With bankruptcy courts' extraordinary power comes great responsibility - and some negative publicity

The recent high profile bankruptcy cases of Purdue Pharma, L.P., and LTL Management, LLC, aka Johnson & Johnson, demonstrate the extraordinary equitable power of bankruptcy courts to address a wide array of problems facing financially distressed companies. The cases have generated headlines due to the two somewhat controversial legal remedies employed by the companies in response to the mass tort litigation facing each, "third party releases" and the "Texas Two-Step."

The goal of a debtor in a chapter 11 bankruptcy case is to obtain the court's approval of a plan of reorganization, setting forth the repayment terms for the debtor's prebankruptcy debts and the amount that must be paid. Approval of a plan coupled with the discharge provided in the Bankruptcy Code prevents creditors from pursuing the debtor, or its assets, to collect their debts after bankruptcy. Instead, creditors are limited to the relief in the approved plan. Creditors are, however, permitted to pursue any co-obligors or guarantors of the debtor's debts. Purdue sought to confirm a plan of reorganization containing releases benefitting non-debtor third parties, the Sacklers, in exchange for a $4.325 billion settlement payment. In bankruptcy parlance, "third party releases" release direct (i.e., not derivative) claims of the debtor's creditors against third parties who are not the debtor and without the consent of such creditors. Creditors and debtors dispute the extent to which a bankruptcy court has the power and the jurisdiction to approve plans containing such releases, and the answer may depend upon the Circuit in which the case is pending.

Putting aside the legal minutia, proponents of third party releases argue that bankruptcy courts, as courts of equity, need the ability to approve third party releases to address truly extraordinary circumstances like those that the Purdue case presents. The creditors will benefit from the billions being contributed by the Sacklers and there is no question that the Sacklers would not part with such substantial sums without the releases provided in Purdue's plan. To opponents of third party releases, it's simple: bankruptcy involves benefits and burdens. Third party releases extend the extraordinary benefits of bankruptcy to non-debtor third parties who have not run the gauntlet of its burdens. From a legal perspective, one key question is whether the bankruptcy court has the broad power to approve plan provisions that are neither expressly authorized nor expressly prohibited by the Bankruptcy Code.

The bankruptcy court confirmed Purdue's plan and the district court, sitting as an appellate court, reversed, holding that the bankruptcy court exceeded its jurisdiction and statutory authority. This reversal created leverage. On remand and after further negotiations, the Sacklers increased the settlement payment to at least $5.5 billion, which garnered more creditor support, but did not resolve all opposition to the plan. The case is currently pending with the Second Circuit Court of Appeals. Arguably, the Johnson & Johnson bankruptcy raises an even more controversial issue than Purdue. Johnson & Johnson did not file for bankruptcy protection. It engaged in a divisional merger under Texas law, a process known as the "Texas-Two Step." A divisional merger permits a company to split into two; one company is saddled with certain of the predecessor's liabilities (like all of its tort liability) and the other receives the lion's share of its assets and operations. Then, only the debt-laden newco files for bankruptcy protection, and does so mere hours after its creation. The solvent, asset rich company continues operations unfettered outside of bankruptcy. The Johnson & Johnson related debtor that filed for bankruptcy was the company that assumed Johnson & Johnson's talc-related liabilities. Another hallmark of the divisional merger- bankruptcy combination is the "funding agreement" by which the asset-rich non-debtor company commits to fund the debtor's plan to repay creditors provided certain conditions are satisfied (like obtaining releases benefitting the non-debtor).

Johnson & Johnson's talc claimants filed a motion to dismiss the bankruptcy case, arguing that its existence is an abuse of the bankruptcy system. This position is certainly understandable. The debtor has no assets, no operations, no business to reorganize, and all value resides with the non-debtor company. The debtor countered that the bankruptcy is meant to accomplish an equitable resolution for all claimants and the divisional merger will help maximize the value that claimants ultimately receive via the funding agreement. The bankruptcy court denied the motion to dismiss. The bankruptcy court discussed the extraordinary litigation facing the debtor's predecessor; nearly 40,000 pending tort claims as of the bankruptcy filing, and thousands of additional tort claims expected annually for decades. The bankruptcy court also expressed its strong conviction that bankruptcy is the optimal, and perhaps only, venue (as opposed to class action or multi-district litigation) to address the harms to present and future victims.

The availability of these substantive remedies in some Circuits and not others raises another noteworthy issue: venue. Many companies, even those with robust California operations, will file in other states. Bankruptcy's venue rules are flexible, permitting a company to file where it, or an affiliate, is incorporated. As a result, certain districts, or divisions within those districts, receive the overwhelming majority of "mega" bankruptcy cases. In fact, in a recent decision overturning another plan providing for third party releases, a district court in the Eastern District of Virginia openly questioned whether the district's recurrent practice of approving third party releases led to the debtors filing there instead of their many other potential options. The gap between the Ninth Circuit and other circuits (at least on some issues) may be narrowing. The availability of third party releases has been thrown into question in some Circuits once thought a given. Historically, the Ninth Circuit has made clear that non-consensual releases of creditor claims against non-debtor third parties (like those in Purdue) violate the Bankruptcy Code.

However, more recently, in a 2020 decision, the Ninth Circuit limited the scope of the broad language it used in its prior decisions prohibiting all third party releases. The Ninth Circuit also seemed to recognize the authority of bankruptcy courts to approve plans containing appropriate provisions that are not otherwise expressly prohibited by the Bankruptcy Code. The Ninth Circuit upheld a plan with releases that are much more limited and far less controversial than those at issue in Purdue, but its rationale could be read as an expansion of its precedent on the subject.

In the wake of Purdue and LTM, there has been a push to curb the perceived abuse of the bankruptcy system. Sure, closing certain venue loopholes and some consistency across the Circuits could be good. There are, no doubt, bankruptcy filings that warrant scrutiny or criticism. The safeguard is the bankruptcy court. Bankruptcy courts have broad equitable powers and many tools to address any abuse and protect claimants. Courts can dismiss cases, appoint trustees, deny confirmation of plans, transfer venue (as happened in the LTM bankruptcy), and/or order extraordinary discovery. As an example of the latter, in Purdue, the bankruptcy court required that the Sacklers provide discovery beyond the already extensive discovery expected of debtors in bankruptcy.

Bankruptcy provides a unique, central forum designed to address many divergent interests and the goal is to reach a consensual resolution. The initial plan in Purdue garnered acceptance by over 95% of the creditor body, and the increased sum by the Sacklers resolved further opposition. It is hard to imagine any other mechanism available to resolve mass tort liability achieving a similar result.

Robert S. Marticello is a founding partner of Smiley Wang‑Ekvall, LLP.