Mass tort Chapter 11 bankruptcy cases have attracted considerable attention over the last few years. High-profile cases like LTL Management, Aearo Technologies, and Purdue Pharma have resulted in federal circuit level appeals that promise to shape the legal landscape for mass tort bankruptcy cases next year and beyond.
Through Chapter 11, companies faced with mass torts seek to centralize claims, obtain efficiency and finality, and avoid the unpredictability of trials. The debtor’s strategies often involve providing nondebtor third parties with some level of bankruptcy court protection. Three debtor strategies to watch in 2023 are the Texas Two-Step, extension of bankruptcy’s automatic stay to third parties, and nonconsensual nondebtor releases.
Tort victims complain that these strategies circumvent trials, unfairly impose settlements on nonconsenting parties, and allow solvent companies to obtain bankruptcy benefits without the burdens.
Three key upcoming decisions will refine the law regarding these strategies in 2023.
The Texas Two-Step
The much-maligned Texas Two-Step—a divisive merger followed by a bankruptcy—is one of the newer mass tort bankruptcy strategies.
Under the Texas Business Organizations Code, an existing company can divide itself into two or more entities. One entity keeps the assets and business while the other takes on the liabilities and files bankruptcy. The entity with the assets ordinarily funds the liability entity’s bankruptcy and a trust for tort claims.
Johnson & Johnson and a subsidiary followed this strategy in the LTL Management case to address voluminous lawsuits concerning J&J’s talc products. As part of the divisive merger, J&J and one of its subsidiaries are subject to a funding agreement with respect to LTL Management’s bankruptcy and potential talc related liabilities.
The LTL Management case is now pending in the Bankruptcy Court for the District of New Jersey while the Third Circuit reviews the bankruptcy court’s denial of motions to dismiss the case for being filed in bad faith.
At oral argument, a committee representing the talc claimants emphasized that the case was designed to provide bankruptcy benefits to nondebtors without the burdens, while the debtor argued that the funding agreement provides protection and a better chance for claimants to recover on their claims than the tort system. The panel appeared to be more inclined towards the debtor’s arguments. A favorable decision may invite others to follow the same strategy, but the structure of the funding agreement may be key to whether such cases survive scrutiny.
Extending the Automatic Stay to Third Parties
Debtor’s affiliates who haven’t filed bankruptcy aren’t generally covered by the Bankruptcy Code’s automatic stay. But some courts have extended the automatic stay to third parties.
In mass tort Chapter 11 cases, this step relieves third parties from litigation until the debtor can obtain a global settlement with releases that will cover the third parties through a plan of reorganization. This strategy is also used in Texas-Two Step cases to protect the companies funding the bankrupt entity.
This issue is front and center in the Aearo case. Aearo and its affiliates are subsidiaries of 3M, all of whom have been embroiled in behemoth multidistrict litigation over earplugs used by the military that have been blamed for causing hearing loss.
Alleging that the MDL process is broken, Aearo and affiliates filed Chapter 11 in the Bankruptcy Court for the Southern District of Indiana, along with a proceeding seeking to extend the automatic stay to 3M.
Bankruptcy Judge Jeffrey Graham refused to extend automatic stay to 3M. Graham noted that Seventh Circuit law on extending the stay wasn’t as accommodating as the Fourth Circuit’s legal standard, which the debtor wanted the court to follow. Another notable factor was that 3M’s obligation to fund Aearo’s bankruptcy wasn’t dependent on it receiving automatic stay protection.
The Seventh Circuit accepted a direct appeal of the bankruptcy court’s ruling. A ruling in favor of 3M might make Seventh Circuit bankruptcy venues more attractive for mass tort cases. Alternatively, the panel might make it more difficult for third parties to benefit from the automatic stay.
This will be an important case to watch as this strategy is vital to the success of the other two strategies mentioned here. A decision likely won’t be rendered until at least the middle of 2023.
Nonconsensual Nondebtor Releases
Chapter 11 plans occasionally include provisions releasing nondebtor third parties from liability associated with the debtor. The federal circuits are currently split as to whether nonconsensual nondebtor releases can be approved, with a majority of circuits allowing them.
The legality of nonconsensual nondebtor releases is currently on appeal at the Second Circuit in the Purdue Pharma case. The court is reviewing the US District Court for the Southern District of New York’s ruling that the bankruptcy court had no statutory authority to approve such releases in Purdue Pharma’s plan.
At oral argument on appeal, the judges seemed open to the debtor’s arguments—including that there’s overwhelming support for the plan and that undoing it would result in little chance of recovery for the claimants—and somewhat more skeptical of the other arguments.
A decision could spell out a clearer standard for approval of nonconsensual nondebtor releases in the circuit. But a patchwork of standards across the circuits will remain unless the US Supreme Court weighs in. A high court showdown might lie ahead for Purdue Pharma.
Will Congress Sink These Strategies?
Previous legislative efforts in Congress have targeted all three of these strategies, but none of the efforts gained momentum. With the realities of divided government, it’s unlikely that Congress will be able to curb these maneuvers.
Instead, parties will continue to litigate these issues, and the law will continue to develop case by case. Because these cases often implicate constitutional issues and circuit splits, one or more of these issues may land in front of the Supreme Court.
Access additional analyses from our Bloomberg Law 2023 series here, covering trends in Litigation, Transactional, ESG & Employment, Technology, and the Future of the Legal Industry.
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