The Restructuring Report

Consensus remains elusive on the two major questions concerning the application of bankruptcy law in mass tort cases. In the past few months, at least five major decisions have addressed the significant issues of the availability of third-party releases and the two-step bankruptcies. Appeals have been filed or are threatened. In the meantime, the authors of a University of Chicago Law Review article argue that, as a matter of public policy, both should be available with court safeguards.

On May 30, 2023, a panel of the Second Circuit of Appeals decided the appeal in the Purdue Pharma case, overruling the decision of the district court and affirming the decision of the bankruptcy court which had confirmed the debtors’ plan of reorganization. The decision was long and eagerly awaited: it was argued on April 29, 2022, and was decided more than a year later. It was eagerly awaited especially because the order of the district court, which had concluded that the bankruptcy court did not have the statutory authority to issue third-party releases, was at odds with the practice in the Second Circuit and other circuits in which third-party releases have been fairly common (even though the courts approving such releases have usually simultaneously cautioned that they should be approved only in limited circumstances). The United States Trustee’s Office filed a request with the U.S. Supreme Court to pause the Chapter 11 plan, which the Supreme Court just granted on August 10, 2023, ordering the parties to brief the third-party release issue and treating the stay request as a writ of certiorari. Oral argument is scheduled for December 2023.

The Second Circuit, after addressing the constitutional authority for courts to grant third-party releases, found statutory authority for third-party releases in sections 105(a) and 1123(b)(6). It then set forth seven factors for courts to look at:

• The identity of interests between the debtors and the released third parties;
• Whether the claims against the debtor and non-debtor release parties are factually and legally intertwined;
• Whether the scope of the releases is appropriate;
• Whether the releases are essential to the reorganization;
• Whether the non-debtor contributed substantial assets to the reorganization;
• Whether the impacted class of creditors voted “overwhelmingly” in favor of the plan (the touch point for “overwhelmingly” was the 75 percent requirement in section 524(g) applicable to asbestos cases); and
• Whether the plan provides “fair” payment to the enjoined claims.

The Second Circuit’s Purdue Pharma decision follows the decisions of the Delaware bankruptcy court (in the Third Circuit) and the district court in the Chapter 11 case of the Boy Scouts of America, confirming a plan of reorganization with third-party releases in favor of insurers, separate local councils, and others partner entities, which had not filed their own bankruptcy cases. Although a number of cases in the Second and Third Circuits have included third-party releases and circuit precedent arguably supported that practice, the Purdue Pharma and Boy Scouts of America decisions address, more directly and clearly than ever before, the questions of constitutional and statutory authority for those releases. Ultimately, the Second and Third Circuits authorized third-party releases in limited circumstances, which are especially applicable in the opioid and sexual abuse mass tort situations where the legal system does not otherwise provide a workable solution.

The Second and Third Circuit cases also somewhat parallel the decision from the Eastern District of Virginia in the Ascena (Patterson v. Mahwah Bergen Retail Group, Inc.) case described in a previous Restructuring Report article by Clint Cutler. There, the district court voided third-party releases in a plan and ordered the redrafting of exculpation provisions. The court did not say that third-party releases were per se impermissible, but said that the releases before it were not consistent with Fourth Circuit precedent.

But with recent cases in the Second, Third and Fourth Circuits reinforcing the use of third-party releases in some circumstances, especially in mass tort cases, the circuits remain divided across the country. Older cases, which are discussed in the Purdue Pharma decision and others, in the Fifth, Ninth and Tenth Circuits, disapprove of third-party releases primarily based on application of 11 U.S.C. § 524(g) which provides a discharge to the debtor, but makes no mention of a discharge to non-debtors. One might wonder whether, if presented with a different set of facts and considering the more recent decisions allowing third-party releases, decisions in those circuits might be different now. However, it appears unlikely for that question to be answered since it is relatively easy for a debtor in need of third-party releases to venue shop and find an excuse to file their cases in a more hospitable circuit; and because lower courts in those circuits with inhospitable precedent would be bound by the circuit level precedent in their circuits.

A change in the bankruptcy venue sections of the Bankruptcy Code would change this—a bill to do so is pending in the House and an earlier bill was pending in the Senate.

In the face of this circuit split and the unavailability of a workable remedy in at least three circuits, an amendment of the Bankruptcy Code to allow third-party releases in limited circumstances is a possible solution. This has been addressed in a long and thorough article by Richard Epling in the Business Lawyer.

In another case important to the field of mass torts, the Third Circuit reversed a bankruptcy court and dismissed a bankruptcy case filed by the Johnson & Johnson subsidiary, LTL Management, LLC for lack of good faith. J&J had utilized the two-step bankruptcy (sometimes called a divisional merger or Texas Two-Step) to separate product liabilities stemming from its talc product from its other businesses. Judge Thomas Ambro found that the new subsidiary was not in financial distress. LTL quickly tried again with a new filing and a new plan, but the case was dismissed by the bankruptcy court on July 28, 2023, which determined that the newly-created subsidiary was still not in financial distress pursuant to the standards articulated by the Third Circuit. LTL has stated that it will appeal. 3M’s Aearo subsidiary suffered the same fate for the same reason when its bankruptcy case was dismissed on June 9, 2023. It has appealed to the Seventh Circuit.

In another recent decision, in the Bestwall LLC case, on June 20, 2023, a divided panel of the Fourth Circuit approved an injunction (effectively a third-party release) protecting parent Georgia-Pacific Corporation after it created a subsidiary to take on the asbestos liabilities of a company that had merged into Georgia Pacific in the past. This two-step case (one of the oldest of the large two-step cases) worked to protect Georgia Pacific, the parent.

Finally, in a timing coincidence, the decision in Purdue Pharma arrived in the inboxes of many of us on the very same day as a blog on the public policy reasons supporting third-party releases and two-step bankruptcies from the Harvard Bankruptcy Roundtable by two professors from the University of Chicago Law School, Anthony J. Casey and Joshua Macey. In their blog, entitled “In Defense of Chapter 11 for Mass Torts,” they defend the use of Chapter 11 and focus on two “notorious maneuvers,” the third-party release and the two-step bankruptcy. They argue in this summary:

Moreover, bankruptcy tools that facilitate efficient, lower-cost resolution should be welcomed. The two-step bankruptcy and the third-party release are such tools, as long as the courts guard against opportunistic abuse. Properly used, the third-party release prevents holdout behavior and incentivizes perpetrators of corporate misconduct to disclose their role in the company and to contribute assets to the bankruptcy estate.

Their full essay was published in the University of Chicago Law Review earlier this year.

So, two major issues remain in suspense and the availability of bankruptcy relief uncertain, depending in part on or where the cases are filed. Stay tuned.