Constrained by Fourth Circuit precedent, Bankruptcy Judge J. Craig Whitley of Charlotte, N.C., denied a motion to dismiss a pair of “asbestos” chapter 11 cases where the family of companies could pay $250 million in current and future liability without breaking a sweat.
In his December 28 opinion, Judge Whitley held that (1) the lack of “financial distress” does not divest the court of subject matter jurisdiction, and (2) there is no violation of the Bankruptcy Clause of the Constitution when the debtor has no “financial distress.”
Overall, Judge Whitley deferred to the Fourth Circuit for an ultimate decision on whether solvent companies can utilize bankruptcy to clean up mass tort liability. However, Judge Whitley has language in the opinion to suggest that he might find a due process violation and deny confirmation of a chapter 11 plan for a family of solvent companies if the plan does not allow opting out.
Although Judge Whitley does not discuss Harrington v. Purdue Pharma L.P., No. 23-124 (Sup. Ct.), much of his opinion could become moot if the Supreme Court decides that the bankruptcy court does not countenance nonconsensual, nondebtor, third-party releases. Purdue was argued on December 4. To read ABI’s report on the argument, click here.
To appreciate the wealth of scholarship in Judge Whitley’s 63-page opinion, we recommend reading the decision in full text.
The Solvent Family of Companies
Judge Whitley said there was no dispute that a family of companies were aiming to use chapter 11 to isolate asbestos liabilities to effect a global resolution giving absolution even to members of the group that would not themselves be filing bankruptcy.
For the sake of simplicity, we will compress the facts. Assume there was a large, solvent company that had several lines of business with products that previously used asbestos. The first lawsuits arose in the 1980s. By 2020 when the chapter 11 case began, there were 90,000 suits estimated to cost about $550 million ultimately. After available insurance, the company estimated that the net cost would be $240 million.
The company was very large and profitable. The book value of the company’s equity was almost $11 billion. Annual revenue was about $16 billion, throwing off excess cash flow of more than $1.8 billion a year.
The company wanted to deal with existing and future asbestos liability without thrusting the entire enterprise into chapter 11. So, the company used the so-called Texas Two-Step divisional merger to create a new company that would assume all asbestos liability but would have no business, no employees and essentially no assets. At the same time, a new sister company was created to take all the assets and continue the profitable businesses.
The new company destined for chapter 11 was given a funding agreement where the nondebtor sister company would fund a trust to pay the costs of the chapter 11 case, along with current and future asbestos claims, as long as the plan gave the nondebtor a release. The funding agreement was unsecured and nonassignable. It required the plan to give the protections to the nondebtor that could be afforded a debtor by Section 524(g).
Seven weeks after the divisional merger, the debtor filed a chapter 11 petition. Early on, Judge Whitley protected the nondebtor with a preliminary injunction.
The official committee of asbestos claimants and several individual asbestos claimants filed a motion to dismiss, alleging that the filings were made in bad faith. The movants contended that the existence of financial distress was jurisdictional. Even given jurisdiction, the movants saw a violation of the Bankruptcy Clause of the Constitution when the debtor has no financial distress.
With important caveats and reservations, Judge Whitley denied the motion to dismiss.
The Tests for Bad Faith
Although courts will dismiss bankruptcies for lack of good faith, Judge Whitley said they do so “under a variety of tests.” On one hand, the Third Circuit recently held that a lack of financial distress shows a lack of good faith. See In re LTL Management LLC, 58 F.4th 738, 64 F.4th 84 (3d Cir. Jan. 30, 2023). To read ABI’s report, click here.
In contrast, Judge Whitley said that the Fourth Circuit has “a more restrictive two-prong test that requires the movant to demonstrate both the objective futility of the case and the subjective bad faith of the petitioner.” See Carolin Corp v. Miller, 886 F.2d 693, 700-701 (4th Cir. 1989).
Financial Distress Isn’t Jurisdictional
Article I, Section 8 of the Constitution gives Congress the power to enact “uniform laws on the subject of Bankruptcies.” The movants submitted that the debtor’s lack of financial distress deprived the bankruptcy court of subject-matter jurisdiction.
With little ado, Judge Whitley found “no provisions in the Bankruptcy Code evidencing a congressional intent to impose a jurisdictional insolvency or ‘financial distress’ requirement to file bankruptcy.” He said that the movants’ constitutional challenges are “not challenges to the Court’s subject matter jurisdiction.”
In a footnote, Judge Whitley mentioned that the Third Circuit in LTL found jurisdiction before dismissing for lack of financial distress.
Solvent Debtors and Unconstitutional Bankruptcies
The movants believed that applying the Bankruptcy Code to solvent debtors violates the Bankruptcy Clause. To resolve the question, Judge Whitley assumed that the debtor had no financial distress, but he found “no cases holding that the Constitution imposes a financial-distress requirement.”
Judge Whitley nonetheless found “considerable force” in the arguments posited by Prof. Ralph Brubaker in The Texas Two-Step and Mandatory Non-Opt-Out Settlement Powers, Har. L. Rev. Bankr. Roundtable (July 12, 2022). For instance, he said:
Common sense dictates that a solvent, nondistressed corporation should rarely consider bankruptcy — and even less often be afforded its protections. After all, in a capitalistic society, those who can pay their creditors, must pay.
Judge Whitley said that bankruptcies are “often” dismissed for bad faith, but “no court has adopted its conclusion that the Bankruptcy Clause requires insolvency.” He concluded that “‘financial distress’ is not a constitutional prerequisite to filing chapter 11.”
Constitutional Constraints on Debtors
Citing Prof. Brubaker’s Texas Two-Step article and a piece by Prof. Melissa B. Jacoby, Unbundling Business Bankruptcy Law, 101 N.C. L. Rev. 1703 (2023), Judge Whitley said that “opportunistic debtors” with no financial distress might violate creditors’ rights under the Commerce Clause, the Due Process Clause or the Seventh Amendment. As an example, he cited the Supreme Court for holding that a class action settlement is unconstitutional when the defendant is solvent and the settlement does not permit opting out. Ortiz v. Fibreboard Corp., 527 U.S. 815, 817-818 (1999).
Citing Prof. Brubaker, Judge Whitley said that no-opt-out provisions can be permissible in a “limited fund” case where the assets to pay creditors are limited. Otherwise, he summed up the constitutional principles as follows:
In sum, a “no-opt-out” bankruptcy plan and trust is entirely appropriate for an insolvent or even a distressed debtor. However, under Ortiz and for solvent and non-distressed debtors, a plan/trust which does not permit creditors to “opt out” and return to the tort system for their jury trials may cause an unconstitutional impairment of the claimants’ due process and jury trial rights.
Judge Whitley noted that the debtor’s plan was “no-opt-out” and that the trust was “capped.” If the debtor and its nondebtor sister company are neither insolvent nor financially distressed, he asked, “is the plan constitutional?”
“[F]ortunately,” Judge Whitley said, the question is “for another day,” because he identified grounds for denying the motion to dismiss.
No Dismissal under Carolin
However he might have felt about the debtor’s chapter 11 case, Judge Whitley said that he was bound by Carolin, “the longstanding standard in this Circuit for dismissal of a Chapter 11 bankruptcy case for bad faith.” In Carolin, he described the Fourth Circuit as holding that “a Chapter 11 case may be dismissed as a bad faith filing only when the bankruptcy reorganization is both (i) objectively futile and (ii) filed in subjective bad faith.” Carolin, supra, 886 F.2d at 706.
Judge Whitley recognized that some courts hold that either objective futility or subjective bad faith is sufficient, but “the Fourth Circuit demands both.”
Judge Whitley mentioned Official Committee of Asbestos Claimants v. Bestwall LLC (In re Bestwall LLC), 71 F.4th 168 (4th Cir. June 20, 2023), as a “factually similar Texas Two-Step asbestos reorganization case.” To read ABI’s report, click here. In Bestwall, he said that the “Fourth Circuit . . . did not see any objective futility in such a debtor filing bankruptcy.”
In short, the Fourth Circuit’s recent recitation of the dual standard means that Carolin remains good law. “Because Carolin involved a fatally insolvent debtor,” he deduced that “the application of its two-prong standard to a case filed by a solvent, financially non-distressed debtor means all such cases survive dismissal, regardless of purpose.”
Noting that Carolin was decided 35 years ago and that bankruptcies by nondistressed companies are a “rarity,” Judge Whitley wondered “whether the Carolin majority contemplated that its test would be employed to the cases of solvent, nondistressed corporations.”
Should the Fourth Circuit “elect[] to reconsider applicability of the Carolin Two-Prong Test in the case of a solvent, non-distressed Chapter 11 debtor,” Judge Whitley said that the appeals court might view the case as a bad faith filing if the debtor is not “financially distressed.”
“For now,” Judge Whitley said, “Carolin is controlling precedent.”
Applying Carolin
As a “last gasp,” Judge Whitley described the movants as arguing that the reorganization was “objectively futile” because the debtor had no business to operate. Going back more than 30 years, he found “no reported case [that] supports the [movants’] theory that objective futility exists due to the lack of a business to rehabilitate.”
Indeed, Judge Whitley said that the case was “quite like” Bestwall, where the Fourth Circuit “did not see any objective futility in such a debtor filing bankruptcy. Bestwall, 71 F.4th at 182.”
Finding no other grounds for dismissal under Section 1112(b), Judge Whitley denied the motion to dismiss, saying that “these cases are not ‘bad faith’ filings under the controlling Carolin test.”
Scholarly Commentary
Prof. Brubaker provided ABI with the following commentary:
This is an extremely thoughtful opinion that is obviously very sympathetic to all of the movants’ arguments: both on the bad-faith filing issue and regarding the constitutionality of an eminently solvent, non-distressed defendant using bankruptcy as a means of imposing on nonconsenting claimants a mandatory no-opt-outs settlement of (that places a judicially approved hard cap on) its aggregate mass-tort liability.
Judge Whitley ultimately determines that there is no constitutional bar on such an entity filing bankruptcy, but he expressly holds open the question of whether such an entity can constitutionally bind nonconsenting claimants to a plan of reorganization that would purport to extinguish their ability to litigate their claims and recover in full through the nonbankruptcy tort system.
Prof. Brubaker is the James H.M. Sprayregen Professor of Law at the University of Illinois College of Law. The professor wishes to disclose that he is a consultant to counsel for one of the participants in a pending Texas Two-Step mass-tort bankruptcy case and that the views expressed are solely his own.
Constrained by Fourth Circuit precedent, Bankruptcy Judge J. Craig Whitley of Charlotte, N.C., denied a motion to dismiss a pair of “asbestos” chapter 11 cases where the family of companies could pay $250 million in current and future liability without breaking a sweat.
In his December 28 opinion, Judge Whitley held that (1) the lack of “financial distress” does not divest the court of subject matter jurisdiction, and (2) there is no violation of the Bankruptcy Clause of the Constitution when the debtor has no “financial distress.”
Overall, Judge Whitley deferred to the Fourth Circuit for an ultimate decision on whether solvent companies can utilize bankruptcy to clean up mass tort liability. However, Judge Whitley has language in the opinion to suggest that he might find a due process violation and deny confirmation of a chapter 11 plan for a family of solvent companies if the plan does not allow opting out.