United States: Back to the Drawing Board for Asbestos Pre-Packs? The Third Circuit’s Recent Opinion in Combustion Engineering

The Third Circuit’s recent opinion overturning confirmation of a plan of reorganization in the Combustion Engineering ("CE") bankruptcy case has significant consequences for mass tort bankruptcies, and specifically for asbestos "pre-pack" cases. While circuit courts have traditionally given mass tort debtors some leeway and flexibility in interpreting the Bankruptcy Code, this court was clearly troubled by the novel design of the CE case. In a lengthy and far-reaching opinion that discussed several important aspects of asbestos bankruptcy cases, the Third Circuit’s rulings may have fundamentally changed the strategy, negotiation dynamic, and structure of a pre-packaged asbestos bankruptcy case.

In a pre-packaged case the debtor has already solicited the votes of all creditors prior to filing the case. Outside of the mass tort context, the advantage of a "pre-pack" is speed and less volatility: because the debtor has already obtained the votes for approval of a plan of reorganization, it can file its disclosure statement and plan as a "first-day" pleading and expect to move swiftly towards confirmation of its plan and exiting bankruptcy.

Facing tremendous asbestos liability, CE, a subsidiary of European conglomerate ABB Ltd., filed a precedent -setting pre-packaged chapter 11 bankruptcy case in February, 2003.

Prior to the filing, CE had negotiated a settlement with the leading asbestos plaintiffs lawyers and created a pre-petition trust to make payments under the settlement (the "Pre-Petition Trust"). CE’s ultimate parent, ABB Ltd. also paid a $20 million "success fee" to a single, prominent asbestos lawyer whose job was to garner support for the CE plan among other asbestos lawyers. The Pre-Petition Trust would be funded by the insurance policies of CE and a contribution by ABB. The majority of asbestos claimants that settled with CE prior to the bankruptcy case would receive a 100% recovery: 95% to be paid out from the Prepetition Trust and a 5% stub claim (the "Stub Claims") to be paid out post-petition under the chapter 11 plan. The settling claimants were primarily individuals who purported to have been exposed to asbestos but had no evidence of illness or incapacity. The non-settling claimants were those who were actually suffering from cancer and other diseases, who viewed the settlement offer as inadequate.

These Stub Claims were the lynchpin of CE’s pre-pack strategy. By leaving 5% to be paid to holders of Stub Claims under the chapter 11 plan those claimants would technically still be creditors under the Bankruptcy Code and were therefore entitled to vote on the plan. These settling claimants without any recognizable injury outnumbered those claimants who were actually sick. By lumping the two groups of claimants in one class for voting on the CE plan, the larger group of claimants who were not sick outvoted those who were.

Finally, CE had two affiliates, Lummus and Basic, that were also facing asbestos liability but did not file for bankruptcy. Some of this liability derived from legal connections between the affiliates and CE (derivative liability) but the majority of lawsuits concerned the affiliates’ direct liability (non-derivative liability). An important aspect of CE’s bankruptcy plan was to enter court-approved releases for Lummus and Basic.

CE’s own asbestos liability would be channeled to a post-petition trust (the "Post-Petition Trust") created under section 524(g) of the Bankruptcy Code. CE’s plan also provided that asbestos liability threatening Lummus and Basic, both derivative and non-derivative, would be channeled to post-petition trusts. While third-party releases for non-debtors is not uncommon in bankruptcy cases, the breadth of the releases for Lummus and Basic could be considered unusual.

The CE plan was confirmed by the Bankruptcy Court and affirmed by the District Court. Certain non-settling asbestos claimants who had contracted cancer from asbestos exposure, as well as a number of ABB’s insurance companies who feared their rights were improperly compromised by the plan, took the case to the Third Circuit Court of Appeals. The Third Circuit overturned the lower courts and found that the CE plan did not satisfy the jurisdictional and legal requirements for confirmation.

First, the Third Circuit held that insurance companies did have limited standing to challenge certain aspects of the plan. The standard to be applied in order to determine whether a party has a right to appeal in a bankruptcy case (bankruptcy appellate standing) is not the usual "party in interest" standard but the more restrictive "persons aggrieved" standard: a party has appellate bankruptcy standing if its rights or interests are directly and adversely affected pecuniarily by an order or decree of the bankruptcy court. As such, insurance companies could challenge a "super-preemptory" provision in the plan. The original plan provision was designed to make sure that insurance companies’ rights were not altered by the plan. However, in approving confirmation of the plan, the District Court had modified this provision to be less advantageous to the insurance companies. The Third Circuit concluded that because this change "diminishes their property, increases their burdens, or impairs their rights," the insurers had the right to appeal. The practical consequence of this holding may be to give insurance companies more leverage during negotiation and formulation of a plan, because previously their rights were less clear.

Second, the court held that in this situation, the bankruptcy court had no jurisdiction to implement releases of non-derivative liability for non-debtor affiliates. Neither mere corporate affiliation between peer companies, nor significant financial contributions by the affiliates, nor shared insurance between CE and its affiliates Lummus and Basic could support the "related to" connection needed to justify the exercise of jurisdiction over these non-debtors and their creditors by the bankruptcy court.

Additionally, the Third Circuit concluded that the broad power given to bankruptcy courts by section 105 of the Bankruptcy Code does not go so far as to give the court the power to release non-derivative liability of non-debtors because section 524(g) of the Bankruptcy Code, which specifically addresses releases of third-party liability, does not allow release of non-derivative liability. Section 524(g) was inserted by Congress into the Bankruptcy Code to deal with releases in asbestos cases. Because section 524(g) specifically addresses the situation while section 105 generally addresses releases, the court relied on one of the fundamental canons of statutory interpretation: a specific provision trumps a general provision.

Third, the court found the practice of creating thousands of stub claims to be "troubling" and held that CE may have "artificially impaired" the settling asbestos claimants in order to improperly manipulate the voting process. This violates the bedrock bankruptcy principle of equality among similarly-situated creditors : "Combustion Engineering made a pre-petition side arrangement with a privileged group of asbestos claimants, who as a consequence represented a voting majority…This type of manipulation is especially problematic in the asbestos context, where a voting majority can be made to consist of non-malignant claimants [i.e. not sick] whose interests may be adverse to those claimants with more severe injuries." As such, the CE plan could not be approved.

The most interesting aspect of the Third Circuit’s ruling was the tone and strength of the opinion, written by the chief judge Anthony Scirica. The court was clearly concerned about how CE had structured its pre-pack, and used words and phrases like "manipulation," "problematic," "engineering literal compliance," and "artificial impairment". The court called the practice of creating massive stub claims, "troubling." Generally, circuit courts have provided significant leeway to mass tort debtors. In the Johns-Manville, Drexel Burnham Lambert Group, A.H. Robins, and recently, Dow Corning cases, circuit courts have demonstrated great flexibility when analyzing the Bankruptcy Code such that these cases came to successful, negotiated conclusions. Thus, the Third Circuit’s almost complete renunciation of the Combustion Engineering paradigm is notable. This may have been due to some unusual decisions that, taken together, troubled the court: (1) the use of vast numbers of stub claims, (2) a $20 million "success fee" given to a single tort lawyer, (3) the lack of a future claims representative for the claims of CE’s affiliates, (4) the totally disparate treatment of asbestos claimants who settled pre- versus post-petition, (5) a shell corporation issuing securities for asbestos trusts, (6) a possible $400 million fraudulent transfer to the Pre-Petition Trust and, of course, (7) the attempt to use section 105 to cleanse non-debtor affiliates of non-derivative liability. Although the court did not completely rule out the possibility of asbestos pre-packaged cases, it called into question the fundamental architecture used by CE, which has since been used in other asbestos pre-pack cases. It remains to be seen if this novel form of using the Bankruptcy Code to address mass tort liability will survive.

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