You have likely heard the term “piercing the veil.” This legal doctrine permits a court to ignore corporate formalities and hold an individual owner liable for a company’s debt. But you may be less familiar with the doctrine of reverse veil piercing, which permits a court to hold a company liable for the debt of an individual owner.

Although courts in most states have eliminated any meaningful distinction between these related doctrines, which treat a company and its owner as alter egos, a recent decision by the California Court of Appeal in Blizzard Energy, Inc. v. Schaefers confirms that reverse veil piercing does not apply in certain situations in California.

Blizzard Energy is the latest in a trilogy of cases in California involving reverse veil piercing.

Back in 2008, the California Court of Appeal held, in Postal Instant Press, Inc. v. Kaswa Corp., 162 Cal.App.4th 1510, that reverse veil piercing does not apply to corporations. As that court noted, such a remedy is unnecessary because a creditor could simply levy and liquidate the individual owner’s interest in a judicial sale of the owner’s corporate shares. The court hypothesized, however, that reverse veil piercing may apply to a single-member limited liability company.

In 2017, in Curci Investments, LLC v. Baldwin, 14 Cal.App.5th 214, the California Court of Appeal expanded that hypothetical and held that reverse veil piercing permitted the trial court to add a limited liability company to a judgment against an individual judgment debtor who owned 99% of that LLC (his wife owned the other 1%). As the court explained, the first element of an alter ego analysis is a “substantial identity of ownership and control” between the debtor and the entity. That element was satisfied by the judgment debtor’s ownership of 99% of the LLC.

Most recently, in Blizzard Energy, the California Court of Appeal reversed the trial court’s order that used reverse veil piercing to add a limited liability company to a fraud judgment against an individual judgment debtor who owned only 50% of the LLC. The judgment debtor’s wife owned the other 50%, and they both acquired their ownership interest after they had legally separated more than 15 years ago. As the Court of Appeal explained, the trial court improperly assumed that the wife’s 50% ownership interest in the LLC was community property of the marriage, which called into question whether there was a “substantial identity of ownership” between the judgment debtor and the LLC necessary to apply reverse veil piercing. Because it was possible that the wife was an innocent member of the LLC, the Court of Appeal remanded the case to the trial court for further proceedings to determine whether it would be inequitable to use reverse veil piercing to add the LLC as an additional judgment debtor given that the wife owns half of that LLC.

Blizzard Energy teaches us that reverse veil piercing remains a restricted remedy in California. It is limited to LLCs and applies only when the plaintiff can demonstrate that there is a substantial identity of ownership and control between an individual judgment debtor and the LLC in question. And that is only the first element of the alter ego test. The plaintiff also must show that conduct amounting to bad faith makes it inequitable for the corporate owner to hide behind the corporate form. Mere difficulty in enforcing a judgment or collecting a debt does not satisfy this standard.

On August 29, 2022, in the PG&E bankruptcy matter, the Court of Appeals for the Ninth Circuit became the first circuit-level court to address the question of what is the correct rate of interest to be applied to unimpaired unsecured claims against a fully solvent debtor.[2] In its decision, the Ninth Circuit reversed the bankruptcy court’s and district court’s rulings and held that such creditors are entitled to receive postpetition interest at the contractual rate or the state law default rate, which are almost always significantly higher than the federal judgment rate.

Outside of the Ninth Circuit, bankruptcy courts are divided on the issue. In recent decisions in the District of Delaware and the Southern District of New York, bankruptcy courts have applied the federal judgment rate in such situations, whereas in the Southern District of Texas, bankruptcy courts have ruled that the contractual rate of interest must be used.[3]

Over the next several years, it is a virtual certainty that other circuit-level courts will be asked to opine on the issue. In the meantime, solvent debtors or potentially solvent may choose to file bankruptcy cases outside the Ninth Circuit, if possible, to avoid paying unimpaired unsecured creditors the higher rate of interest. Additionally, both solvent debtors and unimpaired unsecured creditors to solvent debtors should be prepared to litigate the issue to the circuit level in cases maintained outside the Ninth Circuit.

Background

PG&E was solvent before and during its bankruptcy proceedings. Under the debtors’ proposed chapter 11 plan, members of an ad hoc committee of holders of trade claims were to be paid the full principal amount of their unsecured claims plus interest at the federal judgment rate, rendering such holders’ claims “unimpaired” under the plan. The federal judgment rate, however, was materially lower than what the committee members would have otherwise been entitled to under either state law or the interest rates set forth in their respective contracts. Specifically, the committee members alleged a $200 million discrepancy in their recoveries due to the lower rate of interest being applied.[4] Further, as unimpaired creditors, the committee members were not entitled to vote on the plan. The committee and other unsecured creditors objected to the plan on the basis that unsecured creditors to solvent debtors must be paid interest on their claims at the contractual or state law rate in order to be deemed unimpaired.[5] The bankruptcy court ruled against the committee, however, finding that the lower federal judgment rate applied to their claims.[6] The committee appealed the matter to the District Court for the Northern District of California, and the district court affirmed the bankruptcy court’s decision.[7]

The Ninth Circuit’s Decision

The Ninth Circuit began its analysis by reaffirming the common law solvent-debtor exception, which is that “a solvent debtor must generally pay postpetition interest accruing during bankruptcy at the contractual or state law rates before collecting surplus value from the bankruptcy estate.”[8] This exception was recognized under the former Bankruptcy Act (the predecessor statute to the Bankruptcy Reform Act of 1978). Because the Bankruptcy Code, as amended, lacked “any clear indication” that Congress intended to abrogate the solvent-debtor exception,[9] the appellate court held that unimpaired unsecured creditors retained an equitable right to postpetition interest pursuant to their contracts or state law, and that “failure to compensate creditors according to this equitable right as part of a bankruptcy plan results in impairment.”[10]

In reaching this conclusion, the Ninth Circuit relied on, among other reasons, the Bankruptcy Code’s structure. The court noted that the Bankruptcy Code provided impaired creditors with certain protections (e.g., the right to vote on a plan and the right of a dissenting impaired class to a plan that is “fair and equitable”).[11] Further, the court noted that by defining impairment broadly, Congress ensured these protections would be available “to creditors whose rights were altered in any way by a plan.”[12] The court reasoned that, without the solvent-debtor exception, PG&E would reap an improper windfall while steamrolling creditors’ statutory and equitable rights.[13]

In sum, the court’s decision in PG&E now leaves solvent debtors who file in the Ninth Circuit with two options: (1) use the contractual or state law rate in calculating interest on unsecured unimpaired claims, or (2) designate such claims as impaired.[14]

Conclusion

In its PG&E decision, the Ninth Circuit created the first circuit-level law on an issue that has bedeviled bankruptcy courts around the country. Going forward, parties in interest should expect significant litigation on the issue, and perhaps a circuit split that eventually finds its way to the United States Supreme Court.

The U.S. Court of Appeals for the Eighth Circuit recently affirmed the judgment of a trial court and held that non-consumers cannot bring a claim under Section 1692c(b) of the federal Fair Debt Collection Practices Act (FDCPA).

The Eighth Circuit also concluded that there was no abuse of discretion in the trial court because the plaintiff, a bankruptcy attorney, failed to follow the applicable court rules. Further, the Court ruled that the attorney confused Article III standing, which implicates subject matter jurisdiction and was undisputed here, with statutory standing.

Thus, because the attorney only alleged a violation of Section 1692c(b), and the trial court determined that Section 1692c(b) does not provide the attorney with statutory standing to sue, the Court concluded that judgment as a matter of law was appropriate.

A copy of the opinion in Andrew Magdy v. I.C. System, Inc. is available at: Link to Opinion.

A bankruptcy attorney sued a debt collection agency after he received a letter from the agency identifying him as the attorney for a consumer named in the letter. In fact, the consumer was not the attorney’s client and never had been, and the attorney engaged in an extensive search of his files and records to determine this fact. This search cost the attorney time and resources that he could have spent working on matters for actual clients.

The attorney brought his claim in Missouri state court under 15 U.S.C. Section 1692c(b), which prohibits a debt collector from contacting a third party about the collection of a debt without the prior consent of the consumer. The agency properly removed the case to federal court.

Eventually, the federal trial court granted the agency’s motion for judgment on the pleadings finding that the attorney, a non-consumer, lacked standing to bring a cause of action under Section 1692c(b). The attorney asked for leave to replead his claims pursuant to Section 1692d in his response to the debt collector’s motion, but he never filed an actual motion for leave to amend his pleadings. The attorney timely appealed the trial court’s judgment.

As you may recall, Section 1692c(b) concerns third-party communications by debt collectors:

Except as provided in section 1692b[4] of this title, without the prior consent of the consumer given directly to the debt collector, or the express permission of a court of competent jurisdiction, or as reasonably necessary to effectuate a postjudgment judicial remedy, a debt collector may not communicate, in connection with the collection of any debt, with any person other than the consumer, his attorney, a consumer reporting agency if otherwise permitted by law, the creditor, the attorney of the creditor, or the attorney of the debt collector.

The Eighth Circuit upheld the trial court’s ruling that the debt collector violated Section 1692c(b) by contacting the plaintiff without the consumer’s prior consent. However, the Court also recognized that the agency’s violation of Section 1692c(b) did not guarantee the attorney statutory standing.

The plaintiff attorney relied on the language in 15 U.S.C. § 1692k, the FDCPA’s general civil liability provision, to support his argument that he had standing to sue for a Section 1692c(b) violation.

Section 1692k(a) provides: “Except as otherwise provided by this section, any debt collector who fails to comply with any provision of this subchapter with respect to any person is liable to such person. . .” Focusing on this language, “with respect to any person is liable to such person,” the plaintiff attorney argued that because the agency failed to comply with Section 1692c(b) “with respect to” him by sending him the letter, the agency is liable to him.

“[A] statutory cause of action extends only to plaintiffs whose interests ‘fall within the zone of interests protected by the law invoked.’” Lexmark Int’l, Inc. v. Static Control Components, Inc., 572 U.S. 118, 129 (2014) (quoting Allen v. Wright, 468 U.S. 737, 751 (1984)). The zone-of-interests test requires courts to use “traditional tools of statutory interpretation” to determine “whether a legislatively conferred cause of action encompasses a particular plaintiff’s claim.” Lexmark, 572 U.S. at 127.

Here, the Eighth Circuit reasoned that Section 1692c(b)’s plain language — “without the prior consent of the consumer” — indicates that the attorney is outside the scope of its protection. Any violation of Section 1692c depends on the debt collector making contact without the consumer’s prior consent.

The Court thus read the plain language of Section 1692c(b) as making clear that the provision’s purpose is to protect consumers, not third parties. Cf. Kuntz v. Rodenburg LLP, 838 F.3d 923, 925 n.2 (8th Cir. 2016) (reviewing Section 1692b(3)’s plain language to determine its purpose). Because the purpose of Section 1692c(b) is to protect consumers alone, the Court concluded that the attorney falls outside Section 1692c(b)’s “zone of interests” and thus could not invoke the protection afforded by it.

The Eighth Circuit agreed with the attorney that the FDCPA protects more than just consumers in its regulation of debt collectors. Congress intended for the FDCPA to “make collectors behave responsibly towards people with whom they deal.” H.R. Rep. No. 95-131, at 8 (1977). However, as the Sixth Circuit recognized in Montgomery v. Huntington Bank, the Court here held that the availability of relief to non-consumers under other sections of the FDCPA does not guarantee non-consumers relief under Section 1692c. 346 F.3d 693, 696-97 (6th Cir. 2003).

The Eighth Circuit joined the other circuits that have considered this issue in concluding that non-consumers cannot bring a claim under Section 1692c(b). See, e.g., Todd, 731 F.3d at 737 (“[Section] 1692c restricts debt collectors’ communications with and about consumers and is understood to protect only the consumer-debtors themselves.”); Montgomery, 346 F.3d at 696 (“[O]nly a ‘consumer’ has standing to sue for violations under 15 U.S.C. § 1692c.” (citation omitted)); Johnson v. Ocwen Loan Servicing, 374 F. App’x 868, 874 (11th Cir. 2010) (per curiam) (holding that plaintiff lacked standing to sue under Section 1692c because she was not a consumer).

The plaintiff attorney also argued that the trial court abused its discretion by refusing to grant him leave to amend his pleading. The attorney cited Federal Rule of Civil Procedure 15(a)(2), which provides a party the opportunity to amend its pleadings with the court’s leave and notes that “[t]he court should freely give leave when justice so requires.” However, the Eighth Circuit noted that the attorney never filed a motion to amend or a memorandum in support of such a motion. Therefore, the Court concluded that there was no abuse of discretion because the attorney failed to follow the applicable procedural rules of the trial court.

Lastly, the attorney asserted that, even if the trial court correctly concluded that he lacks standing to sue under Section 1692c(b), the proper action was to remand the case back to Missouri state court. The attorney then cited case law in which the Eighth Circuit instructed trial courts to remand cases originally filed in state court when the plaintiff lacks Article III standing. See Wallace v. ConAgra Foods, Inc., 747 F.3d 1025, 1033 (8th Cir. 2014).

However, the Eighth Circuit determined that the attorney confused Article III standing, which implicates subject matter jurisdiction and was undisputed here, with statutory standing, which implicates whether the plaintiff has the right to sue the defendant to redress alleged injuries. Miller v. Redwood Toxicology Lab’y, Inc., 688 F.3d 928, 934 (8th Cir. 2012). Because this appeal concerned statutory standing under Section 1692c(b), the Eighth Circuit held that the trial court’s decision that the attorney lacks statutory standing was a ruling on the merits of his claim, not on the trial court’s jurisdiction.

Thus, the Eighth Circuit concluded that the attorney only alleged a violation of Section 1692c(b) and the trial court correctly determined that Section 1692c(b) does not provide the attorney with statutory standing to sue. Accordingly, the Eighth Circuit affirmed the trial court’s decision to grant judgment as a matter of law.

In a much anticipated decision released September 8, an en banc panel of the Eleventh Circuit Court of Appeals reversed the district court’s decision that a debt collector’s outsourcing of its letter process to a third-party mail vendor violated the Fair Debt Collection Practices Act’s (FDCPA) prohibition on third-party disclosure and ruled that plaintiff Hunstein lacked standing to bring his claim. The court proclaimed: “Under the most generous reading of his complaint, one company sent his information to another, where it was ‘populated’ into a private letter that was sent to his home. That is simply not enough.”

As we previously posted, on April 21, 2021, the Court of Appeals issued the original Hunstein v. Preferred Collection and Management Services Inc. opinion, which held that (1) a consumer had standing to bring a claim under the FDCPA because he alleged an invasion of privacy based on the spread of his debt-related information; and (2) a debt collector’s outsourcing of its letter process to a third-party mail vendor violated the FDCPA because sending the data to create and mail letters to consumers violates the prohibition on third-party disclosure set forth in FDCPA Section 1692c(b).

The Eleventh Circuit then vacated its original opinion and issued a substitute opinion. See Hunstein vs. Preferred Collection & Management Services, Inc., 17 F. 4th 1016 (11th Cir. 2021) wherein the panel majority reaffirmed its original opinion and held that Hunstein had standing to sue. On November 17, 2021, the Eleventh Circuit vacated the substitute opinion and agreed sua sponte to reconsider en banc whether a debt collector’s transmission of private debtor information to its mail vendor violated the FDCPA. See 2021 WL 5353154 (11th Cir. Nov. 17, 2021). Oral arguments were held on February 22.

Relying heavily on Ramirez, 141 S. Ct. 2190 (2021), which held that a concrete injury under the Fair Credit Reporting Act requires more than the existence of a risk of harm that never materializes, the en banc panel held that Hunstein’s proffered harm of publicity was insufficient to confer Article III standing. “We first identify the precise harm at issue. Hunstein alleged that, rather than preparing a mailing on its own, Preferred Collection sent information about his debt to a mail vendor, which then populated the data in a form letter. That act, according to Hunstein, violated the statutory prohibition on communicating, ‘in connection with the collection of any debt, with any person other than the consumer.’” Hunstein analogized this harm to the tort of public disclosure. However, the court held the disclosure alleged lacked the fundamental requirement of publicity.

According to the en banc panel, publicity requires more than just any communication to a third party. Instead, the private information must be made public. The court noted that Hunstein did not allege that that a single employee ever read or understood the information about his debt. “[N]owhere does Hunstein suggest that Preferred Collection’s communication reached, or was sure to reach, the public. Quite the opposite — the complaint describes a disclosure that reached a single intermediary, which then passed the information back to Hunstein without sharing it more broadly.”

Ultimately, the court held that because Hunstein alleged only a legal infraction and not a concrete harm, the court lacked jurisdiction to consider his claim. “As Hunstein explained, courts have no ‘freewheeling power to hold defendants accountable for legal infractions.’” Although dismissed on Article III standing grounds, the court’s express rejection of the idea that preparation of a letter, without more, constitutes a public disclosure should prove useful in continuing litigation, including in state courts that sometimes have more lax standing requirements.

On June 21, 2022, President Joseph Biden signed S.3823 into law. The law, which is effective immediately, makes the following material changes to the Bankruptcy Code.

The $7.5 million debt limit for eligibility for Chapter 11, Subchapter V bankruptcy cases is renewed for another two years:

In 2019, Congress passed the Small Business Reorganization Act (the “SBRA”), creating a new type of Chapter 11 bankruptcy proceeding for Small Business Debtors. Known as a SBRA Bankruptcy or a Subchapter V Bankruptcy, an eligible business may file for Chapter 11 under a streamlined and expedited process, which does not require payment in full of the debts of unsecured creditors. Advocates say that the streamlined procedures greatly improve the ability of small businesses to reorganize under the Bankruptcy Code.

When enacted in 2020, Congress set a debt limit of $2,725,625 for a small business to be eligible to file a Subchapter V bankruptcy petition. This limited eligibility for many small businesses, especially in high-cost states. On March 27, 2020, Congress, as part of the CARES Act, increased the debt limit for Subchapter V bankruptcy to $7.5 million, with a one- year sunset provision (meaning that the debt limit would be reduced back to the original amount after one year). In 2021, Congress extended the sunset provision, to March 27, 2022. On March 28, 2022, the debt limit reverted back to the prior $2,725,625 limit.

Under S.3832, the SBRA debt limit is again increased to $7.5 million. The language in the bill intends to make this increase retroactive to March 27, 2020, the day it was originally increased, and covers any gap period between the date it reverted back to the original amount and the date the bill is signed into law. However, the bill contains another sunset provision, and the debt limit increase again reverts to the original $2,725,625 limit two years from the date the bill is signed into law. This means that the increased debt limit will again need to be extended or a new bill will need to be signed into law by June 21, 2024 if it is to be made permanent.

The law clarifies that privately held corporations are eligible for Subchapter V bankruptcy:

Current law provides that a debtor is not eligible for Subchapter V bankruptcy if the debtor is “an affiliate of an issuer (as defined in section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c)).” 11 U.S.C. § 101(51)(D)(B)(iii). This language led to uncertainty if a privately held corporation, which could be deemed an affiliate of an issuer, was eligible for Subchapter V bankruptcy relief. Under S.3823, this language is revised to clarify that only affiliates of a publicly held corporation are not eligible for SBRA bankruptcy. Thus, a privately held corporation and its affiliates may file for Subchapter V bankruptcy relief.

The law increases the Chapter 13 Bankruptcy debt limit to $2,750,000:

Current law limits eligibility for Chapter 13 bankruptcy, which is designed to allow individuals to efficiently restructure their debts through a payment plan in a cost-effective process, to individuals with less than $419,275 in unsecured debts and $1,257,850 in secured debts. Individuals over this limit seeking to restructure their debts are required to file Chapter 11 cases, which can be prohibitively expensive and time consuming.

This limit has now permanently been increased to an aggregate debt limit of both secured and unsecured debt in the amount of $2.75 million. This new limit will likely increase the number of individuals eligible for Chapter 13 relief, especially in high-cost states, and thus will likely also lead to an increase in Chapter 13 bankruptcy filings.

This article was written by Bernard Kornberg, partner at Practus, LLP (Bernard.Kornberg@practus.com).

UPDATE: At midnight on March 27, 2022, certain provisions of the CARES Act expired. Importantly for insolvency practitioners, the subchapter V debt limit of $7,500,000 reverted to the lower original amount of $2,725,625. It appears that Congress is working to reinstate the higher debt limit and at least one bill has been proposed (S. 3823) and passed by the Senate on April 8, 2022, reinstating the $7,500,000 debt limit and adding language to make it effective retroactively, but with a two year expiration date. However, the status of this bill or any other efforts by Congress to increase the subchapter V debt limit remains unclear.

 

 

April 20, 2022

Dear constituency list members of the Insolvency Law Committee:

The following is a case update written by Wendy W. Smith, a partner in Binder & Malter, LLP, analyzing a recent decision of interest:

SUMMARY
On December 16, 2021, Judge Colleen McMahon of the United States District Court, Southern District of New York, vacated the order confirming Purdue Pharma’s Chapter 11 plan of re-organization, holding that the bankruptcy court had no power to impose a non-consensual release by third parties of their direct claims against non-debtors. In re Purdue Pharma, L.P., 2021 WL 242236 (S.D.N.Y 2021). The non-debtors here included all of the Sackler family, owners of Purdue Pharma, who were to be released from virtually all non-criminal claims related to the companies and their primary product–OxyContin. In exchange for that release and the related injunctions (the “Shareholders Release”), the Sackers were to pay over $4.275 billion into the plan of reorganization.

To view the opinion, click here.

On first review, the opinion might appear as having limited impact outside the Second Circuit. But many of Judge McMahon’s arguments can apply to any situation where a bankruptcy court exercises authority that is not specifically described in the Bankruptcy Code, particularly to enjoin third parties from suing non-debtors.

FACTUAL BACKGROUND
The Sackler Family’s Role in Purdue Pharma and the OxyContin Litigation.

From the opening of her opinion, Judge McMahon reveals her sensitivity to the underlying issue driving the case—the catastrophic impact of the opioid crisis in America—and that her ruling will most likely result in undoing the Sackler’s funding of the proposed plan and its programs to address opioid addiction. (p. 137) Although the opinion rules only on matters of law, as no finding of fact was appealed, Judge McMahon repeatedly returns to the extreme circumstances of the case to color her legal analysis.

To provide that context, Judge McMahon devotes the first half of the opinion to the facts. She begins with the history of Purdue Pharma and its development and marketing of OxyContin, which has been blamed in large part for fueling the opioid crisis. Judge McMahon describes that before Purdue’s bankruptcy, OxyContin accounted for more than 90% of the company’s U.S. revenue. The Sackler family, which owns the companies, is described as being “long ranked on Forbes’ List of America’s Richest Families,” with a reported net worth in 2015 of $14 billion. (p.11) Judge McMahon states that the Sackler family controlled the operation of the Purdue companies until just before the bankruptcy filing.

The core of Judge McMahon’s factual description is Purdue’s aggressive, and allegedly deceptive, marketing of OxyContin for over 20 years and the resulting litigation with both governments and individuals. Most of the litigation claimed in part that Purdue’s actions caused the over-prescription of OxyContin, leading to addiction, which then resulted in addicted patients turning to street drugs when prescriptions were no longer available.

In 2007 Purdue settled litigation with 26 states, agreeing to pay $19 million and to implement an extensive program to limit OxyContin abuse. (p.21). Purdue was not required to stop the production or sale of OxyContin, however, which it continued. Litigation also continued. When the resulting discovery revealed that individual members of the Sackler family were involved with Purdue’s OxyContin marketing efforts, those individuals were added to the actions. [1]

After the 2007 settlement agreement, the Sacklers began taking substantially greater distributions of revenue from Purdue, which “substantively depleted Purdue’s treasury.” (p.37) Judge McMahon describes this as part of a greater plan by the Sacklers to first remove value from the companies and then use bankruptcy to obtain third-party releases in exchange for funding a bankruptcy settlement. The goal was “to secure for the Sacklers a release from any liability for past and even future opioid-related litigation, without having to pursue personal bankruptcy.” (p.43).

The Purdue companies filed their bankruptcy on September 15, 2019, and quickly obtained an injunction halting over 400 civil suits against the Sackler family.

The Plan and Shareholder Release

Judge McMahon acknowledges the extraordinary efforts of all of the parties to negotiate a plan, including mediators described by Judge McMahon as “the most experienced and respected mediators in the country.” (p. 47) .The opinion describes the plan in detail.

The Shareholders Release was a key element. In exchange for the Sackler’s $4.275 billion contribution, the plan released “third-party claims against over 1000 individuals and entities related to the Sackler family.” (p.55) The release included “claims that third parties have asserted or might assert in the future against the shareholder released parties,” and that were based on or related to the debtors or their bankruptcies. (p. 56) The release was further limited to claims where the “conduct, omission or liability of any Debtor or any Estate is the legal cause or is otherwise a legally relevant factor.” (p. 56) The Shareholders Release was non-consensual; all current and potential claims connected with OxyContin and other opioids would be covered.

Judge McMahon notes that the non-derivative claims against the released parties were “effectively being extinguished for nothing.” (p. 56) The plan prohibited “value being paid based on causes of action (whether pre-or post-petition) against the Sackler family or other non-debtor for opioid-related claims.” (p.56)

The critical element of these released claims is that they must be claims directly against the released parties arising from an independent duty to the claimant, and not derivative of any claim by or against the debtor.

Confirmation

Judge McMahon describes the bankruptcy judge’s opinion confirming the plan as a “judicial tour de force” delivered only days after a lengthy trial, and addressing “every conceivable legal argument in great detail.” (p.58)

The bankruptcy court’s opinion noted that the voting creditors overwhelmingly supported the plan. Of approximately 120,000 votes cast, “an amount far exceeding the voting in any other bankruptcy case” over 95% of those voting favored the plan. (p.62) It also observed that the failure to approve the settlement and confirmation would result in complex litigation and likely with the liquidation of the case and abandonment of the proposed $4.275 billion contribution by the Sacklers.

Judge McMahon briefly summarizes the various legal issues addressed by the bankruptcy court’s opinion, and then focuses on its justification for the third-party non-consensual releases. For its authority to grant the Shareholders Release, the bankruptcy court relied on the concept of its “necessary or appropriate” power to take actions under Section 105(a), combined with the authority in Section 1123(b)(6) to “include any other appropriate provision [in a plan] not inconsistent with the applicable provisions of this title.” (p. 68) The bankruptcy court also justified the grant of the Shareholders Release based on the “rare” and “unique” character of the case. (p.70)

As described below, Judge McMahon rejects these justifications.

[1] While mentioned only briefly in the opinion, it is important to note that the individual Sacklers have at all times denied any wrongdoing

REASONING
Bankruptcy court did not have jurisdiction to enter a final order on confirmation containing the Shareholders Release.

In the context of addressing the standard of review on appeal, Judge McMahon observes that the Shareholders Release would have permanently resolved certain independent claims against the Sackler family. Because the claims did not stem from the bankruptcy itself, and would not be resolved in the claims-allowance process, the only jurisdiction held by the bankruptcy court over them was “related to” the bankruptcy under 28 U.S.C. Section 157(a), as “non-core.”

Applying the Supreme Court ruling of Stern v. Marshall, 564 U.S. 462 (2011), Judge McMahon concludes that that a non-consensual release by a third party of a claim against a non-debtor that is part of a reorganization plan determines the claim with the same finality as it would if adjudicated at trial. Judge McMahon thus holds that the bankruptcy judge did not have jurisdiction to enter a final order confirming a plan which included such third-party release. Rather, the bankruptcy court should have tendered the proposed findings of fact and conclusions of law to the District Court for approval.

Bankruptcy court had subject matter jurisdiction under the Second Circuit case-law

The appellants challenged whether the bankruptcy court’s “related to” jurisdiction included the ability to grant the challenged Shareholders Release. Judge McMahon concludes that in the Second Circuit the only question a court need ask is whether the action’s outcome might have any conceivable effect on the bankruptcy estate. If the answer is yes, then “related to” jurisdiction exists, no matter how improbable it might be that the actions actually will have an effect on the estate. (p.85)

Judge McMahon held that the bankruptcy court had “related to” jurisdiction because claims against the Sackler family could have resulted in indemnification claims against Purdue and that such claims could have impacted the bankruptcy estate.

No bankruptcy statute either prohibits such releases or grants authority to issue them

Judge McMahon opens her discussion by expressing frustration with the Second Circuit for failing to provide guidance on this critical issue. She explains that, though the Bankruptcy Code has no prohibition against these releases, it also has no statute giving bankruptcy courts the authority to grant them. Judge McMahon analyzes each of the sections on which the bankruptcy court relied and finds they are insufficient to grant such authority. Finally, she explains that there is no “residual authority” or general equitable power of the bankruptcy court that can cure the lack of specific statutory authority in the Bankruptcy Code.

Judge McMahon initially dispenses with the appellants’ argument that Section 524(e) essentially prohibits the Shareholders Release. This section provides that the discharge of a debt in bankruptcy does not affect the liability of another for the same debt. Judge McMahon explains that this section does not prohibit a bankruptcy court from issuing an injunction, but addresses only the automatic effect of a discharge. Also, the section is limited to claims that are discharged in bankruptcy for which a third-party is also liable. It does not affect independent claims of third-parties against non-debtors–the type of claim included in the Shareholders Release.

The only sections in the Bankruptcy Code that specifically address third-party releases are Sections 524(g) and (h) regarding the release of third-party claims in asbestos cases. The sections were enacted after the first of several opinions in the case of Johns Manville, the nation’s leading asbestos manufacturers. MacArthur Co. V. Johns-Manville Corp. (In re Johns-Manville Corp.), 837 F.2d 89 (2nd Cir. 1988) (“Manville I”).

In Manville I, the Second Circuit affirmed the bankruptcy court’s entry of a permanent injunction against suing Manville’s insurance carriers, which had contributed the proceeds of their policies to the plan. Judge McMahon explains Sections 524(g) and (h) in detail, emphasizing that they applied to asbestos cases only. Judge McMahon argues that the limitation is evident both from the text of the statues as well as their legislative history, which expressly states that Congress was not acting regarding other industries (p. 100) Because of the limited scope of the asbestos statutes, Judge McMahon concludes that they cannot be read to imply authority to grant non-debtor releases in other types of cases.

The other Bankruptcy Code sections on which the bankruptcy court relied were Section 105(a), which provides general authority to make orders that are “necessary or appropriate to carry out the provisions of the code,” and three sections related to chapter 11 plans—Sections 1123(b)(5) and (b)(6), and 1129. The bankruptcy judge stated that the sections, along with his “residual authority,” gave him authority to approve the Shareholders Release. Judge McMahon rejects this position, holding that each of the sections “confers on the bankruptcy court only the power to enter orders that carry out other, substantive, provisions of the bankruptcy code.” (p.120)

Early in her opinion, Judge McMahon explains in detail that notwithstanding the general language of Section 105(a) it does not grant any general equitable authority. Relying on the Supreme Court opinions of Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1988) and Law v. Siegel, 571 U.S. 415 (2014), as well as several cases in the Second Circuit, Judge McMahon notes that a “bankruptcy court lacks the power to award relief that varies or exceeds the protections contained in the Bankruptcy Code — not even in rare cases, and not even when those orders would help facilitate a particular reorganization.” (p. 101)

The sections related to chapter 11 particularly do not expand that authority. Section 1123(b)(6) describes the possible contents of a plan of reorganization and provides that it may “include any other appropriate provision not inconsistent with the applicable provisions of this title.” Judge McMahon notes that the section is substantially similar to Section 105(a) and concludes that if general authority of Section 105(a) does not allow a bankruptcy court to grant relief beyond specific terms of the Bankruptcy Code, neither does Section 1123(b)(6).

An even more general section relied on by the bankruptcy court is Section 1129(a)(1), which provides that a bankruptcy court “shall confirm a plan only if… the plan complies with the applicable provisions of this title.” Judge McMahon holds that, like Section 1123(b)(6), the section does not grant any substantive authority that could support approving this type of third-party release.

Last, Section 1123(a)(5), also relied on by the bankruptcy court, gives no greater authority. This section provides that a plan must provide adequate means for its implementation. The plan proponents argued that the only way for the debtors to obtain the funds to implement the plan was to grant the Sacklers the Shareholders Release in exchange for the money that the Sacklers were to contribute. This requirement, they argued, meant that the releases were authorized by Section 1123(a)(5) as necessary for the plan’s implementation.

Judge McMahon rejects the argument for a range of reasons, including that Section 1123(a)(5) does not authorize a court to approve such releases “simply because doing so would ensure the funding of a plan.” (p.126) She states that “the fact that Purdue needs the Sacklers to give the money back does not mean that Section1123(a)(5) confers on the Debtors or the Sacklers any right to have the non-debtors receive a release” in exchange for the contribution. (p. 125)

Silence of the Bankruptcy Code does not grant the needed authority.

Judge McMahon rejects the argument that because this type of release is not prohibited it must be permitted. First, she notes that to assume authority from silence is inconsistent with the “comprehensive federal system … to govern the orderly conduct of debtors affairs and creditors rights.” (p. 127) Second, she notes that the type of release being requested includes relieving non-debtors of the types of claims –here for fraud and willful misconduct — that could not be discharged in their own bankruptcies and thus are entirely inconsistent with the Bankruptcy Code. Third, she refers again to Sections 524(g) and (h), which were enacted to allow third-party releases only in asbestos cases, even when there were other mass tort cases pending at the time. Judge McMahon notes that Congress made a conscious decision to exclude other industries, and that its “27 years of unbroken silence” since then “speaks volumes” to Congress’s disinclination to expand the statute.
(p. 129)

Judge McMahon’s review of case law and split in the circuits does not change her analysis.

Judge McMahon reviews the split in the Circuits regarding whether statutory authority exists to grant this type of release. She notes that the Fifth, Ninth and Tenth Circuits reject that bankruptcy court can authorize non-debtor releases outside of the asbestos context, based on Section 524(e). (As noted below, the Ninth Circuit has recently reopened this discussion in its opinion in in re Blixseth v. Credit Suisse, 961 F.3d 1074 (9th Cir. 2020).) She then comments that the remaining Circuits, including the Second, either have not identified any statute that grants such authority other than Sections 105(a) and 1123(b)(6) – which she rejects as inadequate—or have not opined on the issue.

Judge McMahon closes her discussion with an acknowledgment that the result of her invalidating the Shareholders Release will likely be the liquidation of the case and the loss of funding for “desperately need programs to counter opioid addiction.” She notes that, notwithstanding the bankruptcy court’s good intentions, its ability to grant relief to a non-debtor from non-derivative third-party claims could have only been exercised within the confines of the Bankruptcy Code. Because she finds that the Bankruptcy Code “confers no such authority” she holds she must vacate the order confirming the Purdue plan. (p. 137)

AUTHOR’S COMMENT
The primary takeaway from the opinion is that the mechanism of the Bankruptcy Code cannot accommodate every solution to the challenges facing a debtor and its creditors. Here, it is evident that the huge number of stakeholders in the process, and ultimately the bankruptcy court, became vested in trying to provide substantial relief–with the Sacklers’ payment–for the desperate circumstances caused by the opioid crisis. If anything, the Shareholders Release evidences the great forces driving the settlement and plan process. It released over 1,000 people and entities and included claims for fraud and willful misconduct, whether existing or brought in the future–terms that would have been rejected in any other context as overreaching.

Judge McMahon’s opinion provides powerful defenses against such excesses. First and foremost, she reaffirms that any authority of the bankruptcy court must be solidly bound to the Bankruptcy Code itself. While many cases recognize this limitation when applying Section 105(a), Judge McMahon applies it with equal force on all of the other general sections relied on by the bankruptcy court for its claim of “residual authority.”

Until recently, in the Ninth Circuit such third-party releases were not allowed at all on the basis that they were contrary to Section 524(e). In re Blixseth v. Credit Suisse 961 F.3d 1074 9th Cir. 2020) modified that rule and reopened the possibility of including such releases in a chapter 11 plan. In Blixseth, the court considered an exculpation clause in a Chapter 11 plan that released Credit Suisse, a creditor, for liability for post-petition actions “in connection with” among other things, negotiating the plan. The released claims did not include claims derived from the debtor. The court held that, contrary to prior understanding, Section 524(e) did not prohibit such third-party releases, for the same reasons described by Judge McMahon. While the releases in Bixseth included only negligence claims and were narrow in time and the number of parties, substantively, they covered the character of independent claims included in Purdue. The court in Blixseth allowed the releases. It found that both Section105(a) and Section 1123 provided the bankruptcy court with authority to impose such releases on a non-debtor, and that it was justified by the need to limit litigation and “so render the plan viable.” Supra, at p.1085. But, according to Judge McMahon, the referenced sections do not grant such authority, and “plan viability” does not justify granting a third-party release.

What is left open is whether any non-consensual third-party release of non-derivative claims against non-debtors can be approved even when it is limited to negligence claims against specific parties. Under this opinion, the answer is no, since there is no specific statute authorizing it, and neither “residual authority” nor “plan viability” will suffice.

Given the discussion and holdings in Purdue, and the recent 9th Circuit’s opinion in In re Blixseth v. Credit Suisse, the ruling on the likely Purdue appeal will be one to watch.

This review was written by Wendy W. Smith, a partner in Binder & Malter, LLP and a member of the ad hoc group. Editorial contributions were provided by Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., ret.), also a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.

 

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Insolvency Law Committee

Co-Chair
Christopher D. Hughes
Nossaman LLP
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Co-Chair
Cathy Ta
Reorg Research, Inc.
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Kit J. Gardner
Law Offices of Kit J. Gardner
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Aaron E. de Leest
Danning, Gill, Israel & Krasnoff LLP
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