Half a Loaf to No One; The Supreme Court's Decision in Travelers

The U.S. Supreme Court's latest addition to bankruptcy jurisprudence might be the least useful opinion in recent memory. It requires a certain gift to take a clear circuit split and provide essentially no guidance at all to which circuits might be correct. But the Travelers opinion does just that.

For those who have not been following along, the case of Travelers v. Bailey has a long and tortuous (tortious?) history that goes back decades. Once upon a time, Johns Manville Corporation was a leading producer of asbestos products. As one might imagine, that line of business eventually led to bankruptcy court. Manville's primary insurer was Travelers and Travelers ultimately assisted in funding Manville's plan of reorganization. The bankruptcy court in New York confirmed that plan in 1986. Largely from the funds received from Travelers and other insurers, the plan created a trust to pay all asbestos claims against Manville. The plan included a release for Travelers, the scope of which became the focus of the case at the Supreme Court. In theory, all claims against Travelers related to the Manville insurance policies would be channeled to the trust created to pay such claim. After all, why would the insurance companies agree to settle the claims if potential plaintiffs then could sue Travelers directly for their injuries?

Of course, the plaintiffs sued anyway. Roughly a decade after confirmation, the plaintiffs started suing the insurance companies directly. The insurance companies of course invoked the 1986 confirmation order. They asked the bankruptcy court to stay the pending actions. The bankruptcy court did so, fostered a further settlement, and then held an evidentiary hearing on the basis for the direct actions. In 2004, the bankruptcy court issued an order clarifying its 1986 order and concluding that the direct actions were covered by the confirmation order. Thus the bankruptcy court ultimately stayed an action by one non-debtor against another non-debtor. On appeal, the district court affirmed the bankruptcy court but the Second Circuit reversed.

No one doubts that the bankruptcy court had the authority to interpret its own order. The $64,000 question is whether the bankruptcy court had the jurisdiction to enjoin the action of a non-debtor against another non-debtor. On this question, there is a clear circuit split that I discussed a few months back. Guidance from the Supreme here would have been most helpful. This split can affect venue decisions in all sorts of cases and having a uniform rule might have had a beneficial effect on venue issues. Having a uniform rule also might allow parties to make decisions with some degree of certainty about their effects. So what did the Supreme Court do?

They punted.

Thursday's opinion resolved the case without resolving the issue. The Supreme Court held that: (a) the 1986 confirmation order was completely clear and became final years ago; and (b) the bankruptcy court had subject matter jurisdiction to enter the 2004 order. Therefore, according to the Supreme Court, the Second Circuit should not have reversed the bankruptcy court. Regardless of whether the Supreme Court was correct on these matters, the opinion fails to provide any useful guidance to speak of. The ultimate question here was whether a bankruptcy court had the jurisdiction to prevent lawsuits by potential third-party plaintiffs against potential third-party defendants. If the bankruptcy court had the jurisdiction to do so, why not just say it? If the bankruptcy court did not have jurisdiction, affirm the Second Circuit and let Congress figure out what to do about future claims.

Why does this matter? Because no one really knows for certain right now whether bankruptcy courts have the jurisdiction to release claims of one third-party against another. And the issue arises in just about every case in which the debtor is engaged in an industry that might lead to harms to people who cannot be identified yet. Just as a simple example, if an auto manufacturer is reorganized (or sold, either way) and the cars that it manufactured prepetition are defective in a way that results in accidents years from now, whom should the plaintiffs who were harmed be able to sue? The reorganized or reconstituted auto manufacturer? The insurance company who provided insurance coverage to the manufacturer? There might be a bankruptcy court order releasing those parties. According to the Supreme Court's decision in Travelers, if the plaintiffs wanted to be able to sue anyone who was released, the plaintiffs should have appealed the order back when it was entered by the bankruptcy court -- even though the order was entered years before anyone knew about the defect.

How would you like that answer if you were the accident victim? Years before you were hit and injured by a defective car that you did not own, you should have appealed the bankruptcy court order that provided a release for the manufacturer and its insurance company.

I cannot say as a matter of policy what the right result is here. Whether bankruptcy courts should have the jurisdiction to provide release to third-parties for future claims is a policy question that is beyond the scope of my expertise. It certainly would be helpful to know what the answer is though. Because "You should have appealed the order that you didn't know about that deprived you of all sorts of rights you didn't know you would have" is not a particularly satisfactory response.

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Supreme Court Upholds Travelers Order

This morning the U.S. Supreme Court upheld the bankruptcy court's order enjoining lawsuits against Travelers. Opinion is available here. More discussion to follow in upcoming days, I imagine.

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The Chrysler Sale and Spin Wars; How An Early 363 Sale Can Give The Impression Of A Successful Bankruptcy

As usual when I discuss anything of a political nature, I will preface my comments by noting that this not a political site and that politically I am a non-partisan moderate. And given the nature of transaction, I don't have the financial background to comment intelligently on whether the Chrysler sale was economically wise.

By getting the general public to the focus on the duration of Chrysler's bankruptcy case rather than its effect, the Obama administration seems to have won the spin war. Media sources, bloggers and tweets are routinely reporting that, because the Chrysler sale closed, Chrysler has exited bankruptcy. To bankruptcy practitioners, a case is not over because of an asset sale. The case will proceed to address claims and the myriad of other issues that remain. But to most people paying attention, the major assets leaving the ambit of "bankruptcy protection" signals the effective end of "Chrysler in bankruptcy." That the recovery to unsecured creditors is not necessarily high seems to have been lost in the excitement over the sale.

Ironically, the speed with which assets leave a bankruptcy case tends to have an inverse relation to the ultimate recovery in the case. A quick sale of all of the assets from a bankruptcy estate is not a sign of a -- for a lack of a better word -- "healthy" debtor. Quick sales of assets are very common when assets are declining in value; the proverbial truck full of soon-to-be-rotting vegetables is an easy example. The expected return to unsecured creditors from a sale of all assets is usually inconsequential or at least very low. The expected return to unsecured creditors for a reorganization is usually at least a little higher than what we expect from an asset sale. And there certainly is a better chance of tort and future claimants receiving a meaningful recovery in a reorganization than from the remnants of an assets sale. Nevertheless, Chrysler's quick "exit" from bankruptcy gets hailed largely as a success because it only took six weeks.

It is a very fair criticism that long, complex reorganization cases tend to benefit two unpopular groups: bankruptcy professionals and existing management. The longer and more complex a bankruptcy case is, the more work bankruptcy professional must perform and the more fees they are likely to incur. Similarly, the self-preservation tendencies of the debtor's management rarely counsel towards a quick sale. But is the Schadenfreunde value of depriving a relatively small number of unloved people their compensation seems little reason to counsel in favor of a quick sale unless absolutely necessary.

In short, without commenting on the relative merits of the Chrysler sale, celebrating a quick sale as if it had been a successful prepackaged bankruptcy does a disservice to the public's sense of what should and should not be important in a bankruptcy case. It would be better to explain that a quick bankruptcy sale in this instance is necessary to preserve the value that might remain in Chrysler and provide any recovery to creditors rather than suggesting that somehow the Chrysler bankruptcy case was a success because the only assets of substantial value departed the case within a couple months.

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Why The Chrysler Sale Did Not Violate The Absolute Priority Rule

With the Chrysler sale appeal currently pending at the Supreme Court, there have been occasional questions and concerns about whether the sale violates the absolute priority rule. Now is a good time to lay to rest any confusion about the role of the absolute priority rule here.

First a quick primer on the absolute priority rule: It has its origins in the Bankruptcy Act of 1898 and the requirement that reorganization plans be "fair and equitable." The basic principle of the absolute priority rule is that no junior class should receive any distribution until senior classes are paid in full. The Supreme Court in Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 108 S.Ct. 963, 99 L.Ed.2d 169 (1988) confirmed that the principle has extended into the "fair and equitable" requirement in section 1129 of the Bankruptcy Code.

There is confusion about the breadth of the absolute priority rule, though. Some believe that the "absolute" means that the rule applies to all aspects of a bankruptcy case. The appellants to the Chrysler sale made this argument to the Supreme Court while seeking to stay the Chrysler sale. The appellants argued that the terms of the sale were in contravention to the absolute priority rule as expressed in In re Armstrong World Industries, 432 F.3d 507 (3d Cir. 2005). The Armstrong decision, however, came in the context of a plan of reorganization, not an asset sale.

There does not appear to be any reported decision applying the absolute priority rule to an asset sale. As such, the absolute priority rule probably only applies directly to plans being confirmed over the objection of creditors. Recall above that the absolute priority rule became incorporated in the Bankruptcy Code through the requirement contained in section 1129(b)(1) that plans confirmed over objections be "fair and equitable." Section 363 contains no such requirement. Therefore, there is no clear prohibition to a sale that does not conform to the absolute priority rule.

Realistically then, under what circumstances are sales that would not conform to the absolutely priority rule likely to occur? The Chrysler sale is a good illustration. When the purchaser has the mixed motivations of wanting to acquire assets and also address claims for which it might be obligated, the purchaser might seek to satisfy such claims through participation in the sale. For example, Chrysler's retirees who do not have their healthcare provided by Chrysler might be a burden on Medicare and/or Medicaid. Therefore the U.S. government has a strong interest in making sure that those retirees have their healthcare funded. Ultimately these situations are likely to arise when there are such motivations or perhaps when an insider is purchasing the assets.

None of this is to offer an opinion about whether the absolute priority rule should apply to asset sales, whether the Chrysler sale was the best use of the government's resources, or even whether the Chrysler sale's effects on the capital markets were sufficiently negative to counsel against the sale. Unless something truly unexpected happens, however, such as the Supreme Court deciding suddenly that the absolute priority rule applies to asset sales, the Chrysler sale did not violate the absolute priority rule.

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Breaking: Supreme Court Issues Stay Pending Appeal in Chrysler Sale

From the New York Times:

The United States Supreme Court agreed Monday afternoon to delay the sale of most of Chrysler’s assets to Fiat pending further consideration of an appeal by three Indiana state funds, in a move that injects a new element of uncertainty over the carmaker’s bankruptcy case.

Justice Ruth Bader Ginsburg, who handles emergency matters arising from the United States Appeals Court for the Second Circuit, issued a stay of the sale, preventing Chrysler and Fiat from completing the transaction immediately.

Unbelievable.

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Medical Bills Causing Bankruptcies; Just Like 2005

By now many readers of this blog will have heard or read about the Harvard study that came out this week showing that medical bills play a significant role in over sixty percent of personal bankruptcy cases. Here is a story from CNN reporting the study.

Most versions of the story that I read did not explain that the 2009 study is a sequel. The results are not very different from a similar study back in 2005. Here is a story about that study.

Just to compare the results, in the 2005 study forty-six percent of bankruptcies involved medical costs and that grew to sixty-two percent in 2009. The study reprised some of its descriptions too. From the 2009 article:

"That was actually the predominant problem in patients in our study -- 78 percent of them had health insurance, but many of them were bankrupted anyway because there were gaps in their coverage like co-payments and deductibles and uncovered services," says Woolhandler. "Other people had private insurance but got so sick that they lost their job and lost their insurance."

From the 2005 article:

Surprisingly, most of those bankrupted by illness had health insurance. More than three-quarters were insured at the start of the bankrupting illness. However, 38 percent had lost coverage at least temporarily by the time they filed for bankruptcy.

And apparently Warren Buffet is enough of a household name now to be in the same sentence as Bill Gates. From the 2005 article:

Dr. David Himmelstein, the lead author of the study and an Associate Professor of Medicine at Harvard commented: "Unless you're Bill Gates you're just one serious illness away from bankruptcy. Most of the medically bankrupt were average Americans who happened to get sick."

From the 2009 article:

"Unless you're a Warren Buffett or Bill Gates, you're one illness away from financial ruin in this country," says lead author Steffie Woolhandler, M.D., of the Harvard Medical School, in Cambridge, Mass. "If an illness is long enough and expensive enough, private insurance offers very little protection against medical bankruptcy, and that's the major finding in our study."

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In Defense Of Bankruptcy Attorneys Fees

There is a post on the Legal Blog Watch entitled Bankruptcy Lawyers: Parasitic or Productive? which suggests that perhaps bankruptcy attorneys should reduce their fees when bankruptcy cases get complex and provide less of a return to creditors. With high-profile bankruptcy cases in the news in recent days, this was one of the numerous articles about bankruptcy attorneys and their fees. Without wanting to single out any author or any particular article, this one happened to catch my attention. Obviously, there is no need to attempt to defend the decisions of any professional who does not act in the best interests of the client or patient. It is easy in these times, though, to pick on the most visible beneficiaries of hard times. It might be more useful, however, to walk a mile in the shoes of the object of criticism before likening him or her to a parasite.

It is important to understand at the outset the challenges facing bankruptcy attorneys. The practice requires an immense skill set. Not only must they know bankruptcy law inside out and backwards, they often must have both litigation and transactional skills. The practice involves the underlying rights of parties governed by state law but altered by the overlay of federal bankruptcy law. It is a highly technical practice that certainly attracts a cerebral crowd.

The bankruptcy attorneys who end up spending their careers working the larger, more complex cases are not necessarily motivated completely by money. Of course, lawyers are no more inclined to become non-profit institutions than other professionals are. But I would liken the motivation of a high-end bankruptcy lawyer to that of an oncologist. Both sorts of professionals absolutely intend to make a good living from their work. But there are plenty of other specialties in law and medicine in which to do that. At least part of the attraction to a challenging practice is knowing that the tasks ahead might be vary hard and the stakes quite high. Some of the attraction also might be the pressure of working in a difficult and challenging field full of other exceptionally capable professionals.

To continue with the analogy, we do not begrudge the oncologist who is better compensated than a general practitioner. We also do not wonder whether a cancer patient might be just as well off having a less expensive treatment than the one prescribed by the leading oncologist. We do not suggest that the oncologist take a fee cut simply because the first line of treatment was successful. And of course there are not many articles questioning whether oncologists are "parasitic" even though they make their livelihood as a result of other people's substantial misfortune.

None of this is to suggest that there are no decisions based either entirely or excessively on fees. Just as a patient with a serious medical condition will face a battery of tests, not all of which will be strictly justifiable on a medical basis, attorneys will undertake tasks that might not have been the best use of the client's resources. Most attorneys I know can recite at least one cringe-worthy story about a decision that was motivated much more by fees than the best interests of the client. Of course many patients with serious illnesses also were the subject of tests that had little or no chance of furthering his or her treatment.

The nature of professional practice at any level involves filling a need. Sometimes that need involves repairing a tooth. Sometimes that need involves treating a serious illness. Sometimes that need involves negotiating a contract or litigating a significant dispute between sophisticated parties. And sometimes that need involves the complex representation of an entity involved in a chapter 11 bankruptcy proceeding. In each instance someone will call on the expertise of a professional with a lot of training and experience in the hope that the skills and wisdom acquired along the way will lead to a favorable result. The professional also might charge more than necessary or appropriate for his or her services. Doubtless some of the decisions that the professional makes will be subject to second-guessing and some of that second-guessing will be well deserved. But nothing about professional services is unique to bankruptcy practitioners and singling out one kind of professional from the rest of the lot carrying mixed motivations simply makes the kettle stand apart from the pot.

Ultimately the market in one form or another provides a check on professional fees. A dentist who is pushing braces on teenage patients might find the patient heading elsewhere for cleaning. The doctor who prescribes unecessarily might have an insurance company question such practices. The litigator who undertakes fruitless and costly discovery motions might have an angry client questioning the fees. And a bankruptcy practitioner being paid by a bankruptcy estate always will have some combination of a client, a judge, the U.S. Trustee, and the other parties in the case reviewing every fee application. Whether these checks are sufficient in all instances is debatable, but no one should think a large bankruptcy representation is a license to print money.

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Chrysler: Selling Free and Clear of Tort Claimants

This post comes in response to an excellent comment on yesterday's post on the legality of the Chrysler sale. The commenter asked asked about the portion of the Chrysler sale opinion (p. 42-44) dealing with "personal injury, property damage, and wrongful death claims of current and future litigants injured by Chrysler cars bought before the sale to Fiat" and whether there will be any recovery for those claimants. The commenter also asked about whether the same result might occur in GM's bankruptcy case.

We are now into some of the higher metaphysics of bankruptcy law. I apologize in advance to our readers for whom this discussion seems confusing and also for the ways in which I will cut analytical corners to try to explain how future claims work. There is nothing simple about any of this.

The Bankruptcy Code defines a "claim" just about as broadly as possible. The definition includes rights that arise from actions that have not yet occurred and harms about which the injured party is unaware. The definition is designed to elicit and address as many entities that might have any rights against the debtor as possible. So, for example, someone who buys a car that has a latent defect which causes an accident well after the manufacturer's bankruptcy case still arguably had a claim in that bankruptcy case. More famously, a worker in a factory who was exposed to asbestos on the job, but who will not have symptoms of any illness until years after the owner of the factory filed a bankruptcy case, also probably had a claim in that bankruptcy case.

The question then becomes, when a debtor is selling substantially all of its assets to a new purchaser for a price that is nowhere close to enough even to pay the senior lenders, is such a sale free and clear of the tort claims. Section 363(f) of the Bankruptcy Code addresses sales free and clear and states that such sales may be "free and clear of any interest in such property" under any one of five circumstances, one of which is almost always present. There is a split of authority as to whether a future claim constitutes an interest in property for the purposes of section 363(f). But, as Judge Gonzalez noted in his opinion, one of the current leading cases on the subject, In re Trans World Airlines, Inc., 322 F.3d 283 (3d Cir. 2003) held that such claims are interests in property and can be extinguished through a sale.

Obviously, this is a potentially unfair result. When an enterprise causes harm, it is not at all apparent why the previous owner can sell that enterprise without compensating the party harmed. Or, if the owner can sell the enterprise, why is the purchaser of the enterprise not required to compensate the party harmed? I doubt that even the most strident of apologists for the Bankruptcy Code would conclude that its results are always fair.

Fortunately for some tort claimants, purchasers do in some circumstances agree to compensate such claimants. I noted in the news this morning that the Obama administration said that the U.S. Government would back the warranties of GM vehicles. It is often in the interests of the purchaser of manufacturing assets to undertake such efforts to maintain goodwill with customers. Therefore, the owners of defective vehicles might not be left out in the cold.

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Why the Chrysler Sale Was Almost Certainly Lawful

With the Chrysler and GM bankruptcies at the forefront of attention in recent days, I have noticed that I have been spending an increasing amount of time discussing the propriety and legality of the Chrysler sale with friends and neighbors. So perhaps it worth sharing a few thoughts here. With the benefit of the sale opinion now (available here) there is little doubt that the sale was legal under applicable bankruptcy law. Whether the whole transaction was advisable is beyond my area of expertise, but as a bankruptcy attorney I have yet to read or hear a convincing reason that that the sale violated bankruptcy laws.

The State of Indiana carried the flag for the objecting parties and from what I could tell did at least a competent job of objecting to the sale. The objection had a few potentially valid prongs. First, the sale was arguably a "sub rosa plan." Second, the sale ended up reordering creditor priorities to some degree. Third, the sale should not have been approved free and clear of the lenders' liens. Recognizing that not every reader of this blog is a bankruptcy practitioner and that this post in particular might get a broader audience, I am going to try to keep the legal discussion on a fairly general level.

The first objection point is that the Chrysler sale was a "sub rosa plan." The sub rosa plan doctrine dates from the Braniff Airways decision, 700 F.2d 935 (5th Cir. 1983). In Braniff Airways, the Fifth Circuit struck down an asset sale because it included such provisions as dictating the terms of a future plan of reorganization and provided for a release of claims against the debtor. As the Fifth Circuit stated, "The debtor and the Bankruptcy Court should not be able to short circuit the requirements of Chapter 11 for confirmation of a reorganization plan by establishing the terms of the plan sub rosa in connection with a sale of assets." Id at 940.

This argument failed because the sale parties in the Chrysler deal were far too smart to structure this sale to resemble the Braniff Airways mess. Rather than trying to dictate the terms of a plan, the Chrysler sale simply transfers the assets to a new entity, gives the sale proceeds to the senior secured lender, and lets the rest of the bankruptcy case proceed accordingly. That the rest of the case might provide little recovery to other creditors does not render the sale a sub rosa plan. In this sense the Chrysler sale is quite similar to the types of asset-sale bankruptcy cases that are approved routinely.

The second objection point was that some parties end up owning a portion of the New Chrysler in contravention to the expected result in a bankruptcy case. In some ways this is the most compelling argument. The predictability of outcomes is vitally important in law for a variety of reasons beyond the scope of this post. But ultimately this argument fails as well. The basic principle involved is that bankruptcy creates certain priorities for creditors and that these priorities must control the distribution to creditors. The Bankruptcy Code, however, does not order priorities with respect to ultimate ownership of an asset sold. We often refer to the new company formed to purchase an asset as "NewCo." As long as the owners of NewCo are not receiving property on account of their interests in the old debtor company, the formation of NewCo is left to the parties who will own it. For Chrysler, that the other parties are willing to share their ownership in New Chrysler with VEBA, the trust designed to provide health-care benefits to Chrysler's retirees, is immaterial to the legality of the transaction.

The third objection point was quite weak. The objectors contended that Chrysler's assets could not be sold free and clear of the secured creditors' liens absent the consent of the objecting creditors. This is a highly technical bankruptcy point that I will try to explain in a few sentences. Bankruptcy sales are generally free and clear of liens on the property. So if the debtor company owns a factory that is encumbered by a lien and the debtor wants to sell the factory, the purchaser takes title to the factory free and clear of the lien and the lien attaches to the proceeds of the sale. I say that this generally occurs because there are multiple provisions that will permit such a sale to be free and clear. The easiest to fulfill is the consent of the lienholder. It turns out that Indiana held less than 1% of the senior secured debt and had entrusted a collateral agent to act on behalf of all of the participating lenders and the agent had consented to the sale. Thus Indiana had consented to the sale free and clear of liens.

Again, this post is not an endorsement of the policies that led to the sale or the structure of the ownership of New Chrysler. Whether the other New Chrysler equity holders made the correct decision in sharing ownership with VEBA is well beyond my expertise. Nevertheless the sale transaction from my perspective as a bankruptcy attorney appears to be lawful.

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Chrysler Sale Opinion

If you would like to read Judge Gonzalez' opinion on the Chrysler sale, it is available for free here.

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