United States: Third Circuit Ruling Provides Bankruptcy Plans With Broad Preemption Rights

On May 1, 2012, the 3rd U.S. Circuit Court of Appeals ruled on an issue that is of particular importance to insurers, but it may also have wider application to the crafting of plans of reorganization in the asbestos arena and elsewhere. Specifically, the court held that debtor Federal-Mogul could transfer its rights to recover under liability insurance policies to a trust set up under its plan of reorganization for the benefit of asbestos victims, even though the policies contained provisions prohibiting their assignment. In re Federal-Mogul Global Inc., No. 09-2230, 2012 WL 1511773 (3d Cir. 2012).

The 3rd Circuit based its ruling on the preemption language contained in Section 1123(a) of the federal Bankruptcy Code, which provides for the implementa-tion of a plan of reorganization, including by the transfer of property to a non-debtor, "[n]otwithstanding any otherwise applicable non-bankruptcy law." The court dismissed the attempts made by insurer appellants to limit the effects of the preemptive language on the basis of theories of statutory construction and appeals to legislative history.

The circuit court's decision in Federal-Mogul put to rest a dispute relating to a critical component of a plan of reorganization that was confirmed four and a half years ago in a case that was, by then, already six years old. Although the long-awaited decision is narrow in focus, it establishes Section 1123(a) as broad in application.

BACKGROUND

The procedural and factual background of the Federal-Mogul decision is as follows:

The Federal-Mogul corporate group, dating back to 1899, is an original equipment and aftermarket automotive parts manufacturer and distributor. Today, it operates worldwide through 169 manufacturing, distribution and technical facilities with operations in 34 countries. In 2011, it had sales of $6.9 billion. See Federal-Mogul Corp. annual report pursuant to Section 13 and 15(d) (Form 10-K), at 12 (Feb. 28, 2012).

In 2001, however, Federal-Mogul faced significant asbestos-related litigation liability that resulted from the manufacture of asbestos and asbestos-related products at subsidiaries acquired in 1965 and 1998. Federal-Mogul claimed that 500,000 personal injury claims were pending at that time, with many more anticipated in the future, and the corporation asserted that it had spent more than $350 million in the preceding year defending and indemnifying asbestos claims. Federal-Mogul, 2012 WL 1511773 at *4.

In an attempt to finally resolve its asbestos-related exposure, on Oct. 1, 2001, Federal-Mogul Global Inc and more than 150 affiliates filed Chapter 11 bankruptcy petitions in the U.S. Bankruptcy Court for the District of Delaware.

In late 2007, after six years of bankruptcy court proceedings, including much negotiation on the resolution of asbestos-related claims and their treatment and multiple iterations, Federal-Mogul was finally able to present its fourth amended joint plan of reorganization (as modified) for confirmation.

A critical feature of the plan was that all asbestos personal injury and wrongful-death claims against Federal-Mogul and its affiliates under the plan were to be assumed by an asbestos trust created pursuant to Section 524(g) of the Bankruptcy Code¹ and that the reorganized Federal-Mogul would be relieved of that responsibility. Critically, the asbestos trust was to be funded by, among other things, an assignment of the rights to recover under liability insurance policies that had been issued to Federal-Mogul prior to bankruptcy.

The insurers objected to the plan's confirmation, asserting that the plan violated the policies' anti-assignment provisions — standard clauses in liability policies that bar the insured from transferring the policies or insurance rights without the insurers' consent. Federal-Mogul, at *4.

Federal-Mogul argued the transfer was permitted because the anti-assignment provisions in the policies were preempted under 11 U.S.C. § 1123(a)(5)(B), which provides that a Chapter 11 reorganization plan shall provide adequate means for its implementation, including, if appropriate, the transfer of estate property, "notwithstanding otherwise applicable non-bankruptcy law."

The parties agreed to bifurcate the proceedings, permitting the plan to proceed toward confirmation on one track while the preemption issue was to be decided on a separate track.

On Nov. 8, 2007, with all other objections resolved, the Bankruptcy Court confirmed the plan, and the District Court affirmed. The plan went into effect Dec. 27, 2007.

Months later, on March 19, 2008, the Bankruptcy Court issued its preemption order and memorandum opinion, holding that the Bankruptcy Code preempted the anti-assignment provisions within the insurers' policies. In re Federal-Mogul Global Inc., 385 B.R. 560 (Bankr. D. Del. 2008). The District Court affirmed. In re Federal-Mogul Global Inc., 402 B.R. 625 (D. Del. 2009).

A number of insurers² filed two appeals to the 3rd Circuit, which consolidated the appeals.

THE 3RD CIRCUIT RULING

In an opinion written by Circuit Judge Anthony Joseph Scirica, joined by Circuit Judges D. Brooks Smith and Kent A. Jordan, the 3rd Circuit panel rejected the insurers' arguments and found that the preemptive lead-in language of Section 1123(a) was broad in scope, not limited by Section 1142 of the Bankruptcy Code, which governs implementation of a reorganization plan. The panel also found that the language applied to the transfer of the rights of the Federal-Mogul estate to recover under the policies.

ANALYSIS

Section 1123 of the Bankruptcy Code, titled "Contents of a Plan," sets forth certain elements that must be included in a plan of reorganization and certain elements that may be included in such a plan.

The lead-in to Section 1123(a), which describes what must be included in a plan, begins with this preemption language: "Notwithstanding any otherwise applicable non-bankruptcy law, a plan shall—." It then goes on to list a number of requirements for a plan. The fifth requirement under Section 1123(a) is that the plan must:

Federal-Mogul argued that the anti-assignment provisions of the policies, because they were part of a contract that required "applicable non-bankruptcy law" to enforce, were covered by the preemption lead-in language of Section 1123(a), just as the transfer of the estate's right to recover under the policies to the asbestos trust was the transfer of "part of the property of the estate to one or more entities" and thus squarely within Section 1123(a)(5)(B).

The insurers made two arguments related to statutory construction. First, they argued that the preemption lead-in language of Section 1123(a) applied to some of the requirements of Section 1123(a), but not to the various items listed as possible means of implementation under subsection (a)(5).

Second, the insurers claimed that the phrase "notwithstanding any otherwise applicable non-bankruptcy law" in Section 1123(a) should be read in conjunction with, and limited by, Section 1142 of the Bankruptcy Code.

Section 1142 provides for the implementation of a plan, and subsection (a) contains its own, but more limited, preemption language:

The insurers argued, therefore, that the "applicable non-bankruptcy law" preempted in Section 1123(a) should be understood to apply only to laws "relating to financial condition" as specified in Section 1142(a).

In addition, insurers argued that the anti-assignment provisions were not "applicable non-bankruptcy law," but rather were contractual provisions, which were not covered by the preemption language of Section 1123(a).

The 3rd Circuit panel rejected each of the insurers' various arguments.

Federal-Mogul, at *11.

Apart from their arguments regarding statutory construction and interpretation, the insurers also tried to argue from legislative history and policy considerations that the preemption language in Section 1123(a) should be narrowly construed, since Congress, in enacting the 1984 revisions to the Bankruptcy Code that added the "notwithstanding any otherwise applicable non-bankruptcy law" language to Section 1123(a), intended only to make mere technical amendments. It did not intend to make a substantive change from the pre-Bankruptcy Code practice, which did not contain such broad preemption.

The 3rd Circuit rejected that view. "[W]hat-ever the proper characterization of prior practice, it deserves little weight here. We decline to rely on it, or on a thin and vague legislative history that says nearly nothing about the intended preemptive scope."

As a result, the 3rd Circuit found that Section 1123(a) overrode the anti-assign-ment provisions in the policies and that the plan could transfer the right to recover under them to the asbestos trust.

SCOPE OF THE DECISION

The 3rd Circuit's decision in Federal-Mogul delineates a broad scope for the pre-emptive effect of Section 1123(a). By refusing to import the limits of Section 1142's preemption to Section 1123(a), the 3rd Circuit made clear that Section 1123(a) preempts, generally speaking, all non-bankruptcy law, including contractual provisions.

Debtors therefore have great leeway in using a plan of reorganization to transfer property under circumstances that might otherwise be prohibited by applicable law or contract.

Thus, just as the anti-assignment provisions in Federal-Mogul's policies fell by the wayside, so too might other contractual provisions in other agreements (e.g., anti-merger provisions [Section 1123(a)(5)(C)] or restrictions on amendments to organizational documents [Section 1123(a)(5)(I)]).

The question then, is what limits remain on preemptive power in a plan of reorganization under Section 1123(a). Certainly, the 3rd Circuit, recognizing that potential problem, tried to provide some guidance by pointing to the "good faith" requirement of the Bankruptcy Code:

Federal-Mogul, at *17.

Thin as the "good faith" limit may appear in practical terms,³ the 3rd Circuit also suggested that plan preemption may not be used to evade state and federal public welfare–related law, under the "the long-standing presumption against preemption of state police power laws and regulations rooted in federalism concerns and the historic primacy of state regulation of matters of health and safety." Federal-Mogul, at *17, quoting Medtronic Inc. v. Lohr, 518 U.S. 470 (1996), at 485.⁴

Although this does little to help private parties such as liability insurers, it does provide some comfort to regulators that bankruptcy plans will not override existing regulatory schemes. Surely, then, the preemption power of Section 1123 will have some limits. Nevertheless, given the power of the statutory argument adopted by the 3rd Circuit in Federal-Mogul, it remains to be seen how willing future courts will be to circumscribe a plan's preemptive authority outside of the narrow sphere of public welfare laws.

Footnotes

1 Asbestos trusts are a creature of Section 524(g) of the Bankruptcy Code, a statutory provision intended to help debtors resolve massive asbestos liability and to evaluate claims and allocate payments to current and future asbestos claimants. This provision was adopted in the wake of the Johns Manville bankruptcy that stretched through the 1980s. When the requirements of Section 524(g) are satisfied, including the affirmative vote of 75 percent of affected claimants, the bankruptcy court may issue an injunction channeling all current and future claims based on the debtor's asbestos liability to a personal-injury trust. This case centers on one of these trusts, and the importance of the asbestos context to the court's reasoning should not be underestimated. The 3rd Circuit panel devoted considerable space to discussing the history and implementation of Section 524(g) asbestos trusts. It explicitly noted that "Congress believed the transfer of a corporation's assets to a trust to ensure the equitable compensation of present and future claimants, in return for a release from future liability, served the 'fundamental' purposes of bankruptcy." Therefore, the panel said, it is consistent with the policy aims of Congress that Section 1123(a) preempt any non-bankruptcy law that would otherwise prevent the transfer of those assets to a trust for the benefit of claimants. Federal-Mogul, at *14.

2 The appellant insurers were Hartford Accident and Indemnity Co., First State Insurance Co., New England Insurance Co., Columbia Casualty Co., Continental Casualty Co., Continental Insurance Co., Fireman's Fund Insurance Co., National Surety Co., Certain Underwriters at Lloyd's of London and Certain London Market Companies.

3 There is, in fact, developed case law on the "good-faith" requirement for plans of reorganization under Section 1129(a)(3). Although a discussion of that case law is beyond the scope of this article, it is sufficient to note that it would provide little comfort to parties concerned about the preemption provisions of Section 1123 being used to override contractual provisions in connection with an otherwise purposeful reorganization.

4 Indeed, the panel noted that 18 states had filed an amicus brief on this same issue in the In re Global Industrial Technologies case, cautioning that an "overly broad reading" of Section 1123(a) "would destroy [their] ability to preserve their regulatory authority in the face of a bankruptcy filing." Federal-Mogul, at *17, referring to Br. and App. of amicus curiae states at 1-3, In re Global Indus. Techs., 645 F.3d 201 (3d Cir. 2011) (No. 08-3650), 2008 WL 8134099 at *1-*3.

First published in Westlaw Journal, August 2012

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