The Eastern District of Pennsylvania Bankruptcy Conference (“EDPABC”) is a non-profit organization that was formed in 1988 to promote the education and interests of its members and the citizens of the Commonwealth of Pennsylvania residing in the ten counties within the United States District Court for the Eastern District of Pennsylvania. Members include lawyers, other professionals and paraprofessionals who specialize in the practice of Bankruptcy and Creditors’ Rights law in the Eastern District of Pennsylvania. Please visit EDPABC’s website, www.pabankruptcy.org, for more information or to join the organization.
Each year, the EDPABC’s Education Committee formulates challenging hypotheticals based on recent case law. At the EDPABC’s Annual Forum, typically held in January each year, professors from local law schools facilitate lively discussions among EDPABC members about the hypotheticals in small-group breakout sessions. The hypotheticals are always engaging—and sometimes deliberately ambiguous—to mirror the complexity of everyday practice and foster debate among even the most seasoned bankruptcy professionals.
The hypotheticals are accompanied by summaries of the underlying case law and other relevant authorities inspiring the fact patterns. The summaries are intended to give readers insights into how similar issues have been argued before and decided by the courts, and to inform their answers to the questions presented in the hypotheticals.
This hypothetical from a previous Forum, titled “Druul, Inc.,” describes the chapter 11 bankruptcy case of a fictitious company that distributed electronic vaping products, precipitated by short- and long-term liabilities for medical problems caused by the cheap, flavored nicotine cartridges it sold. Druul established separate trusts providing different treatment for known and future claimants and sought confirmation of a channeling injunction for claims against related parties. The hypothetical poses questions relating to Druul’s proposed chapter 11 plan, including the dual-trust structure, its treatment for future claimants, the channeling injunction, and other interesting issues.
Druul, Inc. (“Druul”), a Pennsylvania corporation founded in 2014, manufactures and distributes electronic vaping products. Included among these products is its popular line of flavored nicotine salt cartridges, Druul Stix, which customers vape for a flavorful and refreshing nicotine buzz. As a result of the popularity of its Stix cartridges, Druul had quickly become the leading electronic cigarette company in the country by the end of 2016. In early 2017, the traditional tobacco company Big Tob Corporation (“Big Tob”) purchased a controlling 90 percent interest in Druul. To increase profit margins, Big Tob organized a separate subsidiary, GoodEnuff, LLC (“GoodEnuff”). GoodEnuff manufactured cheap vaping cartridges using more cost effective—but less rigorous—manufacturing processes. Thereafter, GoodEnuff was the exclusive manufacturer of Druul’s vaping cartridges, including its Stix-branded cartridges.
In late 2017, news reports emerged regarding a small outbreak of lung infections in individuals known to have recently used vaping products. Initially, there were only a handful of reports, and Druul was able to avoid any bad press by pointing its finger at the proliferation of black-market vaping cartridges as a potential source of the lung infections. However, scores of additional cases were reported throughout 2018. By mid-2018, over 2,500 cases of vaping-related lung infections had been reported. Many of the cases involved serious and potentially long-lasting health effects. A small number of patients actually died from lung infections. As a result, government officials called for investigations and legislation that would limit or even ban outright the sale of vaping products.
In July 2018, after conducting an investigation, the Center for Disease Control issued a report identifying a potential link between the lung maladies and a defect in GoodEnuff’s manufacturing process that may have allowed contaminants into the Stix cartridges. The CDC’s investigation also uncovered troubling evidence that the effects of the defect were not limited to the immediate short-term illnesses seen thus far. Instead, regular Stix users were also exposed to a significant risk of latent, but serious, lung diseases. The lung diseases might not arise until years later, potentially even years after a regular vaper had quit using Stix.
By early 2019, thousands of lung-related personal injury and products liability cases had been brought against Druul, Big Tob, and GoodEnuff. These plaintiffs alleged that defective vaping cartridges had caused them significant and lasting harm. Druul demanded that its insurer, JustSayNo Insurance Corp. (“JSN”), pay its litigation costs and indemnify Druul for any damages. JSN just said no, leading it to become embroiled in coverage disputes with Druul.
As a result of the bad publicity, civil litigation, and threatened government action, Druul’s profits dramatically decreased in 2018. By early 2019, unable to sustain the mounting legal costs, Druul’s board determined that the best way forward was through a chapter 11 reorganization. In consultation with bankruptcy counsel, Druul devised a strategy to deal with both the mounting number of lawsuits, as well as the likelihood that many additional lawsuits would be filed by vapers who would develop latent lung diseases over the years to come.
Prior to filing for chapter 11, Druul negotiated the basic structure of a settlement with attorneys representing certain vaping-related personal injury plaintiffs, JSN, Big Tob, and GoodEnuff. In accordance with the terms of the settlement, two trusts would be established. The first trust would be a pre-petition settlement trust (the “Settlement Trust”), which Druul would fund with approximately $100 million worth of assets. A second, post-petition trust (the “Bankruptcy Trust”) would be funded largely by contributions from Big Tob, GoodEnuff and JSN. Druul’s proposed chapter 11 plan (the “Plan”) would include a channeling injunction (the “Channeling Injunction”) that would enjoin holders of vaping-related personal injury claims from pursuing claims against Druul, Big Tob, GoodEnuff, and JSN (collectively, the “Protected Entities”) outside the bankruptcy. Persons alleging vaping-related personal injury claims arising from their use of Druul’s products would be required to assert their claims against the trusts only, in accordance with the terms of the settlement and the Plan.
The parties entered into a master settlement agreement (the “MSA”) to implement the Settlement Trust. Participation in the Settlement Trust was offered to all claimants who had formally initiated litigation against Druul as of the petition date (collectively, the “Pre-Petition Claimants”). Any Pre-Petition Claimants who elected not to participate in the MSA would be required to pursue their claims in the bankruptcy. The MSA divided the Pre-Petition Claimants into two categories. The first category was composed of Pre-Petition Claimants who had either obtained judgments or entered into consent judgments with Druul prior to participating in the MSA (the “Category One Claimants”). The second category was composed of Pre-Petition Claimants who had initiated formal litigation, but had not yet obtained judgments (the “Category Two Claimants”). Category One Claimants would receive payment out of the Settlement Trust equaling 85 percent of the value of their claims. Category Two Claimants would receive 70 percent of the value of their claims from the Settlement Trust. To be eligible for distributions from the Settlement Trust, Pre-Petition Claimants would have to agree not to pursue their claims or enforce their judgments outside the anticipated bankruptcy. However, after receiving their distributions from the Settlement Trust, they would be permitted to pursue recovery on the unpaid portions of their claims (the “Stub Claims”) in the bankruptcy from the assets of the Bankruptcy Trust.
The Plan would require persons injured by Druul’s products who had not yet initiated legal proceedings against Druul as of the petition date (the “Non-Settlement Claimants”) and those persons who had used Druul’s products, but would only develop latent lung injuries after the petition date (the “Future Claimants” and together with the Non-Settlement Claimants, the “Post-Petition Claimants”) to seek recovery exclusively from the Bankruptcy Trust.
The Plan would entitle Post-Petition Claimants and holders of Stub Claims (collectively, the “Bankruptcy Trust Claimants”) to receive pro rata distributions from the Bankruptcy Trust assets. The Bankruptcy Trust Claimants would also be enjoined from pursuing actions against any of the Protected Entities outside the bankruptcy. All of the Bankruptcy Trust Claimants would be entitled to an initial payment of 25 percent of their allowed claim amounts. This initial payment would be followed by additional annual payments based on estimates of outstanding claims, as adjusted from time to time. The Bankruptcy Trust Claimants, including the holders of Stub Claims, would be paid on a first-in, first-out basis, with distributions made once a claimant’s allowed claim amount is established. Because the Pre-Petition Claimants are permitted to assert their Stub Claims in the bankruptcy, they are eligible to vote on plan confirmation; however, participation in the Settlement Trust would not require them to vote in favor of the Plan.
In exchange for their contributions to the Bankruptcy Trust, the Plan would extend the protections of the Channeling Injunction to Big Tob, GoodEnuff, and JSN, enjoining claimants from pursuing any vaping-related personal injury claims against them outside the Bankruptcy Trust. GoodEnuff would contribute $10 million to the Bankruptcy Trust. With GoodEnuff relieved of its personal injury liabilities, Big Tob would sell GoodEnuff and contribute approximately $40 million from the sale proceeds to the Bankruptcy Trust. JSN would contribute $85 million—the remaining limit on Druul’s policies—to the Bankruptcy Trust and be relieved of all liability for all vaping-related personal injury claims that could otherwise be asserted against Druul’s insurance policies. As part of the settlement, Druul and JSN released any and all claims they held against each other. Ten million dollars of JSN’s contribution was placed into escrow. These escrowed funds would be used to reimburse JSN in the event that it might later be found liable for any claims that could not be successfully channeled into the Bankruptcy Trust. Any escrowed funds not used within five years of plan confirmation would be transferred to the Bankruptcy Trust.
The Channeling Injunction provision in Druul’s proposed Plan provides:
On and after the Effective Date, the sole recourse of any Bankruptcy Claimant shall be to the Bankruptcy Trust and such Claimants shall have no right whatsoever at any time to assert its lung-related personal injury claims against any Protected Entity. All such Bankruptcy Trust Claimants permanently and forever shall be stayed, restrained, and enjoined from taking any and all legal or other actions or making any demand against any Protected Entity for the purpose of, directly or indirectly, claiming, collecting, recovering, or receiving any payment, recovery, satisfaction, or any other relief whatsoever on, of, or with respect to any PI Claim other than from the Bankruptcy Trust. This provision is implemented pursuant to the Court’s authority under Section 105(a) of the Bankruptcy Code. However, to the fullest extent possible, this Plan, including the terms of this Channeling Injunction, shall be interpreted in accordance with terms and provisions of Section 524(g) of the Bankruptcy Code notwithstanding that Section 524(g) is normally inapplicable outside the context of asbestos cases. To the extent Section 524(g) cannot be adapted to the purposes of this Plan, the Bankruptcy Court shall rely upon its authority under Section 105(a) of the Bankruptcy Code, in addition to any other relevant sections of the Bankruptcy Code in interpreting and enforcing the terms of this Plan.
About three months prior to filing its bankruptcy petition, Druul transferred approximately $100 million in assets to the Settlement Trust to pay the 85 percent and 70 percent partial payments to Category One and Category Two Claimants. On September 15, 2019, Druul filed its voluntary chapter 11 petition and, shortly thereafter, sought approval of the above-summarized Plan. Under the Plan, all Bankruptcy Trust claims, including the Stub Claims and the claims of the Post-Petition Claimants, would be categorized as “Class 5” claims and deemed impaired. The Plan was approved by those creditors entitled to vote, with Class 5 claimants submitting nearly 3,500 ballots by the voting deadline, with approximately 2,700 votes in favor of the Plan. Of those Class 5 votes in favor of the plan, approximately 1,700 of the votes were submitted by holders of Stub Claims.
A group of plaintiffs’ personal injury attorneys (the “Objecting Attorneys”) object to the Plan. The Objecting Attorneys do not represent any present claimants, but anticipate representing Future Claimants in asserting claims against the Bankruptcy Trust. Certain personal injury claimants who were unable or unwilling to participate in the Settlement Trust also object to the Plan (the “Objecting Claimants” and together with the Objecting Attorneys, the “Objectors”). All of the Objectors assert that Druul’s two-trust structure and use of Stub Claims violates the Bankruptcy Code’s principle of equality of distribution among similarly situated creditors. They point to the fact that the two-trust structure provides for greater recoveries to the Pre-Petition Claimants, who would be able to obtain 85 percent or 70 percent recoveries from the Settlement Trust and then pursue recovery on their Stub Claims from the Bankruptcy Trust. Additionally, the Objecting Attorneys argue that the first-in, first-out payment provision discriminates against Future Claimants, whose claims will not be asserted for some time. The Objecting Attorneys argue that as available funds dry up, Future Claimants will recover less than current claimants. The Objecting Attorneys assert that no payments should be made until all claims are resolved, however long that may take.
Druul argues that the Settlement Trust is outside the Plan. According to Druul, the settlement and Settlement Trust were necessary to provide it with some breathing room prior to filing for bankruptcy. By negotiating the MSA with the Pre-Petition Claimants and agreeing to fund the Settlement Trust, Druul was able to buy itself time to prepare its Plan and avoid a potential involuntary chapter 7 liquidation. Druul’s experts testify that after the contributions from Big Tob, JSN and GoodEnuff, the Plan will pay Bankruptcy Trust Claimants between 65 percent and 75 percent of the value of their claims. In contrast, absent the utilization of the two trusts and the contributions from the Protected Entities, all claimants (including both Pre-Petition Claimants and Post-Petition Claimants) would likely receive only approximately 20 percent of the value of their claims in a hypothetical chapter 7 liquidation. Druul also argues that the Plan treats Pre-Petition Claimants and Post-Petition Claimants substantially equally by providing for pro rata distributions from the Bankruptcy Trust. The prior payouts under the Settlement Trust were justified because the Pre-Petition Claimants were further along in pursuing litigation, with some already holding enforceable judgments. For this reason, Druul argues, their claims simply had more value.
- Do the Objecting Attorneys have standing to object to the proposed chapter 11 plan?
- Does the utilization of the two trusts, the Settlement Trust and the Bankruptcy Trust, violate the Bankruptcy Code’s principle of equality among creditors?
- Does the timing of Druul’s funding of the Settlement Trust raise any additional concerns? If so, is it relevant that all claimants would receive less in a theoretical chapter 7 liquidation?
- Does the first-in, first-out structure of the Plan discriminate against Future Claimants whose claims will not be determined until well after existing claims? Should the Plan be modified to provide that no payments will be made from the Bankruptcy Trust until all claims are resolved?
The Objectors additionally assert that Druul artificially created an impaired class of claimants to manipulate the Plan voting. For this allegation, the Objectors point to the Plan’s allowing the Pre-Petition Claimants to obtain substantial recoveries from the Settlement Trust and then submit their Stub Claims to the Bankruptcy Trust. In response, Druul reiterates that (i) the two-trust system was necessary to avoid an involuntary chapter 7 and was not implemented as a means to artificially create an impaired class; (ii) the Pre-Petition Claimants could never receive the full value of their claims and thus their impaired status is anything but artificial; and (iii) there was nothing in the Master Settlement Agreement requiring the Pre-Petition Claimants to vote in favor of the plan.
E. Should the Bankruptcy Court deny confirmation of the Plan because the dual-trust structure and use of Stub Claims allowed Druul to artificially create an impaired class and impermissibly manipulate the voting process?
As of the filing of its chapter 11 bankruptcy, Druul’s experts estimate that Druul’s exposure on the Pre-Petition Claimants’ claims exceeded $150 million. They further believe that exposure on the Post-Petition Claimants’ claims, including future claims, could easily reach an additional $150 to $200 million. Big Tob and GoodEnuff were facing similar exposure. In addition, GoodEnuff was facing exposure as a result of its distribution of defective cartridges to e-cigarette companies other than Druul.
GoodEnuff is contributing $10 million to the Bankruptcy Trust in exchange for the protection of the Channeling Injunction, which it asserts bars all vaping-related personal injury claims arising from the use of its cartridges. Big Tob is contributing $40 million funded, in part, by its anticipated sale of GoodEnuff. At the confirmation hearing, Big Tob asserts that although GoodEnuff’s contribution is relatively modest, Big Tob’s sale of GoodEnuff (and Big Tob’s more substantial contribution to the Bankruptcy Trust) is only possible if Big Tob is able to shed GoodEnuff’s vaping liabilities through the Channeling Injunction. Thus, Big Tob argues, absent extension of the Channeling Injunction to GoodEnuff, the Plan will fail, and all claimants and creditors will be worse off.
- Does the bankruptcy court have jurisdiction over the vaping-related personal injury claims asserted against GoodEnuff, including both those arising from Druul’s products and those arising from cartridges GoodEnuff supplied to other e-cigarette companies?
- Assuming that the bankruptcy court has jurisdiction over at least some of the GoodEnuff claims, can and should the bankruptcy court use its equitable powers under Section 105(a) to extend the Channeling Injunction to protect GoodEnuff?
Prior to Druul’s founding, JSN had provided insurance coverage to Big Tob under numerous policies. During the 1990s, large numbers of plaintiffs brought civil actions against Big Tob based on the harmful effects of cigarettes, and Big Tob’s attempts to hide those harmful effects from consumers for decades. The litigation also included direct actions against JSN as well as coverage disputes between Big Tob and JSN. As one part of a global settlement entered into in the early 2000s, JSN agreed to establish a smoking cessation telephone hotline. Smokers seeking to quit smoking could call the hotline and receive free, over-the-phone counseling and advice. They could also request cessation-related literature and free smoking cessation products, including nicotine patches and nicotine gum. JSN had reason to make sure the hotline was successful. As part of the settlement agreement, Big Tob and JSN agreed to contribute funds annually for anti-smoking advertising campaigns. JSN’s annual contribution amounts are determined by certain metrics measuring the success of the hotline. The more callers who report successfully quitting smoking each year, the less funding JSN has to contribute to the anti-smoking campaigns. With the emergence of vaping during the 2010s, JSN saw an opportunity to increase the efficacy of its hotline. In addition, Druul agreed to provide JSN with free Stix for distribution to callers in exchange for discounts on its own insurance policy payments. Accordingly, JSN began recommending that callers use Druul Stix as a safe alternative to cigarettes and as a result, more callers were able to quit smoking.
Numerous hotline callers who had used Stix to quit smoking subsequently developed lung injuries. After confirmation of the Plan, these hotline callers filed state court actions asserting claims against JSN for negligence and breach of JSN’s duty to warn of the harmful effects of vaping.
JSN filed a motion in the bankruptcy court seeking a determination that the state court actions are barred by the Channeling Injunction. JSN contends that all of the state court actions are barred by the Channeling Injunction because they involve personal injury claims caused by Druul’s vaping products and are, therefore, “vaping-related personal injury claims.” The plaintiffs assert that the causes of action asserted against JSN do not fall within the Channeling Injunction because they are based on independent duties JSN owed to the plaintiffs and, therefore, are not derivative of any claims the plaintiffs might have against Druul or its insurance proceeds. The plaintiffs further assert that the bankruptcy court lacks jurisdiction to enjoin their claims against JSN.
- Which, if any, of plaintiffs’ claims against JSN are properly subject to the Channeling Injunction?
- Assuming that plaintiffs’ claims against JSN are not derivative of any claims they have against Druul or that Druul has against JSN, can the bankruptcy court nevertheless extend the channeling injunction to the claims under Section 105(a) in light of JSN’s significant contributions to the Bankruptcy Trust?
- Does it matter that JSN is entitled to reimbursement from the escrowed funds set aside and that any such reimbursements will deplete the funds available to pay claimants out of the Bankruptcy Trust?
Druul filed its voluntary chapter 11 bankruptcy petition on September 15, 2019. On November 15, 2019, the bankruptcy court set a claims bar date of April 30, 2020, for all claims other than vaping-related personal injury claims. On April 18, 2020, the Internal Revenue Service filed an administrative expense claim for all income taxes due for the tax year ending December 31, 2019. The claim asserts an administrative expense priority claim against Druul in the amount of approximately $2.5 million for all corporate income taxes due for the tax period December 31, 2019, comprised of approximately $2.2 million in taxes, $100,000 in interest and $200,000 in penalties. Because of the bad publicity building during 2019 as well as its bankruptcy filing and related issues, 90 percent of Druul’s taxable income for the year 2019 was earned prior to the petition date. Druul objects to the IRS claim on the basis that the IRS is seeking administrative expense priority for Druul’s corporate income taxes for the entire year, despite the fact that the majority of taxable income was earned prior to the petition date. Druul asserts that the taxes due for the pre-petition period constitute a pre-petition unsecured claim under the Bankruptcy Code not entitled to priority. The IRS asserts that its entire claim is an administrative claim because, although the tax year straddles the petition date, the tax year concluded and the taxes were assessed in the ordinary course post-petition.
- Is the IRS entitled to a priority administrative claim for all of the income taxes due for the tax year 2019?
Summary of Legal Authorities for Question #1
11 U.S.C. § 1109(b)
A party in interest, including the debtor, the trustee, a creditors’ committee, an equity security holders’ committee, a creditor, an equity security holder, or any indenture trustee, may raise and may appear and be heard on any issue in a case under this chapter.
11 U.S.C. § 547(b)
… [T]he trustee may … avoid any transfer of an interest of the debtor in property—
(1) to or for the benefit of a creditor;
(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;
(3) made while the debtor was insolvent;
(A) on or within 90 days before the date of the filing of the petition; or
(B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and
(5) that enables such creditor to receive more than such creditor would receive if—
(A) the case were a case under chapter 7 of this title;
(B) the transfer had not been made; and
(C) such creditor received payment of such debt to the extent provided by the provisions of this title.
11 U.S.C. § 1122(a)
Except as provided in subsection (b) of this section, a plan may place a claim or an interest in a particular class only if such claim or interest is substantially similar to the other claims or interests of such class.
11 U.S.C. § 1123(a)(4)
Notwithstanding any otherwise applicable nonbankruptcy law, a plan shall—
(4) provide the same treatment for each claim or interest of a particular class, unless the holder of a particular claim or interest agrees to a less favorable treatment of such particular claim on interest; …
11 U.S.C. 1124(1)
… [A] class of claims or interests is impaired under a plan unless, with respect to each claim or interest of such class, the plan—
(1) leaves unaltered the legal, equitable, and contractual rights to which such claim or interest entitles the holder of such claim or interest; …
11 U.S.C. 1129(a)(10)
(a) The court shall confirm a plan only if all of the following requirements are met:
(10) If a class of claims is impaired under the plan, at least one class of claims that is impaired under the plan has accepted the plan, determined without including any acceptance of the plan by any insider.
In re Energy Future Holdings Corp., 522 B.R. 520 (Bankr. D. Del. 2015)
The debtors filed a motion seeking a bar date for all prepetition claims. Thereafter, certain asbestos personal injury law firms filed an objection to the bar date motion. Although the debtors had scheduled 392 asbestos-related cases in their schedules, they asserted that their restructuring was not likely to be driven by asbestos liability and they were not seeking to impose a channeling injunction under Section 524(g). The personal injury law firms objected on the basis that many asbestos injury claims were as then unmanifested, and would not be filed for years. They therefore argued that imposing a bar date for those claims would not satisfy due process concerns. Additionally, the personal injury law firms asserted that the asbestos liabilities should be addressed through the creation of a Section 524(g) trust.
Relevant Legal Issue
Did the personal injury law firms have standing to object to plan confirmation?
The bankruptcy court determined that the personal injury law firms lacked standing to object to the debtors’ motion. Although Section 1109(b) allows any party-in-interest (including a creditor) to be heard on any issue in a chapter 11 bankruptcy case, it does not change the general principle of standing. A party may assert only its own legal interests, and not the interests of another. The Third Circuit has described a party-in-interest as “anyone who has a legally protected interest that could be affected by a bankruptcy proceeding.”
The personal injury law firms did not presently represent any holders of unmanifested claims. They did not have a legally protected interest independent of potential future claims. Thus, although the law firms were likely to represent future claimants, they had no standing based on those theoretical future representations. Nevertheless, because of the important due process considerations, the bankruptcy court went on to consider the law firms’ arguments.
The court determined that the establishment of a bar date was warranted. Due process as to unmanifested—and therefore unknown—claimants could potentially be satisfied by notice publication. The court additionally disagreed with the law firms’ contention that the only way to deal with the unmanifested claims was through a personal injury trust and channeling injunction. The court noted that under Fed. R. Bankr. P. 3003(c)(3), “[t]he court shall fix … the time within which proofs of claim or interest may be filed.” However, Section 524(g) provides that after notice and a hearing, a court “may issue … an injunction … ” Thus, the court determined that it was required to establish a bar date, but that establishment of a channeling injunction is not required in all asbestos cases.
In re The Flintkote Company, 486 B.R. 99 (Bankr. D. Del. 2012)
Debtor was historically in the business of manufacturing and distributing building materials, including materials containing asbestos. As a result of asbestos-related lawsuits, debtor filed for chapter 11 protection. Debtor proposed a plan that would include an asbestos personal injury trust and a channeling injunction. The debtor’s former parent company (“ITCAN”) objected to the plan on a number of grounds. Among other things, ITCAN alleged that it had standing as a creditor to object to the proposed plan on two grounds: (1) ITCAN held a future demand for contribution and indemnification in the event that it is ever held liable for debtor’s conduct under an alter ego theory; and (2) ITCAN had an alleged claim for contribution and indemnity against the debtor to the extent that it might have to pay to remediate environmental contamination at a property previously owned by the debtor.
Relevant Legal Issue
Did ITCAN have standing to object to plan confirmation?
“To object to the confirmation of a reorganization plan in bankruptcy court, a party must, in the first instance, meet the requirements for standing that litigants in all federal cases face under Article III of the Constitution.” Those requirements include (1) an injury in fact that is “concrete,” “distinct and palpable,” and “actual or imminent;” (2) a causal connection between the injury and conduct complained of; and (3) a likelihood that a favorable decision will redress the injury.
Parties-in-interest also have standing to object to confirmation of a plan under Section 1109(b) of the Bankruptcy Code. A “party-in-interest” is “anyone who has a legally protected interest that could be affected by a bankruptcy proceeding” or “has a sufficient stake in the proceeding so as to require representation.”
ITCAN argued that it was a creditor; alternatively, it argued that even if it wasn’t a creditor, it was a party-in-interest such that it still had standing to object to the plan.
The court concluded that to the extent ITCAN might have a claim in the future against the debtor related to alter ego liability, that claim was speculative and could not confer standing to object to the plan. The court noted that for ITCAN to demonstrate a cognizable injury, the following things would need to first happen: (1) an asbestos plaintiff would need to establish the merits of a personal injury claim, (2) the plaintiff would need to prevail on alter ego grounds against ITCAN, (3) a court would need to fashion an equitable remedy based on the alter ego status, (4) the plaintiff would need to recover from ITCAN on the claim, and (5) ITCAN would need to establish a right to seek subrogation or contribution from the debtor.
Whether all of these things might come to pass at some point in the future was speculative and therefore, any alleged injury was not actual and imminent.
The court then addressed ITCAN’s argument that, even if it was not a creditor, it was a party-in-interest because the proposed plan would impair its rights. For this proposition, ITCAN alleged that the channeling injunction would effectively remove the debtor from participation in any future asbestos litigation. The court agreed that this was the case, because that is specifically what Section 524(g) is designed to do; however, none of the harm ITCAN complained of was created by the plan or the channeling injunction. Any asbestos liability was not imposed on ITCAN by the plan, but by ITCAN’s own pre-petition conduct. Regardless of whether the plan was confirmed, plaintiffs could still bring alter ego claims against ITCAN in the tort system. The fact that the channeling injunction did not shield ITCAN from liability was a result of ITCAN’s own choice not to contribute to the debtor’s personal injury trust.
The court further rejected ITCAN’s argument that its rights were impaired because of insurance policies that the debtor shared with an ITCAN subsidiary. ITCAN asserted that the plan would result in the shared insurance proceeds being diminished. The court concluded that the plan procedures were not the cause of any insurance depletion. First, the proceeds were always available on a first-come, first-served basis and the plan provided that it did not alter the rights of any co-insureds. Thus, the court found that any injury caused by depletion of the insurance proceeds was not caused by the plan. Rather, the terms of the policies and the order in which claims had been (and would continue to be) made against the policies were the cause of any depletions.
Based on the above, the court determined that ITCAN did not have party-in-interest standing.
In re Combustion Engineering, Inc., 391 F.3d 190 (3d Cir. 2004)
Debtor defended asbestos-related litigation for decades before finally filing for chapter 11 protection. The bankruptcy was an attempt to resolve debtor’s asbestos problems, as well as those of its parent entity, U.S. ABB, and two affiliated entities, Lummus and Basic.
Eighty-seven days prior to filing for bankruptcy, the debtor contributed half of its assets ($400 million) to a pre-petition trust (the “Settlement Trust”). The Settlement Trust would pay asbestos claimants with pending lawsuits for part—but not the entire amount—of their claims. At the time, the debtor was concerned that asbestos claimants who had settlements pending or who were awaiting payment could force it into an involuntary chapter 7. Payments from the Settlement Trust were based upon the length of time a claimant’s case had been pending. Claimants who had settled and were awaiting payment received 95 percent of their claims. Claimants who had agreed to settle but whose payments were due at a future date received 85 percent. Other claimants whose cases were not as far along received smaller payments. None were paid in full, and the unpaid portion of their claims were treated as stub claims. These stub claims could be asserted in the bankruptcy, and provided participants with creditor status under the Bankruptcy Code.
The debtor then filed a prepackaged bankruptcy plan, which included an injunction channeling all asbestos claims to a post-confirmation trust (the “Post-Confirmation Trust”). The plan extended the injunction to non-debtor affiliates Lummus and Basic. The debtor also contributed millions of dollars in cash and assets to the Post-Confirmation Trust. The plan was approved by a majority of asbestos claimants, over the objections of certain insurers and asbestos claimants. Among other things, the plan configured the injunction in favor of Lummus and Basic under Section 105(a) of the Bankruptcy Code instead of Section 524(g). The bankruptcy court approved the plan, and the district court adopted the bankruptcy court’s findings of fact and conclusions of law. Among other things, the district court found that although pre-petition settlement participants might receive more for their claims than non-participants, these claimants were simply not similarly situated.
Objecting parties appealed to the Third Circuit.
Relevant Legal Issues
- Did the two-trust structure and use of stub claims, which allowed certain asbestos claimants to receive a larger recovery than other asbestos claimants, violate the Bankruptcy Code’s principles of equality among similarly situated creditors?
- Did the use of stub claims create an artificially impaired class allowing the debtor to impermissibly manipulate the plan vote?
- Did the funding of the settlement trust within 90 days preceding the bankruptcy constitute a preferential transfer?
(a) Equal Distribution Among Similarly Situated Creditors
Both the bankruptcy court and the district court concluded that the Settlement Trust was necessary to provide the debtor with some breathing space to negotiate the prepackaged chapter 11 plan. Objecting claimants argued that the two-trust structure violated the Bankruptcy Code’s “equality among creditors” principle, because it enabled the Settlement Trust participants to obtain greater recoveries for their claims than similarly situated asbestos claimants.
The Third Circuit noted that “[e]quality of distribution among creditors is a central policy of the Bankruptcy Code.” (quoting Begier v. IRS, 496 U.S. 53, 58 (1990)). The Bankruptcy Code requires that a plan of reorganization provide similar treatment to similarly situated claims. Under Section 1122(a), only “substantially similar” claims may be classified together. Under Section 1123(a)(4), a plan must provide the same treatment for each claim or interest of a particular class.
The court considered the bankruptcy scheme, including the pre-petition Settlement Trust and the plan provisions, as an integrated whole to determine whether plan confirmation was warranted. Viewed in that light, the plan consisted of two elements: the pre-petition Settlement Trust and the Post-Confirmation Trust. Expert testimony showed that on average claimants participating in the Settlement Trust would receive 59 percent of the value of their claims, while future claimants would recover only 18 percent of the value of their claims. Notably, those claimants who had reached settlements and were awaiting payment could receive more than 95 percent of the value of their claims, resulting in a greater disparity compared to future claimants. Accordingly, the two-trust structure of the plan treated similarly situated claimants unequally.
(b) Artificial Impairment
The district court had concluded that the claimants who received payments from the Settlement Trust only received partial payment for their claims because there simply wasn’t enough money to pay them in full. The court thus reasoned that partial payments were not made to “gerrymander” the plan vote, and therefore did not induce participants to vote in favor of the plan or otherwise improperly manipulate the vote.
The objecting claimants argued that the debtor contrived the Settlement Trust and use of stub claims to obtain sufficient votes in favor of the plan.
The Third Circuit noted that a claim is not impaired if the plan “leaves unaltered the legal, equitable, and contractual rights to which such claim or interest entitles the holder of such claim or interest,” or if the plant cures or compensates for past defaults (citing 11 U.S.C. § 1124(1)). Although the Bankruptcy Code does not contain an express prohibition on artificially creating an impaired class, the Third Circuit agreed with the many courts that have found the practice “troubling.”
By providing impaired creditors the right to vote, the Bankruptcy Code ensures that the terms of a reorganization are monitored by parties having a financial stake in the outcome. In some cases, stub claims might play an acceptable role in that process. In this case, however, the debtor “made a pre-petition side arrangement with a privileged group of asbestos claimants, who as a consequence represented a voting majority despite holding, in many cases, only slightly impaired ‘stub claims.’” The debtor made pre-petition payments to certain asbestos claimants that exceeded recoveries available to other asbestos claimants in the bankruptcy, with some receiving as much as 95 percent of their claims pre-petition. As a result, such claimants had little reason to vote against the plan. Thus, the use of the stub claims in this fashion may have artificially created an impaired class and impermissibly manipulated the vote.
The court also noted a potential due process concern. In the resolution of future asbestos liability, future claimants must be adequately represented. However, the future claimants were not represented at all in the negotiations of the pre-petition Settlement Trust. Had they been adequately represented, a properly negotiated two-trust system including a pre-petition trust, stub claims, and a post-petition trust might pass muster because there would at least be some evidence of the creditor support required by the Bankruptcy Code. Here, because the use of stub claims was at the very least problematic, the court remanded this for further consideration by the bankruptcy court.
(c) Preference Analysis
Before addressing the issues surrounding the stub claims and artificial impairment, the Third Circuit considered whether the funding of the settlement trust might also constitute an avoidable preferential transfer.
Eighty-seven days prior to filing its chapter 11 petition, the debtor had transferred significant assets to the pre-petition settlement trust in order to pay the claims of those asbestos claimants with pending litigation. The court noted that to complement the provision of the Bankruptcy Code requiring equal treatment of creditors, Section 547 “operates to ensure that equality among creditors is not undermined by transfers to creditors in contemplation of bankruptcy.”
The court concluded that, based on the available record, the transfer to the settlement trust might be an avoidable preference. Most of the elements of a preferential transfer were satisfied. The debtor had transferred over $400 million to the settlement trust prior to the bankruptcy (Section 547(b)(1)). The transfer was for the benefit of existing asbestos claimants and, accordingly, was made on account of antecedent debt (Section 547(b)(2)). The transfer was made while the debtor was insolvent (Section 547(b)(3)) and less than 90 days before filing for bankruptcy protection (Section 547(b)(4)).
The only open question was whether the transfer to the Settlement Trust allowed Settlement Trust participants to receive more than they would in a hypothetical chapter 7 liquidation, as required by Section 547(b)(5). The Third Circuit found that the lower courts had applied the wrong analysis. According to testimony before the bankruptcy court, assets available to the debtor in a hypothetical chapter 7 would be between $210 and $250 million, while assets available under the plan would be between $640 and $789 million as a result of the contributions from non-debtors. In addition, future claimants would receive more under the proposed plan than in a chapter 7 bankruptcy (or no bankruptcy at all). The district court had concluded that the transfer to the Settlement Trust was not a preference. The district court reasoned that, as a result of the significant contributions made possible by the plan, future claimants would fare better under the plan than in a chapter 7. However, the Third Circuit noted that this was the wrong analysis under Section 547(b)(5). The proper analysis is simply whether the claimants who actually benefited from the alleged preferential transfer would receive more than in a chapter 7, not whether any or even all other claimants would. Accordingly, the Third Circuit found that the available record suggested that the settlement participants would receive more than they would in a chapter 7. The transfer of assets to the settlement trust was therefore likely to be an avoidable preferential transfer.
In re W.R. Grace & Co., 729 F.3d 311 (3d Cir. 2013)
The debtor’s chapter 11 plan involved two trusts, including a personal injury trust. The personal injury trust assumed all of the debtor’s direct and indirect asbestos liability, and was funded by, inter alia, $1.5 billion in contributions from the debtor’s insurers and former affiliates. Included in the claims channeled to the injunction were certain claims held by the state of Montana and by Canada (the “Objecting Governments”). Those claims arose from numerous asbestos-related lawsuits against the Objecting Governments, alleging that they failed to warn their citizens of the risks posed by the debtor’s products and activities. The Objecting Governments’ claims asserted they were entitled to contribution and indemnification from the debtor. The Objecting Governments objected to the chapter 11 plan on a number of grounds, including that the first-in, first-out mechanism for processing and payment of claims discriminated against the Objecting Governments because of the nature of their claims. Citing testimony that there might be insufficient funds to pay future claimants, the Objecting Governments argued that the plan impermissibly discriminated against future claimants. They contended that because their claims for contribution and indemnification depended on another judgment first being obtained, their claims would likely be asserted against the personal injury trust later than other already-established claims. As a result, they would be less likely to obtain recovery. The Objecting Governments also asked that all payments be withheld until all claims—including indirect claims for contribution and indemnification—were resolved, to ensure that future claimants would receive the same distribution as current claimants.
Does a first-in, first-out payment mechanism in connection with a channeling injunction and personal injury trust impermissibly discriminate against future claimants?
The court found that although there might be a “possibility” the trust would have insufficient funds to compensate future claimants, the plan was intended to minimize that risk. First, the plan limited recoveries using a payment percentage to ensure that present and future claimants received equivalent amounts. Second, the court noted the first-in, first-out payment process is a common feature of Section 524(g) trusts; it is designed to treat all claims identically, resolving both direct and indirect claims in the order that they are received.
The court concluded that although it might be true that indirect claims—such as those of the Objecting Governments for contribution and indemnification—would recover later than direct claims, “the delayed receipt of distributions to members of a class whose claims remain disputed does not, in and of itself, violate Section 1123(a)(4).”
Finally, the court concluded that the Objecting Governments’ request that all payments be withheld was unwarranted. It found that it would be “wholly unreasonable” to require asbestos victims, many of whom had already been waiting for years, to continue waiting indefinitely for all indirect claims to be resolved before they could recover from the trust. The court concluded that by requiring courts to ensure that future demands will be treated fairly, Section 524(g) acknowledges that some claims against a trust may recover earlier than others.
Summary of Legal Authorities for Questions #2 and #3
28 U.S.C. § 1334(b)
… [T]he district courts shall have original but not exclusive jurisdiction of all civil proceedings arising under title 11, or arising in or related to cases under title 11.
11 U.S.C. § 105(a)
The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title. No provision of this title providing for the raising of an issue by a party in interest shall be construed to preclude the court from, sua sponte, taking any action or making any determination necessary or appropriate to enforce or implement court orders or rules, or to prevent an abuse of process.
11 U.S.C. § 524(g)(4)(A)
(A) After notice and hearing, a court that enters an order confirming a plan of reorganization under chapter 11 may issue, in connection with such order, an injunction in accordance with this subsection to supplement the injunctive effect of a discharge under this section.
(i) … [A]n injunction described in paragraph (1) shall be valid and enforceable against all entities that it addresses.
(ii) … [S]uch an injunction may bar any action directed against a third party who is identifiable from the terms of such injunction (by name or as part of an identifiable group) and is alleged to be directly or indirectly liable for the conduct of, claims against, or demands on the debtor to the extent such alleged liability of such third party arises by reason of—
(I) the third party’s ownership of a financial interest in the debtor, a past or present affiliate of the debtor, or a predecessor in interest of the debtor;
(II) the third party’s involvement in the management of the debtor or a predecessor in interest of the debtor, or service as an officer, director or employee of the debtor or a related party;
(III) the third party’s provision of insurance to the debtor or a related party; or
(IV) the third party’s involvement in a transaction changing the corporate structure, or in a loan or other financial transaction affecting the financial condition, of the debtor or a related party, including but not limited to—
(aa) involvement in providing financing (debt or equity), or advice to an entity involved in such a transaction; or
(bb) acquiring or selling a financial interest in an entity as part of such a transaction.
(iii) As used in this subparagraph, the term “related party” means—
(I) a past or present affiliate of the debtor;
(II) a predecessor in interest of the debtor; or
(III) any entity that owned a financial interest in—
(aa) the debtor;
(bb) a past or present affiliate of the debtor; or
(cc) a predecessor in interest of the debtor.
28 U.S.C. 157(a)
Each district court may provide that any or all cases under title 11 and any or all proceedings arising under title 11 or arising in or related to a case under title 11 shall be referred to the bankruptcy judges for the district.
In re Combustion Engineering, Inc., 391 F.3d 190 (3d Cir. 2004) (redux)
U.S. ABB acquired the debtor, Combustion Engineering, in 1990 as part of a global acquisition of power technology companies by its parent company, ABB Limited. Between May 2000 and March 2002, U.S. ABB contributed $900 million in cash and other assets toward the debtor’s asbestos obligations. With continuing asbestos liability threatening ABB Limited’s financial viability and continued survival, ABB Limited devised a divestment and restructuring program. The program called for ABB Limited to sell off certain oil and gas divisions, including Lummus. However, this could only be done by cleansing Lummus of its own asbestos liabilities. ABB Limited arranged for the debtor to file a pre-packaged chapter 11 that would cleanse not only the debtor’s asbestos liabilities, but Lummus’s as well. The debtor and ABB Limited entered into negotiations with key players in the asbestos litigations and the above-described two-trust structure was devised (see materials for Question #1).
The debtor would fund the pre-petition Settlement Trust. A combination of the debtor, ABB Limited, and two non-debtor subsidiaries (Lummus and Basic) would fund the Post-Confirmation Trust. The chapter 11 plan would include a channeling injunction that would extend to Lummus and Basic, releasing them from asbestos-related liability. This release would include both asbestos liabilities that were in some fashion derivative of the debtor’s liabilities, and also non-derivative liabilities of Lummus and Basic. Holders of such claims would be left to pursue their claims in the bankruptcy against the Post-Confirmation Trust. The debtor would additionally contribute its rights to insurance proceeds with a face amount exceeding $320 million, as well as $51 million in cash and a $20 million secured note. ABB Limited would contribute 30,000 shares of its common stock (valued at $82 million) and an additional $350 million over approximately 7 years, contingent on future financial performance. Contingent on the sale of Lummus, U.S. ABB would make additional payments of $5 million to the Post-Confirmation Trust and $5 million to the Settlement Trust. In addition, U.S. ABB agreed to contribute almost $38 million to a segregated account to pay asbestos claims attributed solely to Basic and Lummus.
The bankruptcy court found that the plan offered the only feasible mechanism for ensuring the debtor’s creditors would receive any recovery. Although the bankruptcy court found that Section 524(g)(4)(A) of the Bankruptcy Code did not permit the inclusion of the independent, non-derivative claims against Basic and Lummus in the channeling injunction, the court nevertheless invoked its equitable powers under Section 105(a) to enjoin those claims. The bankruptcy court found that extending the injunction to non-derivative claims against Basic and Lummus was justified, because ABB’s need to sell Lummus prompted ABB’s significant contributions to the plan.
- Did the Bankruptcy Court have “related to” jurisdiction over the non-derivative claims asserted against Lummus and Basic?
- Can a non-debtor who contributes funds to a post-confirmation trust take advantage of Section 105(a) to cleanse itself of non-derivative liability?
(a) Related-To Jurisdiction
The Third Circuit found that the district court improperly determined that there was related-to jurisdiction over non-derivative claims against non-debtors Lummus and Basic based on a “unity of interest” between the debtor, Basic, and Lummus. The district court had concluded that the bankruptcy court implicitly made the necessary jurisdictional findings as part of its analysis of the Section 105(a) channeling injunction and its applicability to non-debtor claims. However, the Third Circuit explained that although the Section 105(a) analysis may be relevant to “related to” jurisdiction, it cannot provide an independent source for the court’s jurisdiction. Thus, although it might be helpful in some cases to use Section 105(a) to extend injunctive relief to non-debtors, there still must be jurisdiction over the enjoined claims.
In regard to “related to” jurisdiction, the Third Circuit has “acknowledged that Congress intended to grant bankruptcy courts broad authority to deal expeditiously with all matters pertaining to the bankruptcy.” Nevertheless, this power is not without limitation.
The usual articulation is “whether the outcome of [the civil proceeding] could conceivably have any effect on the estate being administered in bankruptcy … An action is related to a bankruptcy if the outcome could alter the debtor’s rights, liabilities, options, or freedom of action (either positively or negatively) and which in any way impacts upon the handling and administration of the bankrupt estate.”
The Third Circuit found that the corporate affiliation between the debtor, Basic and Lummus was insufficient to provide “related to” jurisdiction over claims against Basic and Lummus. The debtor did not own, and was not owned by, the affiliated entities. Corporate affiliation between lateral, peer companies in a holding company structure, without more, was insufficient. Although such a relationship might be relevant, it would have to be shown that relevant action against the non-debtor entities would deplete the bankruptcy estate or affect the administration of the bankruptcy.
The Third Circuit also rejected the debtor’s arguments that Lummus and Basic’s parent company’s contributions to the asbestos personal injury trust were sufficient to confer jurisdiction. The debtor argued that the contributions were both necessary to the plan and dependent on the debtor’s ability to extend the protections of the channeling injunction to Lummus. Although those contributions might be necessary to the plan, that fact was insufficient to confer jurisdiction. Otherwise, a debtor could create subject matter jurisdiction over non-debtors simply by structuring a plan in such a way that the plan depends on contributions from third parties. The Third Circuit distinguished a case in which it had found that subject matter jurisdiction existed over a dispute between non-debtor creditors because the dispute involved assets of the debtor’s bankruptcy estate. In contrast, there was no indication that the non-derivative claims against Basic and Lummus would have any effect on the bankruptcy estate.
The Third Circuit also rejected the debtor’s argument that “related to” jurisdiction could be premised on the mere possibility that non-derivative claims against Basic and Lummus could affect the bankruptcy estate, such as through future contribution or indemnification claims against the bankruptcy estate. The district court found that the debtor’s and non-debtors’ joint operations at shared sites, extensive financial interdependence, and shared insurance policies justified “related to” jurisdiction. However, there were no statutory or contractual indemnification obligations. The Third Circuit distinguished Dow Corning I, 86 F.3d 482 (6th Cir. 1996), wherein the court extended injunctive relief to non-debtor co-defendants. There, the debtor had been the sole manufacturer and distributor of the defective product at issue, a silicone breast implant. The non-debtor co-defendants who had sold the debtor’s product undeniably would have indemnification and contribution claims against the debtor. Here, in contrast, the potential for future indemnification and contribution claims was much more speculative. The debtor was attempting to extend injunctive relief to non-derivative claims against the non-debtors that were independent of any liability of the debtor.
Although skeptical, the Third Circuit left open the possibility that the debtor and non-debtors’ shared insurance policies might provide a basis for “related to” jurisdiction over non-derivative claims asserted against the non-debtors. However, the court found that there were insufficient factual findings in the record to make that determination.
(b) Section 105(a) Equitable Injunction
Regardless of whether there might be jurisdiction over the non-derivate claims as a result of the shared insurance policies, the Third Circuit found that the plan was fatally flawed because it relied on the bankruptcy court’s use of Section 105(a) to extend the channeling injunction to non-debtors beyond what was permissible under Section 524(g).
The bankruptcy court had entered a channeling injunction under Section 524 in favor of the debtor, Lummus, and Basic, but correctly found that Section 524(g) did not authorize an injunction over non-derivative claims against latter two. Accordingly, the bankruptcy court used its equitable powers under Section 105(a) to extend the channeling injunction to the non-derivative claims.
The Third Circuit agreed with the bankruptcy court that the channeling injunction could not extend to non-derivative claims against Basic and Lummus. However, the Third Circuit found that the bankruptcy court improperly exercised its equitable powers under Section 105(a) to extend the channeling injunction to the non-derivative claims. The Third Circuit concluded that the equitable powers of Section 105(a) cannot trump other specific provisions of the Bankruptcy Code and must be exercised within the parameters of the Bankruptcy Code itself.
Because the plain language and legislative history is clear that Section 524(g) does not extend injunctive relief to non-derivative claims, the Third Circuit held that Section 105(a)’s broad equitable power cannot be used to achieve a result not otherwise available under Section 524(g).
In addition, the practical effect of the Section 105(a) channeling injunction would be to extend bankruptcy relief to two non-debtor companies outside of bankruptcy. Where the Bankruptcy Code provides specific means for a debtor to obtain a specific form of equitable relief, those standards and procedures must be followed.
It would also impermissibly interfere with the rights of potential future claimants with asbestos claims against non-debtors Lummus and Basic. Such claimants had no right or opportunity to participate in the bankruptcy and the bankruptcy court had not appointed a future claims representative to represent their interests. Although a future claims representative had been appointed to represent the future claimants of the debtor, those claimants’ interests were not necessarily aligned with the future claimants of the non-debtors.
In re Pittsburgh Corning Corp., 453 B.R. 570 (Bankr. W.D. Pa. 2011)
The bankruptcy court denied confirmation of the debtors’ amended plan, which included an asbestos personal injury trust and a channeling injunction. The court found that the standards for implementation of a channeling injunction were satisfied. However, the court denied confirmation on the basis that the language enjoining and channeling asbestos personal injury claims was overly broad. The plan’s definition of “asbestos personal injury claim” rendered the channeling injunction overly broad, potentially enjoining suits against non-debtor affiliated entities which were wholly independent from and nonderivative of the debtor’s conduct.
What are the requirements for extending a Section 105(a) injunction to non-debtors?
In denying confirmation, the court discussed the circumstances in which the bankruptcy courts may employ their Section 105(a) equitable powers to issue injunctive relief. The court explained that Section 105(a) cannot be used to extend a channeling injunction under Section 524(g) to non-debtors when the requirements of Section 524(g) are not otherwise met. However, the court described the circumstances in which it might otherwise be appropriate to invoke Section 105(a) to restrain creditors from proceeding against non-debtors:
- When the non-debtor owns assets which will either be a source of funds for the debtor or when the preservation of the non-debtor’s credit standing will play a significant role in the debtor’s attempt to reorganize;
- Upon a showing that the non-debtor’s time, energy and commitment to the debtor are necessary for the formulation of a reorganization plan;
- Where the relationship between the non-debtor and debtor is such that a finding of liability against the non-debtor would effectively be imputed to the debtor, to the detriment of the estate.
(citing In re Saxby’s Coffee Worldwide, LLC, 440, B.R. 369, 379 (Bankr. E.D. Pa. 2009).
Additionally, for issuance of a Section 105 injunction with respect to non-debtors:
- There must be the danger of imminent, irreparable harm to the estate or the debtor’s ability to reorganize;
- There must be a reasonable likelihood of a successful reorganization;
- The court must balance the relative harm as between the debtor and the creditor who would be restrained;
- The court must consider the public policy which requires a balancing of the public interest in successful bankruptcy reorganizations with other competing societal interests.
In re Dow Corning Corp., 280 F.3d 648 (6th Cir. 2002)
Debtor was the predominant manufacturer of silicone gel breast implants. As a result of injuries sustained by persons implanted with the debtor’s products, the debtor ultimately pursued a chapter 11 reorganization. The debtor eventually negotiated a plan with a committee of tort claimants. The plan established a $2.35 billion fund for the payment of claims asserted by (1) personal injury claimants, (2) government health care payers, and (3) other creditors asserting claims related to silicone-implant products liability claims. The fund was established with contributions from the debtor’s products liability insurers, shareholders and operating cash reserves. In exchange for making their contributions, the plan released the insurers and shareholders from all further liability on claims arising out of settled personal injury claims. The non-debtor releases applied to the claims of both consenting and non-consenting creditors.
Does a bankruptcy court have the power, under Section 105(a), to enjoin non-consenting creditors from pursuing claims against a non-debtor to facilitate a plan under chapter 11?
Consistent with Section 105(a)’s broad grant of authority, the Sixth Circuit held that a bankruptcy court can enjoin non-consenting creditors’ claims against non-debtors. However, because it is a “dramatic measure,” it is only appropriate under “unusual circumstances.” The court held that a bankruptcy court may permanently enjoin third-party claims against a non-debtor under Section 105(a) if seven factors are met:
(1) There is an identity of interest between the debtor and the third party, usually an indemnity relationship, such that a suit against the non-debtor is, in essence, a suit against the debtor or will deplete the assets of the estate;
(2) The non-debtor has contributed substantial assets to the reorganization;
(3) The injunction is essential to the reorganization, namely, the reorganization hinges on the debtor being free from indirect suits against parties who would have indemnity or contribution claims against the debtor.
(4) The impacted class, or classes, has overwhelmingly voted to accept the plan;
(5) The plan provides a mechanism to pay all, or substantially all, of the class or classes affected by the injunction;
(6) The plan provides an opportunity for those claimants who choose not to settle to recover in full; and
(7) The bankruptcy court made a record of specific factual findings that support its conclusions.
However, the Sixth Circuit found that the bankruptcy court made an insufficient record to establish that there were unusual circumstances to justify enjoining the non-consenting creditors’ claims. The bankruptcy court had made conclusory and inconsistent factual findings that failed to demonstrate the releases were warranted.
In re W.R. Grace & Co., 607 B.R. 419 (Bankr. D. Del. 2019)
From 1963 to 1990 the debtor owned a vermiculite mine in Libby, Montana, the operation of which generated and released substantial asbestos dust into the surrounding communities. As a result, many of the mine workers, their families, and Libby residents were exposed to—and injured by—the debtor’s asbestos operations. Between 1973 and 1985, the debtor’s insurer (“CNA”) had issued workers’ compensation, employer liability, and other insurance policies in connection with the mining facility. Some of the policies permitted CNA to inspect the facilities. CNA did inspect the premises and also voluntarily provided industrial hygiene services at the facility.
In late 2010, debtor and CNA entered into a settlement agreement pursuant to which CNA would contribute $84 million to an asbestos personal injury trust, which the debtor would establish pursuant to a chapter 11 reorganization plan. Under the plan, asbestos personal liability claims would be channeled to the trust pursuant to a channeling injunction. The channeling injunction would bar asbestos personal injury claimants from pursuing recovery from the debtor and certain non-debtor entities, including CNA. Pursuant to the settlement agreement between the debtor and CNA, the trust was obligated to reimburse CNA up to $13 million for any payments CNA made on account of asbestos personal injury claims not channeled to the trust. In 2011, the debtor’s chapter 11 plan was confirmed. The plan included a channeling injunction pursuant to Section 524(g) which enjoined holders of asbestos personal injury claims from attempting to recover from the debtor or certain protected entities, including CNA, outside the bankruptcy.
In 2014, several complaints were filed against CNA in Montana state court alleging that plaintiffs had contracted asbestos-related injuries, and that CNA’s negligence in performing the industrial hygiene services and its failure to warn the plaintiffs about the dangers of asbestos exposure contributed to or caused plaintiffs’ injuries. CNA filed an adversary proceeding seeking a declaratory judgment that the claims asserted in Montana state court were subject to the channeling injunction and, therefore, plaintiffs were limited to seeking recovery from the asbestos trust. Plaintiffs filed a motion to dismiss the adversary proceeding, and CNA moved for summary judgment.
Relevant Legal Issue
Whether certain state law tort claims against a third-party insurance company are derivative of the debtor’s liability such that they fall within the debtor’s channeling injunction.
(a) The Third Circuit’s Instructions to the Bankruptcy Court
The bankruptcy court previously held that the claims were enjoined by the channeling injunction, because they were derivative of the debtor’s liability and met the statutory relationship requirements of Section 524(g)(4)(A)(ii). The bankruptcy court found that (i) the claims were derivative because they sought to hold CNA liable for harms caused by the debtor’s conduct, i.e., the manufacturing of asbestos, and (ii) CNA’s alleged liability arose by reason of CNA’s provision of insurance, since CNA’s inspection and hygiene services arose from its insurance relationship with the debtor.
On appeal, the Third Circuit vacated and remanded with instructions to the bankruptcy court. The Third Circuit rejected CNA’s position that the derivative requirement of Section 524(g) applies to any claim against a third party based on injuries arising from the debtor’s asbestos products. The Third Circuit found such an approach to be overly broad. It also rejected, as overly narrow, the plaintiffs’ assertion that Section 524(g)(4)(A)(ii) only applies to direct actions against insurance proceeds.
(b) The Bankruptcy Court’s Analysis on Remand
On remand, the bankruptcy court began with a discussion of the history and nature of Section 524(g) channeling injunctions. The court explained that over the course of the Johns-Manville bankruptcy case—which pioneered asbestos trusts and ultimately led to the enactment of Section 524(g)—the Second Circuit had developed a “derivative liability inquiry.” This inquiry was used to determine whether a claim was derivative and would be channeled to the Johns-Manville asbestos trust. At the time the channeling injunction was approved by the court, the parties agreed that the channeling injunction would only enjoin derivative litigation, e.g., claims seeking recovery from the debtor’s insurance policies, over which the bankruptcy court had jurisdiction.
Under this inquiry, a claim was deemed derivative if it was (1) based upon allegations of the debtor’s misconduct, not the insurer’s misconduct, and (2) if the claim affected the debtor’s res, such as the debtor’s insurance policies. The inquiry was further refined by looking beyond the factual origins of an injury to determine whether the insurer owed a duty to the claimant that was independent of its contractual duties to the debtor. This inquiry was created largely to address those claims over which the bankruptcy courts have jurisdiction. The Second Circuit had found that, although the bankruptcy court had in rem jurisdiction over the debtor’s insurance policies, it did not have in personam jurisdiction over the insurers themselves. When Congress enacted Section 524(g), it incorporated the derivative liability requirement as well as certain statutory relationship requirements embodied in Section 524(g)(4)(A)(ii).
The Third Circuit, relying on case law from the Second Circuit, instructed the bankruptcy court to focus on whether CNA owed a duty to the plaintiffs which was independent of its contractual duties to the debtor under insurance policies issued by CNA to the debtor.
The Second Circuit had noted that, although the derivative liability inquiry is used as a tool by courts to determine whether a court has jurisdiction over a claim, it is not a requirement that must be satisfied before a court determines it has jurisdiction. The standard for determining jurisdiction is whether the outcome of litigation will have a conceivable effect on the bankruptcy estate. This is broader than the derivative liability inquiry, which turns on whether the litigation is based upon the debtor’s conduct and affects the res of the bankruptcy estate. Thus, the bankruptcy court noted, “bankruptcy courts always have jurisdiction over derivative claims, but rarely have jurisdiction over those that are nonderivative.”
The bankruptcy court provided a summary of the derivative inquiry:
[I]f a plaintiff’s claim against a third party is based upon: (1) the plaintiff’s claim against a debtor (the debtor’s liability); and (2) the debtor’s claim against the third party (the third party’s liability to the debtor), then the plaintiff’s claim is derivative. On the other hand, if a plaintiff’s claim against a third party is not based upon the debtor’s liability and the third party’s liability to the debtor but, rather, an entirely independent claim held by the plaintiff directly against the third party, then the plaintiff’s claim is nonderivative.
Plaintiffs asserted two state law claims against CNA: negligence and breach of duty to warn. The bankruptcy court found that under the elements of each of these claims, CNA owed duties to plaintiffs that were entirely independent of CNA’s contractual duties to the debtor under the insurance policies. Further, the claims were not based on any claims that the debtor had against CNA.
The elements of plaintiffs’ negligence claims were: (i) CNA had a legal duty to the plaintiffs; (ii) CNA breached that legal duty; (iii) CNA’s breach had caused the plaintiffs’ injuries; and (iv) damages. The parties agreed that the element on which the analysis hinged was the first element—the basis for CNA’s legal duty to plaintiffs.
As for plaintiffs’ failure to warn claims, the court determined that under Montana law, CNA owed a duty to the plaintiffs to the extent that they could prove that CNA was either (i) engaged in a hazard; or (ii) in a position with respect to the foreseeable victims and a hazard which invokes the public policy expectation of warning; and that it was foreseeable the plaintiffs would be harmed if CNA did not warn them.
The court found that under Montana law, CNA owed a duty to plaintiffs to the extent that they could prove that it was foreseeable that plaintiffs could be injured by CNA’s negligence in providing the industrial hygiene services. The court acknowledged that, completely independent of CNA’s duty to plaintiffs, CNA also had contractual indemnification obligations to the debtor. However, CNA’s duty to plaintiffs in connection with their negligence claims was completely independent of its contractual obligations to the debtor. This duty was based on allegations of CNA’s own misconduct, not the debtor’s misconduct. Thus, the claims were not based on any claim the plaintiffs had against the debtor.
Further, the court noted that the debtor had no right to sue CNA for negligence or breach of a duty to warn under Montana common law. As a result, the plaintiffs’ rights to sue CNA did not run through any rights the debtor had, and were not derivative of any claim the debtor had against CNA. Thus, the plaintiff’s claims (1) were not based on any claim the plaintiffs had against the debtor and (2) were not based on any claim the debtor had against CNA.
In sum, the bankruptcy court concluded that the plaintiffs had (i) direct claims against the debtor for asbestos injuries caused by the debtor’s wrongdoing; (ii) derivative claims against CNA arising under CNA’s insurance policies and based on the debtor’s rights to sue CNA under those policies; and (iii) non-derivative claims against CNA based on CNA’s alleged negligence and failure to warn. The first two categories of claims fell within the channeling injunction; the third did not.
In the initial decision, the bankruptcy court had held that it had jurisdiction over the plaintiffs’ claims against CNA because the claims would affect the res of the debtor’s bankruptcy estate. Although it vacated the decision of the bankruptcy court on other grounds, the Third Circuit agreed that the bankruptcy court had jurisdiction to enjoin the plaintiffs’ claims.
This determination was based on the reimbursement provisions of the trust. These provisions provided that the trust would be required to reimburse CNA for any payment that CNA made on account of claims not successfully channeled to the trust. The bankruptcy court had previously determined that this would have an effect on the res of the bankruptcy estate and, therefore, it had jurisdiction over the plaintiffs’ claims. Relying on Combustion Engineering, the Third Circuit concluded that the bankruptcy court had jurisdiction because “related to” jurisdiction exists over actions against non-debtors involving contractual indemnity obligations between the debtor and non-debtor that automatically result in indemnification liability against the debtor. Therefore, the Third Circuit reasoned that the reimbursement provision in the settlement agreement conferred jurisdiction.
On remand, the bankruptcy court respectfully disagreed with this analysis. The court noted that outside the reimbursement provision, neither the debtor nor the trust had any liability to CNA for the plaintiffs’ non-derivative tort claims. “Since subject matter jurisdiction cannot be conferred by consent of the parties and there is no basis for jurisdiction other than the reimbursement provision … the bankruptcy court lacked jurisdiction to enjoin the tort claims.” Although the bankruptcy court recognized that a debtor’s indemnification obligations can provide the basis for subject matter jurisdiction over third-party claims in certain circumstances, those circumstances did not exist in this case. Outside of the reimbursement provisions of the settlement agreement, the debtor would have no independent liability to CNA for any recoveries the plaintiffs would obtain from CNA. Therefore, the parties could not manufacture jurisdiction with the reimbursement provision.
In re Tronox Inc., 855 F.3d 84 (2d Cir. 2017)
The case involved state court litigation by thousands of plaintiffs who had been injured by the debtor’s wood treatment plant. They originally brought their claims in Pennsylvania state court, but the suits were stayed when the debtors filed for bankruptcy. The bankruptcy revealed that through a series of corporate transactions, the debtors had spun off their more lucrative oil and gas operations to a new entity (“NewCo”) while leaving the debtors with the massive tort liabilities arising from the wood treatment plant. The debtors then pursued fraudulent transfer claims against NewCo. Pursuant to a settlement agreement approved by the bankruptcy court, NewCo paid over $5 billion to the debtors, $600 million of which was set aside for the tort claims arising from the wood-treatment plant. Under the settlement agreement, an injunction was issued barring litigation of claims against NewCo that were derivative of the debtors’ claims against NewCo. Thereafter, the plaintiffs attempted to revive their claims in state court, naming NewCo as a defendant. These actions asserted fraudulent transfer and personal injury claims, and advanced alter-ego and veil piercing theories to hold NewCo liable for the debtors’ conduct. NewCo moved in the district court for an order enforcing the injunction. NewCo asserted that the injunction barred the claims because they arose form liabilities derived from the debtors that are also generalized and common to all creditors.
Relevant Legal Issue
Were the claims asserted against NewCo derivative of the debtors’ own claims against NewCo such that they were properly barred by the settlement agreement and injunction?
The district court sided with NewCo, concluding that plaintiffs had not asserted any direct claims the plaintiffs held against NewCo, but instead asserted indirect claims that were derivative of the debtors’ claims against NewCo and therefore were property of the estate.
The Second Circuit agreed with the district court that all of the claims were derivative and, therefore, subject to the settlement injunction. The court noted that while bankruptcy courts generally have only limited authority to release a non-debtor’s independent claims, derivative claims—which are based on the rights of the debtors—are property of the bankruptcy estate. On the other hand, where a creditor has a claim against a third-party that is exclusive to that creditor, the creditor is entitled to pursue that claim. Because such a claim does not belong to the bankruptcy estate, the debtor or trustee is unable to pursue—or settle—that claim. In other words, derivative claims are those that arise from harm to the estate and seek relief against third parties that pushed the debtor into bankruptcy.
The court noted that: (1) the plaintiffs were pursuing claims against only NewCo; (2) any claims against the debtors had been discharged in the bankruptcy; (3) any claims against NewCo for harm done to the bankruptcy estate were barred by the channeling injunction; and (4) NewCo did not exist until years after the plant that had caused the plaintiffs’ injuries had closed.
The plaintiffs could not assert that NewCo was directly liable to the plaintiffs and had breached an independent duty that NewCo may have owed to plaintiffs. This is because NewCo did not exist when the injuries occurred. The plaintiffs might have been able to allege direct claims against NewCo that they failed to clean up the toxic site or were negligent in doing so. Those claims would be independent and particularized to the injured plaintiffs. However, the plaintiffs never alleged, and acknowledged that they could not allege, any such facts.
The court noted it had no problem determining that the fraudulent transfer actions were derivative. Such claims are paradigmatically general to all creditors and, therefore, are derivative of the rights of the bankruptcy estate and within the purview of the channeling injunction. However, consideration of the personal injury claims was more difficult. The plaintiffs attempted to particularize these claims by personalizing the harm. However, the court concluded that the plaintiffs could not trace their harm to NewCo. Instead, the harm arose not from NewCo’s conduct but from its alleged status as the alter ego and successor of the debtors, the actual tortfeasor. The harm suffered at the hands of the debtors was particularized, but the harm suffered at the hands of NewCo was the same harm general to all creditors of the debtors.
In re Quigley Co., Inc., 676 F.3d 45 (2d Cir. 2012)
The debtor was a manufacturer of certain products containing asbestos and, as such, faced significant liability which resulted in its filing for chapter 11 protection. Decades prior, the debtor had been acquired by Pfizer. Thereafter, Pfizer had placed its trade name and logo on the products of debtor. Pfizer and the debtor shared a number of insurance policies under which they were joint beneficiaries. Pursuant to these policies, claims were covered on a “first billed, first paid” basis. The debtor intended to use the remaining limits of the policies to fund its negotiated plan of reorganization and a trust under Section 524(g). The bankruptcy court instituted a preliminary injunction which barred the prosecution of any asbestos-related personal injury suits against Pfizer during the pendency of the bankruptcy. A plaintiff’s personal injury law firm had instituted numerous suits against Pfizer, seeking to hold Pfizer liable for injuries caused by the debtor’s products under an “apparent manufacturer” theory set out in Restatement (Second) of Torts § 400. These allegations would impose liability on Pfizer as a result of its logo being placed on the debtor’s advertising and products. Under § 400, “[o]ne who puts out as his own product a chattel manufactured by another is subject to the same liability as though he were its manufacturer.” The law firm asserted that the claims were not derivative of the debtors’ claims because they were premised on an independent duty owed by Pfizer to the plaintiffs, and did not arise solely by reason of Pfizer’s ownership of the debtor. In the bankruptcy court, Pfizer moved to enforce the preliminary injunction against the law firm. The bankruptcy court issued a clarifying order concluding that it had jurisdiction over the state law claims against Pfizer, and that the preliminary injunction extended to the claims asserted against Pfizer. The clarifying order directed the law firm to dismiss its suits. The district court sided with the law firm and reversed the bankruptcy court.
On appeal, although the Second Circuit agreed with the district court that the injunction did not extend to the claims asserted by the law firm. However, the court disagreed with the law firm’s argument that the bankruptcy court lacked jurisdiction over the state court claims.
Did the bankruptcy court properly exercise jurisdiction over the state law claims asserted against the non-debtor parent of the debtor?
Among other things, the law firm argued that the bankruptcy court lacked jurisdiction over the lawsuits such that it could not enjoin them. However, the Second Circuit determined that the bankruptcy court actually did have jurisdiction over the suits even though, as it ultimately concluded, it was improper for the court to permanently enjoin the lawsuits.
The court noted that bankruptcy jurisdiction is appropriate over third-party, non-debtor claims that directly affect the res of the bankruptcy estate. The court observed that the shared insurance policies were the joint property of both Pfizer and the debtor’s estate. Therefore, Pfizer would seek defense costs from the policies and, if the suits were successful, Pfizer would assert claims against the policies. Therefore, the court concluded, the lawsuits could directly affect the debtor’s bankruptcy estate—which included the proceeds available under the policies. Therefore, the bankruptcy court had jurisdiction under 28 U.S.C. § 1334.
The law firm argued that any impact on the bankruptcy estate was too attenuated to confer jurisdiction, but the Second Circuit disagreed. The court concluded that the potential impact of the suits on the bankruptcy estate was “nothing but direct: at Pfizer’s election, any judgments, settlements, or litigation expenses” arising out of the lawsuits would be paid by the debtor’s estate.
Accordingly, the court concluded that the bankruptcy court had jurisdiction to enjoin the lawsuits provided other considerations were met.
Matter of Zale Corp., 62 F.3d 746 (5th Cir. 1995)
The debtor filed for chapter 11 protection, and the creditors’ committee instituted investigations of its directors and other third parties. The committee threatened to sue the debtor’s four former directors, and settlement discussions ensued. Ultimately a settlement was reached between the debtor, three of the four directors, and CIGNA, the debtor’s primary D & O insurer. Pursuant to the settlement, the three directors agreed to a $32 million judgment against them to be satisfied solely out of insurance proceeds. The three directors would assign all of their rights under the policies to the debtor, and all rights of contribution or indemnification against third parties arising out of their activities as directors. CIGNA would pay the debtor $10 million (the limits of its policy) and would sell to debtor all subrogation rights arising out of those rights assigned by the three directors. The debtor would pay CIGNA $1.5 million in cash, and up to $2.5 million in proceeds from suits against other third parties. The settlement agreement also included a permanent injunction that would prevent parties from suing the settling parties for their actions related to the settlement. The purpose of the settlement was to prevent the fourth director and the debtor’s excess D & O insurer from bringing claims against CIGNA for bad faith and breach of contract. The excess insurer and fourth director objected to the settlement, asserting that the bankruptcy court lacked jurisdiction to enjoin their claims against CIGNA. The bankruptcy court approved the settlement agreement and injunction, and the district court affirmed.
Did the bankruptcy court have the jurisdiction and authority to enjoin the non-parties’ bad faith and breach of contract claims against the debtor’s D & O insurer under Section 105(a) of the Bankruptcy Code?
The court first addressed whether the bankruptcy court had jurisdiction to issue the injunction. The court noted that because the fourth director and excess insurer were not parties to the bankruptcy, it had to determine whether the bad faith and breach of contract actions were “related to” the bankruptcy. A bankruptcy court’s “related to” jurisdiction cannot be limitless. For the bankruptcy court to have subject matter jurisdiction, some nexus must exist between the related civil proceeding and the bankruptcy.
The court reiterated the standard that a matter is “related to” a bankruptcy case if the outcome of that proceeding could conceivably have any effect on the estate being administered in bankruptcy. Moreover, the court noted, an action is related to bankruptcy if the outcome could alter the debtor’s rights, liabilities, options, or freedom of action and in any way impact upon the handling and administration of the bankruptcy estate.
In regard to the bad faith claims, CIGNA argued that the disputes—the tort claims of the fourth director and the excess insurer against CIGNA—were related to the bankruptcy because the debtor had agreed to indemnity CIGNA for any such claims and thus, the claims would have an impact on the bankruptcy estate.
Although indemnification agreements had brought unrelated actions within the scope of a bankruptcy court’s jurisdiction in other cases, the court noted that those cases involved the debtor’s behavior. In such cases, the purpose of the indemnification agreement was to eliminate the necessity of a formal suit against the debtor. Accordingly, indemnification agreements that might confer jurisdiction typically have a procedural goal, not a substantive one. In this case, the bad faith claims involved a creditor’s behavior. Outside the settlement agreement, CIGNA would have no independent claim against the debtor for indemnification.
Thus, because CIGNA, the fourth director and the excess insurer were not debtors, and because the property at issue (the bad faith claims) was not property of the estate, the bankruptcy court had no jurisdiction over the bad faith claims.
As for the breach of contract claims, the court concluded that the bankruptcy court had jurisdiction over disputes arising under the insurance policy with CIGNA. As a result of certain terms in the debtor’s disclosure statement regarding claims against third parties, the court inferred that creditors approved the debtor’s chapter 11 plan on the assumption that some amount of proceeds from the CIGNA policy would flow to the estate. Additionally, the court found that disputes and lawsuits over the policy would tie up certain assets, including policy assets, and therefore have an effect on the estate.
However, the court agreed with the fourth director and excess insurer that, although the bankruptcy court had jurisdiction over the contract claims, the bankruptcy court lacked the authority under Section 105(a) to enjoin their contract claims permanently. The fourth director and excess insurer argued that a permanent injunction was improper because it eliminated CIGNA’s liability for contract debts to the fourth director and excess insurer and therefore violated Section 524, which generally prohibits the discharge of debts of non-debtors. The court agreed that because the injunction permanently enjoined the contract claims without providing another avenue for relief on those claims, e.g., by channeling recovery to separate assets, it was an impermissible exercise of Section 105(a) equitable power.
Summary of Legal Authorities for Question #4
11 U.S.C. § 503(a) and (b)
(a) an entity may timely file a request for payment of an administrative expense, or may tardily file such a request if permitted by the court for cause.
(b) After notice and a hearing, there shall be allowed administrative expenses, … including –
(1)(B) any tax –
(i) Incurred by the estate, whether secured or unsecured including property taxes for which liability is in rem, in personam, or both, except a tax of a kind specified in section 507(a)(8) of this title; or
(ii) Attributable to an excessive allowance of a tentative carryback adjustment that the estate received, whether the taxable year to which such adjustment relates ended before or after the commencement of the case; …
11 U.S.C. § 507(a)(8)
(a) The following expenses and claim have priority in the following order:
(8) Eighth, allowed unsecured claims of governmental units, only to the extent that such claims are for—
(A) a tax on or measured by income or gross receipts for a taxable year ending on or before the date of the filing of the petition—
(i) For which a return, if required, is last due, including extensions, after three years before the date of the filing of the petition;
(ii) Assessed within 240 days before the date of the filing of the petition, exclusive of—
(I) Any time during which an offer in compromise with respect to that tax was pending or in effect during that 240-day period, plus 30 days; and
(II) Any time during which a stay of proceedings against collections was in effect in a prior case under this title during that 240-day period, plus 90 days; or
(iii) Other than a tax of a kind specified in section 523(a)(1)(B) or 523(a)(1)(C) of this title, not assessed before, but assessable, under applicable law or by agreement, after, the commencement of the case; …
In re Affirmative Insurance Holdings, Inc., 607 B.R. 175 (Bankr. D. Del. 2019)
Debtors, insurance companies, filed voluntary petitions for relief under chapter 11 in October 2015. As of the petition date, debtors had disposed of substantially all of their assets and had discontinued virtually all business operations. The case was converted to chapter 7 and a chapter 7 trustee was appointed. In April 2016, the IRS filed an administrative expense claim for income taxes due for the tax year ending 2015. The IRS claim asserted an administrative expense priority claim in the amount of $856,704.52 on account of corporate taxes for the tax period December 31, 2015. The chapter 7 trustee objected to the IRS asserting an administrative claim for the debtors’ income taxes for the entire 2015 year, even though all material taxable events occurred pre-petition.
Whether a claim for taxes for a tax year that straddles the petition date is entirely entitled to administrative priority or whether it must be bifurcated between pre- and post-petition taxes.
The court noted that Section 507(a)(8) was amended by BAPCPA, limiting the scope of priority treatment to tax claims for taxable years “ending on or before the date of the filing of the petition.” Prior to BAPCPA, the former Section 507(a)(7) included a catch-all provision that gave seventh priority treatment not only to tax claims for taxable years ending before filing, but also to any tax that was assessable after commencement of the bankruptcy without regard to the tax year. Because the tax year in question straddled the petition date, the court held that the claim was not entitled to priority under Section 507(a)(8). Thus, the court turned to whether the IRS was an entitled to administrative status for the entire claim.
The court considered whether the taxes were “incurred by the estate” as provided under Section 503(b)(1)(B)(i). The Bankruptcy Code does not define “incurred by the estate.” Most courts have found that a tax is incurred when it accrues and becomes a fixed liability. State law determines the date a tax is incurred.
The court cited the pre-BAPCPA case of In re Columbia Gas Transmission Corp., in which the Third Circuit held that a tax liability is generally “incurred” on the date it accrues and not on the date of the assessment or the date on which it is payable.
The court noted that pre-BAPCPA there was a split of authority whether to bifurcate a tax year straddling the petition date. The Third Circuit held that that such years must be bifurcated into priority and unsecured claims. The court also concluded that the language in Section 503(b)(1)(B)(ii), which specifically refers to events occurring before or after commencement of a bankruptcy case, shows that Congress has the ability to be specific and to show intention. Thus, the court concluded, if Congress wanted to grant administrative priority to all straddle year taxes, it would have included similar language in Section 503(b)(1)(B)(i).
The court discussed In re Earl Gaudio & Son, Inc. and In re FR & S Corp. (summarized below), which come out the other way, but disagreed with those decisions. The bankruptcy court held that tax claims that straddle the petition date must be bifurcated into pre- and post-petition claims.
In re Earl Gaudio & Son, Inc., 2017 WL 377918, Case No. 13-90942 (Bankr. C.D. Ill. Jan.25, 2017)
Debtor filed a voluntary petition under chapter 11 in June 2015. The Illinois Department of Revenue filed two administrative expense claims, including one for business income tax for the 2013.
Whether a claim for taxes for a tax year that straddles the petition date is entirely entitled to administrative priority, or whether it must be bifurcated between pre- and post-petition taxes.
The court found that the tax claim did not fall within Section 507(a)(8), and accordingly looked to Section 503(b)(1) to determine whether it was entitled to administrative status. The court noted that the primary issue was whether the tax debt was “incurred by the estate” as provided for under the statute. The court concluded that state law determined when the tax was incurred. The court noted that several courts have determined that under Section 503(b)(1), a tax is incurred “when it accrues and becomes a fixed liability or when liability has been inescapably imposed.” The court looked to the Illinois Income Tax Act and found that it does not specifically identify when tax liability is incurred. The statute provides that income tax is imposed on every corporation for each taxable year. A taxpayer’s taxable year is simply the calendar or fiscal year upon which base income is computed. The statue also provides that the terms “paid”, “incurred” and “accrued” shall be construed according to the method of accounting upon the basis of which the taxpayer’s base income is computed under the Act. Additionally, the court noted that income tax in Illinois is assessed on the date of the filing of the tax return, which a number of courts have noted is not necessarily equivalent to the time a tax is incurred. Taking all of the above together, the court determined that under Illinois law, income tax is incurred no earlier than the end of the taxable year. Accordingly, the court determined that the entire tax claim was entitled to administrative status.
In re FR & S Corp., 2011 WL 1261329, Case No. 08-08659 ESL (Bankr. D.P.R., Mar. 30, 2011)
Debtor filed for chapter 11 protection on December 19, 2008. The case was subsequently converted to chapter 7 in May 2009. The Treasury Department of the Commonwealth of Puerto Rico filed a motion for allowance and payment of post-petition administrative expenses, including for corporate income taxes for the year 2008. The chapter 7 trustee objected, arguing that the Treasury Department’s claim was a general unsecured claim because the taxes were for services rendered prior to filing even though they were not due until after.
Whether a claim for taxes for a tax year that straddles the petition date is entirely entitled to administrative priority, or whether it must be bifurcated between pre- and post-petition taxes.
The court described the determination of whether the tax should be afforded administrative expense priority as a two-prong test, consisting of (1) whether the tax was “incurred” by the estate; and (2) whether the tax claim is not a claim which must be treated as a pre-petition priority claim under Section 507(a)(8).
The court addressed the second prong first and easily determined that Section 507(a)(8) was inapplicable. The court noted that the debtor, as a calendar year taxpayer, filed for bankruptcy on December 19, 2008, eleven days prior to the closing of its taxable year.
As for whether the tax was incurred by the estate, the court stated that this was a harder question. Citing prior case law, the court determined that a tax is incurred under Puerto Rico law when it accrues—generally at the end of the tax year. Based on this case law, the court concluded that the tax claim was entirely entitled to administrative priority. The court distinguished pre-BAPCPA case law bifurcating income taxes between pre- and post-petition amounts. The court, relying on commentary in Collier on Bankruptcy, concluded that the BAPCPA amendments to Section 507(a)(8) governing priority of taxes resulted in straddle year income tax claims being treated as administrative claims in their entirety.