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Bankruptcy Future Claims—Elizabeth Warren Edition

posted by Adam Levitin

Welcome to Credit Slips, the rarified world of “self-described bankruptcy nerds.” Today we’re looking at Future Claims—Elizabeth Warren Edition.

Now, it’s not every day that our humble group blog gets discussed in the New York Times. But as our former-co-blogger Elizabeth Warren continues to rise in the polls, the media and her opponents are taking a renewed interest in the bankruptcy consulting work she did when she was a law professor. Just recently, the New York Times ran a lengthy article on her past consulting workthat even referred our little “bankruptcy nerd” blog. (You might note that we now also offer sovereign debt, financial regulation, and side salads. Come for the bankruptcy, stay for the pie.)

The NY Times piece discussed several cases that Elizabeth worked on, but it failed to clearly articulate the core bankruptcy principle that Elizabeth was fighting for that runs throughout most of the cases highlighted in the article and how Elizabeth’s work was consistently about making the economy and the bankruptcy system work for employees of companies in distress, retirees, and folks injured by a company’s product. To suggest otherwise is ridiculous and fundamentally misunderstands how the bankruptcy system is supposed to work.  

To really understand Elizabeth’s work, you first need to understand how our bankruptcy system works. At its core, bankruptcy is about making the best of a bad situation and helping debtors get back on their feet—whether it’s a family pushed to its limit by a sudden job loss or overwhelming medical debt, or a business dealing with a sudden downturn in the market. When a family or a business is at the point of filing for bankruptcy, it’s unable to pay everyone they owe, whether that’s a bank that made a loan or workers who were promised benefits. That’s why the bankruptcy process brings the debtor and all its creditors into a single court to hammer out a resolution that is as fair as possible for everyone involved. If a business has filed for bankruptcy, but there is greater value in the business continuing to operate after bankruptcy, then goal is to come up with a plan for dealing with all of the claims against the debtor. Critically, once the court confirms the plan, a new reorganized company emerges from bankruptcy free of all pre-bankruptcy debts.

The bankruptcy process would not work if it did not provide the debtor with that last component—the “fresh start” of discharging all pre-bankruptcy debt. The fresh start policy protects consumer debtors from eternal hounding by zealous creditors and debt collectors. It also ensures that companies that can still contribute to the economy are able to do so. Without the discharge, aggressive creditors could force companies into liquidation, which would lead to job losses and harm to vendors and suppliers that rely on the company. Furthermore, without the discharge, creditors might be incentivized to wait until the reorganized company bounces back financially before coming to collect. If creditors were allowed to collect post-bankruptcy, new investors would be dissuaded from investing in reorganized companies because they’d be on the hook for the failed company’s pre-bankruptcy obligations.           

In order to provide a fresh start, the bankruptcy system must be able to resolve all possible claims against the debtor at one time, so that no single creditor can bring claims against the individual or reorganized company post-bankruptcy. For this reason, in Chapter 11, the court sets a deadline for creditors to file any claims they may have against the debtor. And indeed, current bankruptcy law provides for a sweeping discharge of pre-bankruptcy debt. In Chapter 11, all debts not provided for by the debtor’s plan of reorganization are discharged, meaning any attempt to collect on them is prohibited by a federal injunction. There are only a few fraud-based exceptions to the Chapter 11 discharge for corporate entities.

What is to be done, then, about debts that may arise after the debtor has emerged from bankruptcy, but that are based on the debtor’s pre-bankruptcy behavior? For example, if the debtor manufactured asbestos before bankruptcy, but a worker only manifested asbestosis or mesothelioma after the bankruptcy? Or if a debtor made silicone implants before bankruptcy, but some of them leaked and caused health problems that manifested after the bankruptcy?

There are two basic ways these obligations could be treated. First, these future claims could be treated as post-bankruptcy obligations that are the responsibility of the reorganized debtor. Doing so, however, undercuts the fresh start policy and ultimately the bankruptcy system as a whole. It means that the firm can never truly start with a clean slate. It also creates an unfair race to the courthouse because the first creditors to sue are more likely to receive compensation than those who bring suit later. For example, people exposed to asbestos may not develop an illness for years or decades after the manufacturer filed for bankruptcy. If future claims are not dealt with in bankruptcy, then it is less likely that there will be enough money remaining to pay their claims. Even if there is money, they likely won’t receive as much as those people who were able to sue earlier. Tort victims, however, have no control over when their injuries manifest themselves. This sort of pay-as-you-go approach risks unfairly disadvantaging victims whose injuries manifest themselves later.

Alternatively, these future claims could be addressed in the bankruptcy itself, such that they will be treated equally with existing claims, and the court can ensure that money is set aside for them. But how is that possible? These future claims do not yet exist, after all. As it happens, bankruptcy has a mechanism for handling the problem. It involves estimating the total amount of future claims liability and making a provision for it in a plan, such as putting aside money in a trust that will be used to pay future claims when the arise. The process isn’t perfect, but it’s a lot fairer than pay-as-you-go because it ensures at least a minimum amount of funds for future claims.   

The position Elizabeth has consistently advocated, whether as a lawyer or expert in a case or as a scholar urging bankruptcy reform, is the latter position—treat future claimants fairly by bringing them into the bankruptcy and ensuring that a mechanism exists to compensate them. As Elizabeth has consistently argued, the best way to achieve this goal is by having the debtor fund a trust to pay out these future claims. The use of such trusts is now standard in mass tort bankruptcies. These trusts are critical in both providing the fresh start that is central to the bankruptcy system and in ensuring compensation for current and future claimants.

Ensuring the effectiveness and fairness of the bankruptcy system by facilitating a fresh start, yet ensuring a source of compensation for future victims, was a major theme in Elizabeth’s consulting work. The fair treatment of future claims is the thematic line that connects her consulting work in cases like LTV Steel, Travelers,Dow Corning, Fairchild Aircraft, and CMC Heartland Partners among others. It is reflected in an amicus brief she wrote on her own behalf (that is not representing any client, but simply trying to help the court) in Piper Aircraft. It is also consistent with the work she did as Reporter for the National Bankruptcy Review Commission.

It’s easy for someone who isn’t a “self-described bankruptcy nerd” to miss this thematic connection, but to bankruptcy cognoscenti this is a very clear line, and it shows that what motivated Elizabeth, whether as a consultant or as an amicus, helping the court pro bono, was a concern about the fair treatment of future claims in bankruptcy. 

And here’s the other thing that’s easily missed: Elizabeth was selective in the cases she took as a consultant. If Elizabeth had just wanted to cash in, she would have taken her tenured position at Harvard, stopped spending her time on teaching and research, and just consulted from dawn to dusk. Plenty of other professors have done just that, becoming full-time hired guns. But that’s not what Elizabeth did. Instead, Elizabeth continued to treat teaching and research as her primary job (winning teaching awards at nearly every law school where she taught, including two awards while she was at Harvard). And she also consistently engaged in pro bono legal work, such as fighting against a bank try to force consumers into mandatory arbitration or trying to help small business owners hold onto their businesses. When Elizabeth took cases, it was to fight for legal principles that were important to the health of the system.

Bankruptcy is a complex topic that is not easy to understand for casual observers. But complexity is not an excuse for facile thinking and cheap shots. To suggest that Elizabeth Warren's consulting work was somehow inconsistent with her lifelong commitment to fighting for fairness in market place is uninformed and absurd. 

Comments

Excellent article. Thanks for sharing, Adam !

I'm a financial insolvency lawyer. The financial insolvency nerds have their own ways of treating future claims. In the first place, we call them "contingent" claims, distinguishing them from long-term obligations that don't rely on any contingencies other than the ordinary risk of interest-rate or fx movements.

In insurance insolvency, we spin the insolvency procedure out, for years or decades, so that every claim comes to fruition before the final liquidation. In bank insolvency--well, banks don't have many contingent claims. Derivatives appear to be contingent claims, but the entire law of derivatives is about present-valuing them in event of insolvency. Standby letters of credit are the only traditional bank product that leads to contingent claims. The FDIC has opposed them as provable claims from time immemorial, but they've lost in the courts more often than Hamilton Burger.

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