February 22, 2008

In an important decision published last week, the United States Court of Appeals for the Second Circuit reversed orders by both the Bankruptcy Court and the District Court approving settlements that enjoined lawsuits by various class-action plaintiffs against one of the primary liability insurers of the debtor. The Second Circuit firmly reiterated that non-debtor releases in plans of reorganization or other bankruptcy orders are permissible only in exceptional circumstances, and that a non-debtor's "financial contribution to a debtor's estate" is not a sufficient basis for providing it with releases. The Court also ruled that the Bankruptcy Court was without jurisdiction to order the release or injunction of third-party claims whose prosecution would not impact the debtor's estate.

Johns-Manville Corporation et al. v. Chubb Indemnity Insurance et al., 2008 WL 399010 (2d Cir. Feb. 15, 2008) (Calabresi, J., Sotomayor, J., Wesley, J.)

Facts

Johns-Manville, once the largest manufacturer of asbestos in the United States, filed for chapter 11 in 1982. As part of its reorganization, Johns-Manville, which had significant liability arising from its production of asbestos, settled with its principal insurers for approximately $770 million. Travelers, Johns-Manville's principal insurer, contributed approximately $80 million to this settlement in exchange for "full and final release of Manville-related claims."

This release was buttressed by an injunction in the Johns-Manville Confirmation Order that channeled all claims related to Johns-Manville's liability insurance policies into the Manville Personal Injury Settlement Trust. The Confirmation Order further enjoined "all persons" from commencing any action against any of the settling insurance companies "for the purpose of, directly or indirectly, collecting, recovering or receiving payment of, on or with respect to any Claim . . . or Other Asbestos Obligation . . . ." The Confirmation Order was entered in December 1986.

In subsequent years, various groups of plaintiffs filed "Direct Action" lawsuits against Travelers and Johns-Manville's other insurers in several states that essentially sought to recharacterize their original asbestos claims against Johns-Manville as causes of action against the insurers under state insurance and consumer protection laws - alleging, inter alia, breach of fiduciary duty, breach of statutory duty and failure to disclose.

The Bankruptcy Court's and District Court's Approval of Settlements of the Direct Action Lawsuits

By 2002, the volume of these Direct Action lawsuits against Travelers had grown sufficiently large that Travelers moved in the Bankruptcy Court to enjoin them pursuant to the 1986 Confirmation Order.

The matter was referred to mediation before former New York Governor Mario M. Cuomo, which ultimately resulted in a new settlement, pursuant to which (i) three classes of plaintiffs would receive nearly $500 million from Travelers, (ii) the bankruptcy court would issue a clarifying order specifying that the Direct Action lawsuits were (and had always been) subject to the injunction in the Confirmation Order and (iii) participating plaintiffs would release Travelers from further liability separate and apart from the Direct Actions.

The Bankruptcy Court (Lifland, J.) approved the settlement and entered the clarifying order on August 17, 2004.

The District Court (Koetl, J.) subsequently affirmed the Bankruptcy Court's findings of fact and conclusions of law in substantial part, describing the Direct Action suits as "creatively pleaded attempts to collect indirectly against the Manville insurance policies" and concluded that "barring these claims was a proper exercise of jurisdiction" by the Bankruptcy Court.

The Second Circuit's Reversal

Describing the case as primarily a question of jurisdiction, the Second Circuit reversed on the ground that the plaintiffs' claims seek damages from Travelers that are unrelated to the policy proceeds and do not seek to collect on the basis of Manville's conduct. Rather, they sought to recover directly from Travelers for its own alleged misconduct. Op. at 22. Because the Second Circuit found that the Direct Action plaintiffs "raise no claim against Manville's insurance coverage, [] make no claim against an asset of the bankruptcy estate, [and their actions do not] affect the estate," it held that the "bankruptcy court had no jurisdiction to enjoin the Direct Action claims against Travelers." Id.

The Second Circuit acknowledged that the Direct Action claims against Travelers fundamentally arose from the asbestos production of Johns-Manville and implicated many of the same events and facts implicated in Johns-Manville's reorganization. Nonetheless, it held that the fact that state common law and statutory law actions against Travelers happen to "arise from a common nucleus of operative facts involving Travelers and Manville is of little relevance from a jurisdictional standpoint." Op. at 25.

The Second Circuit also reiterated its concern - previously expressed in In re Metromedia, 416 F.3d 136 (2d Cir. 2005) - about the potential for "abuse" inherent in injunctive non-debtor releases. While acknowledging Travelers' $80 million contribution to the initial settlements that culminated in the 1986 confirmation of Johns-Manville's plan of reorganization, the Second Circuit nevertheless observed:

It was inappropriate for the bankruptcy court to enjoin claims brought against a third-party non-debtor solely on the basis of that third-party's financial contribution to a debtor's estate. If that were possible, a debtor could create subject matter jurisdiction over any non-debtor third-party by structuring a plan in such a way that it depended upon third-party contributions. As we have made clear, subject matter jurisdiction cannot be conferred by consent of the parties. Where a court lacks subject matter jurisdiction over a dispute, the parties cannot create it by agreement even in a plan of reorganization.

Id. at 24

Future Implications

For institutional lenders, investors and other parties that are active in chapter 11 reorganizations, Johns-Manville is the latest manifestation of the Second Circuit's strong (and growing stronger) view that bankruptcy courts should approve, only on very rare occasions, injunctive releases that provide non-debtors (e.g., lenders, equity investors or other third parties) with broad protections against claims by other non-debtor third parties.

In its 2005 Metromedia decision, the Second Circuit reiterated its longstanding view that injunctive non-debtor releases are sometimes permissible. It also described a number of illustrative situations that might justify such releases, including whether "the estate received substantial consideration" for the releases. 416 F.3d at 142. However, the Second Circuit declined to draw a bright-line rule, indicating that the key inquiry was whether "truly unusual circumstances render the release terms important to success of the plan." Id. at 143. Moreover, the Second Circuit made clear that a "material contribution" by the non-debtor to the debtor's estate, by itself, was not enough to justify the protections of a non-debtor release. Id.

The Second Circuit's decision in Johns-Manville further underscores this point, reinforcing the Second Circuit's view that a non-debtor's "financial contribution" to the debtor's reorganization cannot, by itself, justify the use of injunctive non-debtor releases to protect the non-debtor from liability to third parties.

Lenders or other institutional investors that frequently make financial contributions to the estate of a chapter 11 debtor as part of the debtor's reorganization should therefore be prepared to demonstrate that any protections that they receive from non-debtor releases are justified for reasons other than the mere fact of their financial contribution, and that the releases themselves are important to the success of the debtor's reorganization.

If you have any questions, please call your regular Davis Polk contact.