[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] Upending the Traditional Chapter 11 Bargain
by | posted in: Bankruptcy, Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, Corporate Governance, Fiduciary Duties, Mass Torts, Texas Two-Step and the Future of Mass Tort Bankruptcy Series | 0

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).

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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.

As Michael Francus recently argued, J&J’s strategy is best understood as the latest move in the long-standing chess game of hardball bankruptcy tactics between the lawyers who represent tort victims and the lawyers who advise large companies with tort liability.  For example, in 2003, Pfizer resurrected a dead subsidiary and caused it to file for bankruptcy to obtain a judicial order halting all litigation against Pfizer, which potentially had its own liability associated with the subsidiary’s products.  Pfizer’s strategy involved taking a corporation that had been defunct for over a decade, giving it an “independent board of directors,” employees and office space.  By doing so, Pfizer was able to benefit from a bankruptcy court injunction for several years before reaching a settlement after a decade of scorched earth litigation.  Other high-profile companies, most prominently Purdue Pharma, have also tried to stretch bankruptcy law to resolve claims against third parties without those entities filing for bankruptcy themselves.

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.

In his ruling, Judge Kaplan overruled the arguments of, among others, a group of bankruptcy scholars (including myself) that worry that the complexity of J&J’s maneuvers will undermine public confidence in the integrity of the bankruptcy system. To be sure, Judge Kaplan’s opinion makes persuasive arguments about the limits of the tort system.  The question, though, is whether the ultimate outcome of Judge Kaplan’s attempt to use bankruptcy law to rectify problems in the tort system will be to create new problems for the bankruptcy system as Congress explores new legislation and appellate courts issue rulings that respond to perceived overreach by reducing the power of bankruptcy judges and, as a result, the usefulness of bankruptcy law.

Government Activism in Bankruptcy
by | posted in: Bankruptcy, Bankruptcy Roundtable Updates | 0

By Jared A. Ellias (Bion M. Gregory Chair in Business Law and Professor of Law, UC Hastings College of Law) and George Triantis (Professor of Law and Business, Stanford Law School)

Jared A. Ellias
George Triantis

It is widely recognized that bankruptcy law can stymie regulatory enforcement and present challenges for governments when regulated businesses file for Chapter 11.  It is less-widely understood that bankruptcy law can present governments with opportunities to advance policy goals if they are willing to adopt tactics traditionally associated with activist investors, a strategy we call “government bankruptcy activism.”  The bankruptcy filings by Chrysler and General Motors in 2009 are a famous example: the government of the United States used the bankruptcy process to help both auto manufacturers resolve their financial distress while promoting the policy objectives of protecting union workers and addressing climate change.  A decade later, the government of California applied its bargaining power and used an innovative state law in the Pacific Gas & Electric Company’s Chapter 11 case to protect climate policies and the victims of wildfires.  These examples illustrate that, by tapping into the bankruptcy system, governments gain access to the exceptional powers that a debtor enjoys under bankruptcy law, which can complement the traditional tools of appropriations and regulation to facilitate and accelerate policy outcomes.  This strategy is especially useful in times of urgency and policy paralysis, when government bankruptcy activism can provide a pathway past veto players in the political system.  However, making policy through the bankruptcy system presents potential downsides as well, as it may also allow governments to evade democratic accountability and obscure the financial losses that stakeholders are forced to absorb to help fund those policy outcomes.

The full article is available here.

Delaware Corporate Law and the “End of History” in Creditor Protection
by | posted in: Bankruptcy Roundtable Updates, Corporate Governance, Jurisprudence | 0

By Jared A. Ellias (University of California Hastings Law) and Robert J. Stark (Brown Rudnick LLP)

Jared A. Ellias
Robert J. Stark

We briefly survey the common law’s adventures with creditor protection over the course of American history with a special focus on Delaware, the most important jurisdiction for corporate law. We examine the evolution of the equitable doctrines that judges have used to answer a question that arises time and again: What help, if any, should the common law be to creditors that suffer losses due to the purported carelessness or disloyalty of corporate directors and officers? Judges have struggled to answer that question, first deploying Judge Story’s “trust fund doctrine” and then molding fiduciary duty law to fashion a remedy for creditors. In Delaware, the appetite of corporate law judges to protect creditors reached a high point in the early 2000s as judges flirted with recognizing a “deepening insolvency” tort cause of action. Suddenly, though, a new course was set, and Delaware’s judges effectively abandoned this project in a series of important decisions around the time of the financial crisis. In this “third generation” of jurisprudence, Delaware’s corporate law judges told creditors to look to other areas of law to protect themselves from opportunistic misconduct, such as bankruptcy law, fraudulent transfer law, and their loan contracts. However, the same question of whether the common law ought to protect creditors has arisen time and again and today’s “settled” law is unlikely to represent the end of history in creditor protection.

The full chapter is available here.

For related Roundtable posts, see Jared Ellias and Robert Stark, Bankruptcy Hardball.

Bankruptcy Process for Sale
by | posted in: Bankruptcy Roundtable Updates, Cramdown and Priority, Workouts and Pre-Packs | 0

By Kenneth Ayotte (University of California Berkeley School of Law) and Jared A. Ellias (University of California Hastings College of the Law)

Kenneth Ayotte
Jared A. Ellias

The lenders that fund Chapter 11 reorganizations exert significant influence over the bankruptcy process through the contract associated with the debtor-in-possession (“DIP”) loan. In this Article, we study a large sample of DIP loan contracts and document a trend: over the past three decades, DIP lenders have steadily increased their contractual control of Chapter 11. In fact, today’s DIP loan agreements routinely go so far as to dictate the very outcome of the restructuring process. When managers sell control over the bankruptcy case to a subset of the creditors in exchange for compensation, we call this transaction a “bankruptcy process sale.” We model two situations where process sales raise bankruptcy policy concerns: (1) when a senior creditor leverages the debtor’s need for financing to lock in a preferred outcome at the outset of the case (“plan protection”); and (2) when a senior creditor steers the case to protect its claim against litigation (“entitlement protection”). We show that both scenarios can lead to bankruptcy outcomes that fail to maximize the value of the firm for creditors as a whole. We study a new dataset that uses the text of 1.5 million court documents to identify creditor conflict over process sales, and our analysis offers evidence consistent with the predictions of the model.

The full article is available here.

The Law and Economics of Investing in Bankruptcy in the United States
by | posted in: Bankruptcy Roundtable Updates, Claims Trading, Distressed Debt Markets | 0

By Jared A. Ellias (University of California Hastings College of the Law)

Jared A. Ellias

When commentators describe American bankruptcy law as “the model to which European restructuring laws should aspire,” they are really speaking about an ‘American bankruptcy ecosystem’ of which law is only a significant part. The American bankruptcy ecosystem is best understood as a complex system inhabited by bankruptcy judges, law firms, investment bankers and activist investors. In this Report, I focus on one of the major components of this ecosystem: specialized investors that participate in the ‘bankruptcy claims trade.’ As I discuss, American bankruptcy courts today are best understood not as a place of shame and failure but rather as an integrated part of the capital markets, similar to the private equity firms of New York and the venture capital investors of Palo Alto. As this view of bankruptcy law took hold, investors, typically hedge funds, began to raise a large stock of capital to deploy in it. Importantly, while these investors were born of the bankruptcy bar’s development of institutions that situated bankruptcy courts within the capital markets, they have deployed their capital to accelerate it. This Report chronicles the rise of claims trading and the state of the academic literature on activist investing. In sum, the best interpretation of the available empirical evidence is that claims trading and activist investing have, at the very least, not harmed Chapter 11 or distressed corporations, and may have actually improved the capacity of the American bankruptcy system to reorganize distressed assets.

The Report is available here.

Estimating the Need for Additional Bankruptcy Judges in Light of the COVID-19 Pandemic
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, Bankruptcy Roundtable Updates | 0

By Benjamin Iverson (BYU Marriott School of Business), Jared A. Ellias (University of California, Hastings College of the Law), and Mark Roe (Harvard Law School)

Ben Iverson
Jared A. Ellias
Mark Roe

We recently estimated the bankruptcy system’s ability to absorb an anticipated surge of financial distress among American consumers, businesses, and municipalities as a result of COVID-19.

An increase in the unemployment rate has historically been a leading indicator of the volume of bankruptcy filings that occur months later.  If prior trends repeat this time, the May 2020 unemployment rate of 13.3% will lead to a substantial increase in all types of bankruptcy filings.  Mitigation, governmental assistance, the unique features of the COVID-19 pandemic, and judicial triage should reduce the potential volume of bankruptcies to some extent, or make it less difficult to handle, and it is plausible that the impact of the recent unemployment spike will be smaller than history would otherwise predict. We hope this will be so.  Yet, even assuming that the worst-case scenario could be averted, our analysis suggests substantial, temporary investments in the bankruptcy system may be needed.

Our model assumes that Congress would like to have enough bankruptcy judges such that the average judge would not be pressed to work more than was the case during the last bankruptcy peak in 2010, when the bankruptcy system was pressured and the public caseload figures indicate that judges worked 50 hour weeks on average.

To keep the judiciary’s workload at 2010 levels, we project that, in the worst-case scenario, the bankruptcy system could need as many as 246 temporary judges, a very large number. But even in our most optimistic model, the bankruptcy system will still need 50 additional temporary bankruptcy judgeships, as well as the continuation of all current temporary judgeships.

Our memorandum’s conclusions were endorsed by an interdisciplinary group of academics and forwarded to Congress.

Congress is ignoring the best solution for troubled companies: bankruptcy
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Legislation | 0

By Jared A. Ellias (University of California Hastings College of the Law), George Triantis (Stanford Law School)

Jared A. Ellias
George Triantis

During the COVID-19 pandemic, Congress has moved quickly to get trillions of dollars of emergency relief to consumers, small businesses, and large firms. These efforts aim to rescue millions of American consumers and businesses from insolvency.

It is troubling, though, that the federal government is ignoring the law that already exists for cushioning the blows associated with financial distress: the bankruptcy system. In its strategy to provide relief and stimulus, the government is in effect offering roadside emergency assistance when the infrastructure and expertise of a hospital is easily accessible.

Because the bankruptcy system entails a detailed restructuring process, it forces companies to think hard about how they’ve been doing things and whether it makes sense to continue doing them that way. Cash infusions from programs like those in the CARES Act, on the other hand, are only designed to keep businesses’ heads above water. That’s all that some companies need, but for others that were already struggling before the crisis hit, such as J.Crew and Neiman Marcus, bankruptcy can encourage them to focus on their long-term health.

Our existing bankruptcy system isn’t only crucial for helping companies move past their immediate crisis of zero revenue and illiquidity, it will also be essential in helping entire industries adapt to a prolonged period of uncertainty created by the coronavirus pandemic.

For the full opinion piece, click here.

For other Roundtable posts relating to the Covid-19 crisis, see Andrew N. Goldman, George W. Shuster Jr., Benjamin W. Loveland, Lauren R. Lifland, “COVID-19: Rethinking Chapter 11 Bankruptcy Valuation Issues in the Crisis.”

Bankruptcy Hardball
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, Bankruptcy Roundtable Updates | 0

By Jared A. Ellias (University of California, Hastings) & Robert Stark (Brown Rudnick LLP)

On the eve of the financial crisis, a series of Delaware court decisions added up to a radical change in law: Creditors would no longer have the kind of common law protections from opportunism that helped protect their bargain for the better part of two centuries. In this Article, we argue that Delaware’s shift materially altered the way large firms approach financial distress, which is now characterized by a level of chaos and rent-seeking unchecked by norms that formerly restrained managerial opportunism. We refer to the new status quo as “bankruptcy hardball.” It is now routine for distressed firms to engage in tactics that harm some creditors for the benefit of other stakeholders, often in violation of contractual promises and basic principles of corporate finance. The fundamental problem is that Delaware’s change in law was predicated on the faulty assumption that creditors are fully capable of protecting their bargain during periods of distress with contracts and bankruptcy law. We show through a series of case studies how the creditor’s bargain is, contrary to that undergirding assumption, often an easy target for opportunistic repudiation and, in turn, dashed expectations once distress sets in. We further argue that the Delaware courts paved the way for scorched earth distressed governance, but also that judges can help fix the problem.

The full article is available here.

Regulating Bankruptcy Bonuses
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, Bankruptcy Roundtable Updates | 0

By Jared Ellias (University of California, Hastings)

In 2005, the perception that wealthy executives were being rewarded for failure led Congress to ban Chapter 11 firms from paying retention bonuses to senior managers. After the amendment became effective, Chapter 11 debtors could only pay executive bonuses through court-approved “Key Employee Incentive Plans,” which required managers to earn their pay by accomplishing specific performance goals, such as increasing revenue or moving the firm through the bankruptcy process.

In my article, I use newly collected data on the compensation practices of Chapter 11 debtors between 2002 and 2012 to examine how the reform changed bankruptcy practice. I find that relatively fewer firms used court-approved bonus plans after the reform, but the overall level of executive compensation appears to be similar. I hypothesize that three problems undermined the efficacy of the reform. First, the 2005 law asks bankruptcy judges to police the line between “incentive” bonuses and “retention” bonuses, which is extremely hard to do – judges are poorly equipped to assess the “challenging-ness” of a proposed performance goal. Second, creditors have limited incentives to police executive compensation themselves and help bankruptcy judges perform their inquiry, and the Department of Justice’s US Trustee program, while vigilant, lacks expertise in executive compensation. Third, gaps in the new regime make it easy for firms to bypass the 2005 law and pay managers without the judges’ permission. I support each of these hypotheses with empirical evidence. Further, there is also evidence that the reform significantly increased the litigation surrounding bonuses plans and, unsurprisingly, the attorneys’ fees associated with them. In many ways this paper examines what happens when Congress tries to change the balance of bargaining power between managers and creditors, and the result appears to be that firms found ways to get around a poorly written rule.

The full article is available here.

 

Bankruptcy Claims Trading
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Claims Trading | 0

By Jared A. Ellias (University of California, Hastings)

Over the past twenty years, a robust secondary market has emerged in the debt of Chapter 11 firms. Critics worry that the trading associated with this market has undermined bankruptcy governance, by forcing managers to negotiate with shifting groups of activist investors in the Chapter 11 bargaining process. In my new Article, “Bankruptcy Claims Trading” I perform the first empirical study of trading in the financial claims of Chapter 11 debtors to learn more about how claims trading impacts the average Chapter 11 case. Using the entire record of trading in bond debt for all Chapter 11 debtors that filed for bankruptcy between 2002 and 2012, I find that nearly all Chapter 11 bonds trade very heavily throughout the bankruptcy process. However, I find that claims trading appears to be less important for bankruptcy governance than many critics fear. The activist groups that tend to participate in negotiations usually enter cases early and rarely change significantly. This suggests that bankruptcy claims trading is, on average, much more about passive investment and much less about activist entrance and exit.

The full article is available here.