In the June 2004 Journal, we addressed several significant issues pending before the Third Circuit from the order confirming the pre-packaged bankruptcy plan of Combustion Engineering Inc. (CE).³ This plan would have allowed CE and, more importantly, its American parent company, Asea Brown Boveri Inc. (US ABB), ultimate Swiss parent ABB Ltd. (ABB), and corporate affiliates ABB Lummus Global Inc. (Lummus) and Basic Inc. to obtain a channeling injunction under 11 U.S.C. §524(g), forever protecting them from future asbestos-related liabilities. But apparently it is not to be.

In its opinion vacating the district court's order and remanding the case for further proceedings, the Third Circuit announced that asbestos-channeling injunction protection is available only to non-debtor affiliates complying strictly with the letter of §524(g)'s requirements.⁴ Moreover, the court provided guidance, albeit in dicta, concerning a number of other aspects of §524(g), of great import both to parties involved in pre-packaged asbestos bankruptcy cases and to those interested in conventional asbestos bankruptcy cases pending within that circuit and, perhaps, elsewhere.⁵

The Lower Court Proceedings

At the heart of CE's pre-packaged plan was ABB's attempt to obtain for itself and its U.S. subsidiaries, through CE's bankruptcy filing, the benefits of the discharge provisions and channeling injunction available under §524(g). To that end, CE and ABB agreed to establish a pre-petition settlement trust (CE Settlement Trust) to resolve current asbestos claims filed against all of these companies. The CE Settlement Trust divided these claims into several categories based on whether the claim had been settled and the status of the settlement, but not based on the severity of the claimant's injury. Each CE Settlement Trust claimant was paid pre-petition on a specified portion of his or her claim and was left with an unsecured "stub" claim that was impaired under CE's plan, thus enabling the claimant to vote on the plan.

Significantly, the plan also proposed to relieve CE's non-debtor affiliates Lummus and Basic not only from asbestos liabilities derivative of CE's liabilities, but also from their own independent asbestos liabilities, by channeling those liabilities to CE's §524(g), post-confirmation bankruptcy trust (Asbestos PI Trust).⁶ CE claimed that the release of Lummus and Basic from their respective non-derivative asbestos liabilities was essential to the plan because CE's restructuring, and ABB's funding of the plan, was contingent upon the sale of Lummus free and clear of asbestos liabilities.⁷

Initially, the bankruptcy court approved the disclosure statement but withheld confirmation of the plan until the district court decided certain non-core issues arising under §524(g).⁸ Several insurers filed confirmation objections, some arguing that the plan impaired their rights and that they were therefore entitled to vote on the plan. Certain Cancer Claimants⁹ also objected to confirmation, arguing, inter alia, that the funding of the CE Settlement Trust constituted preferential treatment to the pre-petition settling claimants, contrary to the requirement that all similarly situated claimants be treated similarly under the plan.

The bankruptcy court held that §524(g)(4)(A)(ii) "did not permit the inclusion of independent claims against non-debtors Lummus and Basic in the channeling injunction,"¹⁰ but concluded it had supplemental authority under §105(a) of the Bankruptcy Code to enjoin third party claims against Lummus and Basic. The bankruptcy court acknowledged "it was critical...that Lummus and Basic be included in the §524(g) injunction"¹¹ and held that the plan satisfied the provisions of §§1129(a) and 524(g) because "< i>as a practical matter, the plan offered the only feasible mechanism for ensuring Combustion Engineering's creditors would receive any recovery."¹² Following the district court's confirmation of the plan, certain objecting insurers and the Certain Cancer Claimants appealed.

The Third Circuit's Opinion

The insurers and Certain Cancer Claimants raised three primary issues on their appeals with respect to §524(g): (1) whether the bankruptcy court had "related to" jurisdiction over the non-derivative asbestos claims against Lummus and Basic (and could therefore issue a channeling injunction with respect to such claims pursuant to §105(a)); (2) whether a non-debtor that contributes assets to a §524(g) trust can "cleanse itself" of non-derivative asbestos liabilities; and (3) whether the "two-trust" structure of CE's plan and the voting on the plan by those asbestos personal-injury claimants holding "stub" claims (who were paid a substantial portion of their respective claims pre-petition and apparently received a larger recovery than other asbestos claimants) complied with the Bankruptcy Code.¹³

As to the first issue, the Third Circuit held that the bankruptcy court did not have "related to" jurisdiction to issue a channeling injunction in favor of Lummus and Basic. Citing the seminal case on "related to" jurisdiction, Pacor v. Higgins, 743 F.2d 984 (3d Cir. 1984), the court found that a debtor cannot create jurisdiction through the structure of a plan: "[a]lthough ABB Limited's contributions to the Asbestos PI Trust may depend on freeing Lummus and Basic of asbestos liability, and these contributions may inure to the benefit of certain Combustion Engineering asbestos claimants, these factors alone do not provide a sufficient basis for exercising subject matter jurisdiction."¹⁴ The court further found that a "corporate affiliation between lateral, peer companies in a holding-company structure, without more, cannot provide a sufficient basis for exercising federal subject-matter jurisdiction."¹⁵ The court left open the issue (although it stated it was "doubtful") of whether shared insurance among and between CE, Lummus and Basic would be sufficient to extend jurisdiction over non-derivative claims against Lummus and Basic.¹⁶

Most importantly, the Third Circuit found that because express conditions of §524(g) had not been met, the bankruptcy court had no authority under §105(a) to issue a channeling injunction in favor of Lummus and Basic. Although it recognized that other courts had relied on §105(a) as authority for enjoining and channeling tort claims to a trust,¹⁷ the Third Circuit held that "[b]ecause §524(g) expressly contemplates the inclusion of third parties' liability within the scope of a channeling injunction—and sets out the specific requirements that must be met in order to permit inclusion—the general powers of §105(a) cannot be used to achieve a result not contemplated by the more specific provisions of §524(g)."18 The court emphasized that the plain language of §524(g)(4)(A) prohibited the extension of the channeling injunction to Lummus and Basic because "§524(g) provides no specific authority to extend a channeling injunction to include third-party actions against non-debtors where the liability alleged is not derivative of the debtor."¹⁹ The court implied that non-debtors may not obtain channeling injunction relief for their non-debtor derivative asbestos liabilities without themselves "enduring the rigors of bankruptcy."²⁰

The Third Circuit agreed with the Certain Cancer Claimants that the plan appeared to impermissibly favor the pre-petition CE Settlement Trust claimants over the post-confirmation Asbestos PI Trust claimants because the former would receive greater payments for their claims than the latter. It determined that not only would the CE Settlement Trust claimants receive more than would be available to them in a chapter 7 liquidation of CE, but that the pre-petition transfer of assets and funds to the CE Settlement Trust might constitute voidable preferences.²¹ The court found that the pre-petition settlements and the post-petition §524(g) trust should be viewed as the whole of the pre-packaged plan, and that when so viewed, "non-parties to the pre-petition settlement appear to receive a demonstrably unequal share of the limited Combustion Engineering fund."²² The court therefore remanded two issues for further findings: whether the plan provided for inappropriately disparate treatment (1) between present and future asbestos claimants, and (2) between malignant and non-malignant claimants.²³

According to the Certain Cancer Claimants, CE had created the "stub" claims in order to artificially impair the CE Settlement Trust claims and consequently gerrymander votes in favor of the plan. The Third Circuit noted that "[t]he chief concern with such conduct is that it potentially allows a debtor to manipulate the chapter 11 confirmation process by engineering literal compliance with the Code while avoiding opposition to reorganization by truly impaired creditors."²⁴ The court stated that although not expressly prohibited by statute, "courts have found this practice troubling [and], [i]n the context of this asbestos-related bankruptcy, so do we."²⁵

The Third Circuit was further troubled that the lower courts did not consider the potential conflict between the CE Settlement Trust claimants and the Asbestos PI Trust claimants:

Combustion Engineering made a pre-petition side arrangement with a privileged group of asbestos claimants, who as a consequence represented a voting majority despite holding, in many cases, only slightly impaired "stub claims." On the facts here, the monitoring function of §1129(a)(10) may have been significantly weakened. This type of manipulation is especially problematic in the asbestos context, where a voting majority can be made to consist of non-malignant claimants whose interests may be adverse to those of claimants with more severe injuries."²⁶

As the court observed, not only did the pre-petition settling claimants, who received much more than those claimants who did not settle, have "little incentive to scrutinize the terms of the proposed plan...their incentive appears to have been otherwise, given that the favorable pre-petition settlements were conditioned, at least implicitly, on a subsequent vote in favor of the plan."²⁷ The court remanded this issue of "artificial impairment" to the lower court.²⁸ Finally, the court noted due process concerns in the plan's structure because neither the future claimants nor the non-participating claimants were represented when the CE Settlement Trust was established.²⁹

The Third Circuit also remanded for further consideration the question of whether CE violated the requirement of 11 U.S.C. §1129(a)(3) that the plan be proposed in good faith. The lower courts found that the plan was proposed in good faith because it was intended to pay asbestos liabilities, but the Third Circuit remanded in light of its findings concerning the "two-trust" structure and the certain cancer claimants' contention that the purpose of this structure was to gerrymander the vote on the plan at the expense of the future and non-participating claimants.³⁰

Implications

One issue raised by the court (albeit in dicta) but not decided may have important implications in this and other asbestos bankruptcy cases. As noted by the court, "[i]n theory, a debtor emerging from a chapter 11 reorganization as a going-concern cleansed of asbestos liability will provide the asbestos personal injury trust with an 'evergreen' source of funding to pay future claims... To achieve this relief, a debtor must satisfy the prerequisites set forth in §524(g)...."³¹ On appeal, certain insurers questioned whether CE's plan complied with the "evergreen" provisions of §524(g), which requires asbestos personal injury trusts to be "funded in whole or in part by the securities of one or more debtors involved in such plan and by the obligation of such debtor or debtors to make future payments, including dividends."³² The court did not rule on the issue, finding that the insurers' limited standing prevented
the court's consideration of §524(g)'s "evergreen" provision. In CE's case, the lower courts recognized that post-emergence, CE would only have a "continuing real estate business" but nevertheless held that such business would satisfy §524(g)'s evergreen provisions.³³ The Third Circuit noted that CE's post-emergence business operations would be at most "minimal" and that CE (as opposed to its parents) may have been unable to fund the Asbestos PI Trust. However, having concluded that the plan failed on other grounds and because the only party with standing to bring such an objection, the Certain Cancer Claimants, failed to raise the issue, the court declined to evaluate whether CE was in a position to provide ongoing "evergreen" funding to the Asbestos PI Trust post-emergence.³⁴

Beyond this, the actual holdings of the Third Circuit were narrow. Technically, the court vacated the confirmation order because it found that the §105(a) injunction in favor of Lummus and Basic for their non-derivative asbestos liabilities was unlawful. However, the court expressly held out the possibility that other pre-packaged bankruptcy plans might be able to satisfy the requirements of §524(g) and otherwise be confirmable under the Code.35 Yet the court's disdain for the "two-trust" structure of this pre-packaged plan is apparent. The opinion seems quite explicit in holding that §524(g) is the exclusive remedy for those seeking to benefit from channeling injunctions for asbestos claims, and that bankruptcy plans, pre-packaged or not, must comply with each of the specific requirements of §524(g). It follows from the court's reasoning that §105(a) cannot be used to trump the requirements of §524(g), even if it may facilitate a debtor's reorganization. Therefore, as provided for by the express language of the statute, non-debtors' liabilities for asbestos claims cannot be channeled to a trust unless such liabilities are derivative of claims against the debtors.

The Third Circuit's decision also seems to be the death knell for the use of "stub" claims in asbestos pre-packs, at least to the extent that pre-petition settling claimants receive disparate treatment as compared to future and non-participating claimants. Companies attempting a pre-pack will need to keep in mind the Bankruptcy Code's policy favoring "equality among creditors" and the requirement of good faith, both of which are plainly satisfied by providing substantially similar recoveries to all asbestos claimants with substantially similar injuries, without regard to whether they resolved their claim as part of a pre-petition settlement trust or post-petition. At a minimum, debtors should ensure that claimants similar to CE's Asbestos PI Trust claimants, both present and future, are adequately represented at the pre-petition stages of the pre-packaged bankruptcy plan.

In light of the many asbestos bankruptcies pending in the Third Circuit, the court's decision in Combustion Engineering is likely not the last word this court will have concerning §524(g). In any event, as the court's first pronouncement of its interpretation of §524(g), the decision provides some guideposts for future parties to follow in crafting reorganization plans seeking the protections provided by the statute.

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Footnotes

¹ James Gutierrez, an associate in the Financial Restructuring Practice Group of Stroock & Stroock & Lavan LLP, assisted in the preparation of this article. Return to article

² Stroock is counsel to the Official Committee of Unsecured Creditors in In re USG, No. 01-2094 (Bankr. D. Del.) (JKF), and In re W.R. Grace, No. 01-01139 (Bankr. D. Del.) (JKF), and represents certain bondholders in In re Owens Corning, No. 00-03837 (Bankr. D. Del.) (JKF), all of which are asbestos bankruptcy cases pending within the Third Circuit. Return to article

³ See Pasquale, Kenneth, "Combustion Engineering: Can a Pre-packaged Bankruptcy Plan Satisfy §524(g)?," ABIJournal (June 2004). Return to article

⁴ In re Combustion Eng'g. Inc., 391 F.3d 190 (3d Cir. 2004). Return to article

⁵ Although the Third Circuit also made certain significant rulings concerning insurers' appellate standing as "persons aggrieved," this article focuses on the §524(g) issues. Return to article

⁶ 391 F.3d at 204-207. Return to article

⁷ Id. at 204. Return to article

⁸ Id. at 208-209. Return to article

⁹ The Certain Cancer Claimants were 291 persons (or their legal representatives) who were diagnosed with cancer allegedly caused by exposure to CE's or its affiliates' asbestos-containing products. Id. at 209, n. 15. Return to article

¹⁰ Id. at 210. Return to article

¹¹ In re Combustion Eng'g. Inc., 295 B.R. 459, 465 (Bankr. D. Del. 2003). Return to article

¹² 391 F.3d at 209 (emphasis added). Return to article

¹³ Id. at 202. Return to article

¹⁴ Id. at 228. Return to article

¹⁵ Id. (emphasis added). Return to article

¹⁶ Id. at 232-233. Return to article

¹⁷ Id. at 235-236. Return to article

¹⁸ Id. at 236-237. Return to article

¹⁹ Id. at 236. Return to article

²⁰ Id. at 237. The court made no mention in its decision of certain language in the public law containing §524(g) that "[n]othing in [§524(g)] shall be construed to modify, impair or supersede any other authority the court has to issue injunctions in connection with an order confirming a plan of reorganization." Bankruptcy Reform Act of 1994, Pub. L. 103-394, §111(b), 11 U.S.C. §524(g) note. The plan proponents raised this omission in seeking further review by the Third Circuit through its Combined Petition for Rehearing and Rehearing En Banc, dated Dec. 15, 2004. A decision had not been issued with respect to the petition at the time this article was submitted for publication. See First State Ins. Co., et al. v. Combustion Eng'g. Inc. and Asea Brown Boveri Inc. (In re Combustion Eng'g Inc.), 391 F.3d 190 (3d Cir. 2004), petition for reh'g docketed, Nos. 03-3392, 03-3415, 03-3425, 03-3436, 03-3445, 03-3446, 03-3450, 03-3451, 03-3452, 03-3468, 03-3492 (Consolidated) (3d Cir. Dec. 16, 2004). Return to article

²¹ Id. at 240. On this point, it is noteworthy that CE, apparently forced by pressure from the Certain Cancer Claimants, filed its petition 87 days after distributing the settlement funds from the CE Settlement Trust—therefore within the 90-day avoidance period of 11 U.S.C §547(b). It is unclear whether the court's views on the treatment and/or classification of the "stub" claims would have been any different had the full 90-day run following the disbursement of the settlement funds to the preferred claimants. Return to article

²² Id. at 242. Return to article

²³ Id. Return to article

²⁴ Id. at 243. Return to article

²⁵ Id. Return to article

²⁶ Id. at 244 (citations omitted). Return to article

²⁷ Id. Return to article

²⁸ Id. at 245. Return to article

²⁹ Id. Return to article

³⁰ Id. at 246-247. Return to article

³¹ Id. at 234. Return to article

³² 11 U.S.C. §524(g)(2)(B)(i)(II). Return to article

³³ Id. at 248. Return to article

³⁴ Id. Return to article

³⁵ Id. at 201 ("Although pre-packaged bankruptcy may yet provide debtors and claimants with a vehicle for the general resolution of asbestos liability, [the court] find[s] the Combustion Engineering plan defective..."). Return to article