Third U.S. Circuit Court of Appeals issues landmark ruling dismissing chapter 11 case of Johnson & Johnson subsidiary.

The court emphasised that LTL was not in “financial distress” when it filed Chapter 11 due to a $61.5 billion “backstop” funding agreement with Johnson & Johnson. This ruling is a major blow to the popular “Texas Two-Step” strategy frequently utilised to isolate mass liabilities with a newly created entity without assets.

As a result of similar high-profile Chapter 11 cases, such as Purdue Pharma, there has been great Congressional and media attention to controversial Chapter 11 practices. These include debtors’ forum and judge shopping, non-consensual third-party releases of non-debtors in the Plan of Reorganization, and the use of divisional mergers to isolate liabilities into special purpose entities.

On Tuesday, February 14, 2023, two members of Congress introduced the Bankruptcy Venue Reform Act to address judge shopping concerns. Both Representatives, Zoe Lofgren and Ken Buck co-sponsored the current bill as well as the Bankruptcy Venue Reform Act of 2021, which never made it past the committee level. The Nondebtor Release Prohibition Act was also introduced in 2021 to prohibit non-consensual third-party releases of non-debtors.

Venue bill
Currently, a corporate debtor can file a Chapter 11 case where it has its domicile (usually state of incorporation), principal place of business (usually corporate headquarters), location of principal assets for at least 180 days, or where there is a pending Chapter 11 case of an affiliate.

Chapter 11 debtors have routinely filed their cases essentially wherever they choose. According to testimony in a July 28, 2021 House Judiciary Subcommittee on Confronting Abuses of the Chapter 11 System, certain U.S. bankruptcy courts are eager to attract large complex Chapter 11 cases to their districts. In fact, it was noted that three out of 375 U.S. bankruptcy judges presided over 57 percent of large public company cases in 2020. Furthermore, the suggestion is certain courts may be more likely to rule in favour of Chapter 11 debtors on key issues, such as third-party releases, incentive compensation packages, and fast-track sales of assets or pre-packaged plans. In Purdue Pharma, the Bankruptcy Court for the Southern District of New York (White Plains division) approved a Plan of Reorganization that included releases of all claims against the Sackler family (officers, directors, or shareholders), including the claims of opioid victims.

In addition, certain bankruptcy courts have case assignment procedures that direct cases to certain judges. In the Southern District of New York, all White Plains cases were assigned to Judge Robert Drain, who presided over the Purdue Pharma case. In the Southern District of Texas, all complex cases are assigned to Judges David Jones or Marvin Isgur. Delaware’s case assignment procedures are random. In the wake of media attention and judicial challenges to third-party releases, the Southern District of New York changed the case assignment procedures so that White Plains cases are now randomly assigned. The same change occurred in the Eastern District of Virginia.

Under the Venue Bill, businesses could only file their Chapter 11 cases where they have their principal place of business or where their principal assets are located. The Venue Bill eliminates affiliate-based filings unless the affiliate is the debtor’s controlling shareholder.

The Venue Bill would certainly end debtors’ forum and judge shopping, which presumably would reduce alleged debtor bias by certain bankruptcy courts. On the other hand, certain bankruptcy courts, including Delaware, the Southern District of New York, and the Southern District of Texas, have developed a high level of expertise in handling complex Chapter 11 cases efficiently. In considering the Venue Bill, these conflicting policy issues should be considered.

Non-debtor third-party releases
The Release Bill would generally prohibit bankruptcy courts approving non-consensual third-party releases of claims against non-debtors, such as the Sacklers in Purdue Pharma. In addition, the Release Bill would prohibit bankruptcy courts from applying the Section 362 automatic stay (injunction of all actions) to non-debtors for more than 90 days. Finally, the Release Bill would require the dismissal of Chapter 11 cases where the debtor was created by a “divisional merger,” effectively ending the so-called “Texas Two-Step” cases, such as in Johnson & Johnson.

To date, U.S. bankruptcy courts have issued conflicting rulings on third-party releases. The most notable ruling was in the Purdue Pharma case, where on December 16, 2021, the U.S. District Court for the Southern District of New York vacated the order confirming the Chapter 11 Plan of Reorganization and the releases in favour of the Sackler family. The District Court found there is no statutory authority in the Bankruptcy Code for third-party releases except in cases involving asbestos claims (where channelling injunctions are permitted). However, in another opioid case, Mallinckrodt PLC, the Delaware Bankruptcy Court ruled that non-consensual third-party releases are permissible.

The Release Bill would simply prohibit non-consensual third-party releases of non-debtors, applicable to all U.S. bankruptcy courts. Moreover, the Release Bill requires consent to a proposed release only by a written consent signed by the releasing party (example, opioid claimants). This would eliminate consent by voting for a plan, failing to reject or object to a proposed plan, or failing to opt out of or object to the releases, all of which are common tactics utilised by debtors.

The controversial third-party release cases have generally been associated with mass tort claims, such as the opioid claims in Purdue Pharma and Mallinckrodt or asbestos claims. However, third-party releases are very broadly drafted and have released perhaps unintended claims. We were involved in a Delaware case where our client had significant executory contracts, specifically a $3.5 billion supply agreement and related consignment and security agreements. Negotiations regarding the assumption of these contracts were complex and sometimes contentious. Ultimately, our client was able to achieve a favourable resolution, requiring the debtor to honour 100 percent of its obligations post-confirmation of the Plan on a fully secured basis. However, the Plan contained broad releases of all claims with respect to any creditor that would include obligations owed to our client that were negotiated and approved by the bankruptcy court. Thus, we were required to file an objection to the Plan’s third-party releases to preserve the performance and other obligations by the debtor and its lenders, with respect to our client’s executory contracts.