Two decisions were issued last week in separate bankruptcy cases that might be of interest to our clients. In one, a Delaware District Court issued an opinion further constraining the use of “plan consolidation” in cases involving multiple related corporate debtors. In the other, the Supreme Court of the United States upheld a 20-year-old injunction issued by the Southern District of New York Bankruptcy Court preventing certain asbestos litigation.
In an opinion issued on June 16, 2009, the Honorable Sue Robinson in the District of Delaware reversed the confirmation of the liquidating chapter 11 plan of New Century Financial Corporation. Schroeder v. New Century Liquidating Trust (In re New Century TRS Holdings, Inc.), Case. No. 07-10416 (KJC), Civ. No. 08-546-SLR (D. Del. June 16, 2009). The reversal was based in part on the court’s determination that the plan improperly pooled – for voting and distribution purposes – the assets and liabilities of multiple corporate affiliates. The decision, which closely followed the principles articulated by the Third Circuit in In re Owens Corning, 419 F.3d 195 (3d Cir. 2005), warned that substantive consolidation is an extreme remedy that is “to be used sparingly” and applied its holding to “plan consolidation.”
New Century Financial Corporation and its affiliates (“New Century” or the “Debtors”), once the second largest subprime mortgage lender in the United States, filed voluntary chapter 11 bankruptcy petitions on April 2, 2007.
The Debtors are comprised of 16 separate legal entities, each of which filed a separate bankruptcy petition. In an effort to facilitate the distribution of assets to unsecured creditors and ease the liquidation process, the Debtors’ joint chapter 11 plan (the “Plan”) called for the pooling of the assets and claims of each of the 16 entities into three groups. The Plan provided for the distribution of available assets in each group of debtors to the unsecured claim holders of the debtors in that group.
In July 2008, the Bankruptcy Court approved the Plan over the objections of a group of former New Century employees, who maintained that their deferred compensation plans should not be counted among the assets used to satisfy claims against other Debtors. The Bankruptcy Court did not reach the question of whether substantive consolidation was an appropriate remedy under the Owens Corning framework. Instead, the court held that merging the 16 Debtors into three groups based on many complex “layers of compromises” did not amount to substantive consolidation, in which all assets and liabilities of the Debtors would be pooled, effectively merging separate legal entities into a single surviving entity.
Application of the Doctrine of Substantive Consolidation in the Third Circuit
In 2005, the Third Circuit articulated a narrow framework in Owens Corning for the use of substantive consolidation, and warned against the inequities it may cause. The Owens Corning court explained that substantive consolidation restructures and revalues the rights of creditors, which may result in significantly less recovery for some. Creditors, who initially bargained for the assets and liabilities of a particular entity, suddenly find themselves vying for access to a different group of assets among a different, larger group of creditors. The court emphasized that the equitable remedy is extreme, imprecise and works “rough justice,” and should therefore be used sparingly. In the Third Circuit, substantive consolidation, absent consent from all parties, may only be used where (a) the entities pre-petition disregarded their separateness so significantly that their creditors relied on the breakdown of entity borders and treated them as one legal entity or (b) the entities’ post-petition assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors. These rationales protect creditors’ expectations and acknowledge the practical boundaries of separating “hopelessly comingled” assets.
The District Court Disallowed the Proposed Plan Consolidation
Consolidating the assets and liabilities of multiple affiliates for voting and distribution purposes is reasonably common in a joint chapter 11 plan of reorganization for a “corporate family.” The Bankruptcy Court had described the Plan as embodying “thoughtful compromises” rather than effecting substantive consolidation, and Plan proponents argued that it was a crucial step toward resolving the subprime mortgage giant’s complex web of financial issues. However, the District Court reversed the Bankruptcy Court’s confirmation of the Plan, finding that the court had erred when it concluded that the Plan did not effect substantive consolidation.
While the Plan was approved by every class of creditors entitled to vote except the appellant’s class, that legal challenge was enough to trigger the careful scrutiny that is warranted when substantive consolidation lacks consent from all parties. Judge Robinson explained that while substantive consolidation typically results in a single surviving entity, a “many-into-three framework still presents the same potential inequities for creditors as would be presented in the many-into-one framework.” Creditors in either instance “face increased competition for a consolidated pool of assets and a re-valued claim that is less precise than if the creditors were dealing with debtors individually.” Despite arguments that the Plan endeavored to preserve creditors’ rights, maintained inter-entity liabilities, and resulted from a compromise and settlement, Judge Robinson found that the Plan effected substantive consolidation, and that the record did not support its application under the Owens Corning framework. Although not directly stated in her opinion, Judge Robinson apparently did not consider the cost and delay of unscrambling the financial affairs New Century’s 16 entities so prohibitive or complicated as to warrant substantive consolidation.
New Century expands the application of Owens Corning to joint chapter 11 plans that consolidate solely for voting and distribution purposes. If followed, this case may limit the ability of companies and their creditors to simplify the plan process through carefully considered pooling arrangements. Absent the ability to have consolidating plans, emergence may become substantially more complex, potentially requiring separate plans of reorganization for each and every debtor.
Schroeder v. New Century Liquidating Trust (In re New Century TRS Holdings, Inc.), Case. No. 07-10416 (KJC), Civ. No. 08-546-SLR (D. Del. June 16, 2009).
In re New Century TRS Holdings, Inc., 390 B.R. 140 (Bankr. D. Del. 2008).
In re Owens Corning, 419 F.3d 195 (3d Cir. 2005).
In a 7-2 opinion authored by Justice Souter on June 18, 2009, the Supreme Court of the United States reinstated an order that had released Travelers Indemnity Company, an insurer of the largest supplier of raw asbestos, Johns-Manville Corporation, of all liability “relating to” its insurance coverage. Travelers Indemnity Co. v. Bailey, __ U.S. __, 2009 WL 1685625 (June 18, 2009). Relying on the principle of res judicata, the Court held that once the Bankruptcy Court’s order had become final in 1988, the Bankruptcy Court’s jurisdiction could not be challenged.
Travelers Indemnity Company (“Travelers”) was one of the primary liability insurers of Johns-Manville Corporation (“Manville”), the largest supplier of raw asbestos. In 1982, facing crushing liability, Manville filed for bankruptcy. As part of a massive settlement under the subsequent plan of reorganization, Travelers contributed $70 million to a trust to compensate third-party asbestos victims. As a condition to the plan, Bankruptcy Judge Burton Lifland ordered a broad release of future liability of Travelers and other insurers, enjoining “any and all claims . . . based upon, arising out of or relating to any or all” of the insurance policies. This settlement order became final on direct review in 1988.
A decade later, however, certain plaintiffs filed direct suits against Travelers alleging under state law that Travelers was directly liable for their damages, rather than derivatively liable as Manville’s insurer. In 2002, the question before the Bankruptcy Court was whether the 1986 release of liability covered not only derivative claims, but also direct claims against Travelers.
In the course of litigation, Travelers and these plaintiffs agreed to a second settlement pursuant to which Travelers paid more than $400 million, contingent upon the Bankruptcy Court’s order clarifying the scope of the 1986 liability release (the “Clarifying Order”). The Clarifying Order provided that further direct actions were enjoined because “direct action claims against Travelers were inextricably intertwined with Travelers long relationship as Mansville’s insurer,” and therefore sufficiently “related to” Mansville’s insurance coverage to be within the ambit of the broad 1986 order.
Several individual claimants objected to this settlement and appealed the Clarifying Order. The Second Circuit ultimately reversed, holding that the Bankruptcy Court lacked subject-matter jurisdiction in 1986 to enjoin direct actions against a “non-debtor insurer, for its own alleged misconduct.” The Second Circuit opined that a bankruptcy court “only has jurisdiction to enjoin third-party non-debtor claims that directly affect the res of the bankruptcy estate.” Thus, the Second Circuit found that the 1986 settlement order enjoining Travelers’ liability was outside the scope of the Bankruptcy Court’s jurisdiction.
The Court Broadly Construed 1986 Settlement Order to Include Release from “Direct Actions”
The Supreme Court, agreeing with the Clarifying Order, found that the language of the 1986 settlement order – releasing “any and all claims…based upon, arising out of or relating to any or all of the Policies” – released Travelers from asbestos claims alleging direct wrongdoing. Justice Souter reasoned that the words “relating to” in the 1986 order should be construed broadly to include not only claims arising out of Travelers' derivative obligations, but also claims against Travelers for its own misconduct as an insurer.
The Court Held that the Jurisdictional Challenge Was Untimely
The Supreme Court reversed the Second Circuit but expressly avoided deciding the question of whether a bankruptcy court has jurisdiction to “enjoin claims against nondebtor insurers that are not derivative of the debtor’s wrongdoing.” Instead, the Court, in what Justice Souter described as a “narrow” holding, held that the challenge to the Bankruptcy Court’s subject-matter jurisdiction was untimely and that “[a]lmost a quarter-century after the 1986 orders were entered, the time to prune them is over.” The Court found that the Second Circuit had erred by inquiring into the Bankruptcy Court’s 1986 subject-matter jurisdiction, because the settlement order had become final on direct review in 1988. Under the doctrine of res judicata – final judgments cannot be challenged if the parties have had the opportunity to challenge them on direct appeal – the Court foreclosed this jurisdictional challenge.
Although the Supreme Court did not clarify the scope of a bankruptcy court’s jurisdiction, it did make clear that once a settlement order becomes final on direct appeal, it cannot be subsequently attacked (though it may be interpreted). Justice Souter, however, did acknowledge that Congress had explicitly granted, pursuant to section 524 of the Bankruptcy Code, jurisdiction to the bankruptcy courts to enjoin actions alleging misconduct arising from the provision of insurance by asbestos claimants against a nondebtor in at least “some circumstances.” The precise scope of this jurisdictional authority, however, remains unresolved.
Travelers Indemnity Co. v. Bailey, __ U.S. __, 2009 WL 1685625 (June 18, 2009).
In re Johns-Manville Corp., 2004 WL 1876046 (Bankr. S.D.N.Y. Aug. 17, 2004).