcy court ruled that, unlike most state fraudulent transfer laws, which limit a creditor’s recovery to the amount of its unpaid claim against the transferor, section 550 of the Bankruptcy Code imposes no such limitation on the estate’s recovery. The ruling reinforces the idea that federal and state fraudulent transfer avoidance laws are intended to be remedial rather than punitive. Under state law, this understandably means that an avoidance recovery is limited to the amount necessary to make an injured creditor whole. Under federal bankruptcy law, recoveries must benefit the bankruptcy estate, which includes the interests of creditors and other stakeholders.
By Ralph Brubaker (University of Illinois College of Law), Bruce A. Markell (Northwestern University Pritzker School of Law), Charles W. Mooney, Jr. (University of Pennsylvania Law School), and Mark Roe (Harvard Law School).
Bankruptcy Code § 546(e) contains a safe harbor that prevents avoidance of a securities settlement payment, e.g. as a preferential or constructively fraudulent transfer. This amicus brief was filed in Merit Management Group, LP v. FTI Consulting, Inc., No. 16-784 (U.S.). The brief explains how § 546(e) rationally constrains its scope via the statutory specification that the safe harbor only applies (because it need only apply) if the “transfer” sought to be avoided was allegedly “madeby or to (or for the benefit of)” a protected securities market intermediary, such as a stockbroker or a financial institution.
Ascertaining the meaning and function of that determinative scope language requires an understanding of (1) the concept of a “transfer” as the fundamental analytical transaction unit throughout the Code’s avoidance provisions, and (2) the relationship between that avoidable “transfer” concept and the inextricably interrelated concepts of who that “transfer” is “made by or to (or for the benefit of).” By its express terms, § 546(e) only shields a challenged “transfer” from avoidance if (1) that transfer was “made by” a debtor-transferor who was a qualifying intermediary, “or” (2) a party with potential liability—because the challenged transfer allegedly was made “to or for the benefit of” that party—was a protected intermediary. Thus, the transfer of cash to a stock seller and of the stock back to the buyer is not safe-harbored. The delivery of the cash (and the stock) through financial intermediaries, however, is.