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By: Travis Knobbe
For the most part, the nuances of bankruptcy law go unnoticed by our colleagues who do not frequent the bankruptcy courts. Some issues we deal with, however, have broad application to the practice of law generally. Consider, for example, how a coverage attorney analyzing various claims filed against the manufacturer of an allegedly defective product might benefit from a bankruptcy procedure that could channel all claims into a single place.
Indeed, this is exactly what happened over 30 years ago in the Johns-Manville bankruptcy case. The practice of establishing channeling trusts or similar devices for claims against all manner of debtors—and even non-debtor parties—has grown since its first conception as a way of introducing efficiency into resolution of asbestos-related injury claims.
Reviewing complex Chapter 11 cases from the past decade reveals a commonplace practice that looks like this. A debtor facing myriad claims, usually (but not always) for tort liability, files bankruptcy to stop the bleeding. The debtor restructures its business, perhaps sells a few profitable pieces (sometimes to its current owners) and establishes a fund (variably referred to as channeling trusts, liquidating trusts, or various other related vehicles) from which the entire universe of those myriad claims will be paid.
Third parties who might also face a risk of liability under certain theories offer to pay money into the estate to help establish that fund. In exchange, the debtor and those contributing third parties ask the bankruptcy court for two key provisions in a confirmed Chapter 11 plan. First, they want all claims (even future claims for current liabilities) to be enjoined and funneled into the funds established. Second, they want broad releases of liability, essentially compelling all current and future claimants to seek recourse solely against whatever fund they established in bankruptcy.
This practice began in the “unique cases” of asbestos manufacturers facing liability for injuries that were (arguably) already caused but that, in many cases, would not manifest for decades. Early-adopters of this structure argued successfully that these unique circumstances justified a departure from the general rule that only those who actually filed for bankruptcy protection could obtain relief from liability and that, even then, that relief could, by and large, only be afforded to current claimants of those debtors.
Step forward over 30 years, and the practice has become far from unique. Indeed, in 2019, the Honorable Michael E. Wiles, Bankruptcy Judge for the Southern District of New York, astutely observed the following: “[I]n actual practice the parties . . . often seek to impose involuntary releases based solely on the contention that anybody who makes a contribution to the case has earned a third-party release. Almost every proposed Chapter 11 Plan that I receive includes proposed releases [that] . . . are as broad as possible in their scope[.]” He added, “[i]f this [the practice of third party contributions] were enough then releases would never be limited to the ‘rare’ and ‘unusual’ circumstances” initially contemplated when such practice first arose. In re Aegean Marine Petroleum Network Inc., 599 B.R. 717, 726-27 (Bankr. S.D.N.Y. 2019).
The rationale behind this practice, of course, makes practical sense to those who advocate for it. For companies facing litigation across the country (sometimes, the world), the results of that litigation can prove wildly inconsistent across various jurisdictions. When dealing with a limited asset pool, the costs to defend lawsuits in multiple places can add up in a hurry. Insurance companies defending claims under an occurrence policy also face these considerations. Executives and owners of those companies might fear some combination of direct personal liability, derivative shareholder liability, and alter-ego/veil-piercing risks that could put them on the hook if the company files bankruptcy to combat its liability efficiently.
Indeed, plenty of judges have blessed the practice. After all, the practice could not have become commonplace without the blessings of those gatekeepers. Thus, regardless whether the bankruptcy code supports these contribute-for-release mechanisms (and supporting framework), lawyers across various practice areas have, to one degree or another, come to rely on the practice. Insurance defense lawyers, coverage lawyers, estate planning lawyers, personal injury lawyers, transactions lawyers, and general corporate lawyers all have this framework in mind when advising their respective clients of their rights.
Recently, however, the District Court for the Southern District of New York issued a decision in the Purdue Pharma case that, for better or worse, could upend the practice.
By way of brief background, Purdue Pharma manufactured and sold, among other things, the opioid pain medication OxyContin. A series of investigations by various state and federal authorities uncovered an alleged decades-long pattern of behavior that subjected both Purdue Pharma and its primary owners to criminal and civil liability. Once the investigations reached a tipping point, the owners of Purdue Pharma began withdrawing billions (totaling $10.4 billion, give or take) from the corporate coffers.
Shortly after doing so, the owners withdrew from the operations of Purdue Pharma, and Purdue ultimately filed for bankruptcy protection. In the bankruptcy case, Purdue Pharma, together with its primary owners and various other third parties, cobbled together a plan (the framework of which had been discussed prior to the case filing) that saw various third parties contribute over $4 billion (nearly all of which came from the same owners who had previously withdrawn $10 billion from the company) in exchange for broad releases of all liability by those owners for any civil claim relating to Purdue Pharma’s activities in manufacturing, selling, and marketing OxyContin.
While the facts are certainly unique, the various parties simply re-tooled a commonplace practice in bankruptcy courts to seek financial absolution for the affair. In Purdue Pharma, however, the District Court, on appeal from the order confirming the Chapter 11 plan containing this framework, reversed the order confirming the plan and took exception to the practice.
While the Court readily observes that the practice grew out of the asbestos bankruptcies of the 80s and 90s, the Court notes that subsequent amendments to the Bankruptcy Code have specifically blessed the use of channeling trusts (and the releases that come with them) in the asbestos context. Congress, however, did not bless the use of these vehicles in other contexts. Therefore, the Court says that the Bankruptcy Code does not permit the combination of trusts and releases employed by Purdue Pharma. The Court meticulously analyzes the current split among Circuit Courts as to whether the practice is allowed, and the Court openly invites the Second Circuit Court of Appeals (which had, to date, called it an open question on which it refused to rule) to consider the question and issue guidance to the lower courts on the practice.
How the Second Circuit comes out on the issue is anybody’s guess. That decision, however, certainly has wide-ranging implications on a larger pool of lawyers than those of us who routinely deal with bankruptcy.