Solvent Debtors Behaving Badly And The Bankruptcy Code Sections And Other Statutes That Enables Them To Screw Their Creditors

As a solo community-based practitioner whose financial issues practice focuses on consumer and small business bankruptcy clients, by choice; I readily admit that I sometimes see the world through the lens of my clients. As such, it is my contention that the primary purpose of the Bankruptcy Clause, is the means through which honest, but unfortunate[1] individuals, families and small business owners, who find themselves so overwhelmed by debt that it destroys the quality of their lives and limits their ability to support themselves, their families and their communities can reclaim their financial lives and/or the economic viability of their small business and thereby obtain a fresh (financial) start.[2]
 
However, I say this elegantly simple theorem is being put to the test by well-healed, well-lawyered and otherwise solvent corporate entities, and the rich men that run them, seeking to use the bankruptcy court to turn that system upside down through the manipulation of some apparently unintended consequences in the law that have in some instances corrupted, but at the very least, side-tracked the self-evident goals of the Bankruptcy Clause.
 
What forms the basis of my assertion?
 
The Bankruptcy Code at § 1123(a)(5)(B) allows for the confirmation of plans using the transfer of all or any part of the property of the bankruptcy estate to one or more entities, whether organised before or after the confirmation of such plans.[3]
 
The Bankruptcy Code at § 1123(a)(5)(C) allows for the confirmation of plans using merger or consolidation of the debtor with one or more persons as the means for the plan’s implementation.
 
The Bankruptcy Code at § 1123(a)(5)(B), in conjunction with § 524(g), allows for the confirmation of plans that utilise “asbestos claimant payment trusts” to discharge a debtor’s asbestos related liabilities in exchange for the debtor satisfying a variety of statutory requirements and conveying at least 50% of its equity (or the right to acquire that equity) to the trust.[4] Section 524(g)(4)expands the discharge to include nondebtor third parties that have derivative liability for the asbestos-related claims against the debtor. As such, these nondebtor third parties may be protected by §524(g) to the extent a claimant seeks to hold the third party “directly or indirectly liable for the conduct of, claims against, or demands on” the debtor.[5]The rationale for this extension appears to “provide an incentive for related [nondebtors] to contribute assets to the litigation trust for the payment of tort claims.”[6],[7]
 
By bootstrapping onto § 524,some high-profile non-asbestos-related debtors are incorporating third party release provisions into their plans with scant or even no statutory authority other than the Bankruptcy Code’ silence on the subject, coupled with the certain “catch all provisions” of the Code, including §§ 105(a),[8] 1123(a)(5),[9] 1123(b)(6)[10] and 1129(a)(1).[11]
 
Various provisions of the Small Business Reorganization Act of 2019[12] (“SBRA”), which when taken as a whole, is intended to provide small and medium-sized businesses (aka “mom and pop” businesses) access to the bankruptcy court’s protection in a manner that is cost and other resource efficient in order to help these debtors reorganise and thereby continue to employ people and pay taxes and not be forced to liquidate when their sometimes meager resources were needed to pay for the administration costs of the bankruptcy case itself, resources that were inevitably depleted in the course of a chapter 11 before the advent of SBRA.
 
However, SBRA’s well-intended limits on the participation and oversight of creditors as stated at § 1181(b)[13], as well as the expeditious confirmation process to be utilised, as stated at §§ 1181(a)[14]1181(b)[15], 1187(c)[16], 1189(a)[17] and 1189(b)[18],among others, are mechanisms intentionally designed by Congress to cut the costs and time needed to reorganise. As a result, provisions designed to assist honest, but unfortunate mom and pop business debtors may produce the unintended consequences of “aiding and abetting” bad actors with the means through which they can liquidate their liabilities at a discount via SBRA to the detriment of the very real, very human creditors they have harmed and the public in general, while the whole world watches.
 
How is this bad behavior accomplished?
 
A.            Debtor(s) can establish a Chapter 11 Liquidating Trust that satisfies the requirement of § 1123(a)(5)(B) by:

1. Allowing the debtor(s) to place and manage its/their assets in a trust;
2. If the assets placed in the trust are illiquid, allowing the liquidation of debtor’s illiquid assets to create a pool of funds;
3. Allowing the debtor(s) to pursue potential recoveries related to any pending or past litigations the debtor has initiated against third parties, while shielding the debtor(s) from any pending or past litigations against itself/themselves;
4. Preparing and making distributions from the pool of funds to holders of allowed claims;
5. Dissolving the debtor(s) entities, and possibly absolving the debtor(s) non-filing related entities and other third parties from any and all liabilities for any and all creditors’ claims, after the distributions have been made.
6. The end.

 
The above-stated actions are accomplished by obtaining the confirmation of a plan of liquidation that “includes the rules of interpretation, classification, and treatment of claims; means for implementation; procedures for resolving claims; provisions governing distributions; and other miscellaneous provisions. The plan of liquidation may reference the disclosure statement. The disclosure statement contains historical information related to the debtor including assets, liabilities, and financial performance. The plan of liquidation is usually accompanied by a liquidating trust agreement, which establishes the liquidating trust and details the role of the liquidating trustee.”[19]
 
B.            The Debtors can undertake a Pre-filing Divisive Merger under either Delaware or Texas (aka the “Texas two-step”) statutes that satisfy the requirement of § 1123(a)(5)(C) because:

1. Under the Texas Business Organization Code, TBOC § 10.008[20], TBOC 1.002(55): Defines a “merger” to include “(A) the division of a domestic entity into two or more new domestic entities or other organisation or into a surviving domestic entity and one or more new domestic or foreign entities or non-code organisations;” and, the divisive merger statute applies to corporations, partnerships, and LLCs.
2. Under Delaware law with the addition of Section 18-217, which was enacted on 23 July 2018, the Delaware Limited Liability Act (the Delaware LLC Act”) was amended to allow an LLC to divide into two or more LLCs, with the dividing LLC either continuing its existence or terminating as part of the division process.[21]
3. A divisive merger is not deemed to be an assignment or transfer of the dividing entity’s assets or liabilities under either the Texas or Delaware statutes. Therefore, it is presumed that a divisive merger may be used to “transfer” property and still avoid certain transfer restrictions in contracts and place the corpus of the transfer beyond the reach of the claw back provisions of § 548(a)(1)(A)[22] or § 548(a)(1)(B)[23]
4. “Under Texas law, the dividing entity must file a certificate of merger with the Texas Secretary of State. Similarly, under Delaware law, the dividing company must file a certificate of division with the Delaware Secretary of State. From and after the time that such certificate becomes effective, the assets, debts, liabilities and obligations of the dividing entity will vest in the entities to which they are allocated under the plan of merger or division, and no other entity will be liable for such debts, liabilities or obligations, subject to a finding that such allocation constitutes a fraudulent transfer. Further, any debts or liabilities of the dividing entity that are not allocated under the plan merger or division shall be the joint and several obligations of the surviving entity (if applicable) and each of the entities formed pursuant to the division.”[24]

 
In sum, the use of a ubiquitous liquidating trust either standing alone or in concert with a divisive merger countenanced under either Texas or Delaware statues will shield a debtor with the financial where-with-all to hire the very smart, very expensive professionals needed to draft and then execute these strategies from their liability. They can thereby limit the recovery for the mass tort claimants and others the debtor harmed because either a liquidating trust and/or a divisive merger will alter and reduce the pool of assets that these creditors may have been able to look to as a source for repayment or to satisfy a pre-petition judgment if these maneuvers are undertaken on the eve of or in conjunction with a bankruptcy.
 
Some real life examples of the impact of pre-petition divisive mergers and the formation of trusts
 
Koch Industries: In July 2017, Georgia-Pacific, a subsidiary of Koch Industries, moved its headquarters to Texas for just one day to undertake its divisive merger and created two new entities: (i) “New Georgia-Pacific” (“NGP”); and, (ii) Bestwall LLC (“Bestwall”), which became subsidiaries of Georgia-Pacific Holdings. NGP gifted $175 million to Bestwall and allocated all of its asbestos liabilities to the Bestwall.
 
Then, NGP moved its headquarters back to Delaware, taking slight detour on its way back home to relocate Bestwall to North Carolina. And on 2 November 2017, just three months after the entity was created, Bestwall filed for Chapter 11 bankruptcy protection in North Carolina[25] bursting at the seams with the more than 62,000 asbestos lawsuits pending against it. As part of its plan, Bestwall sought authority of the bankruptcy court to establish a trust which would deal with all the claims of current and future asbestos claimants under section 524(g) of the Bankruptcy Code,[26] with the goal of attaining a cap on its asbestos liabilities the way Garlock Sealing Technologies[27] had in the state in 2014. In Garlock, the bankruptcy court determined after a claims estimation hearing and issued an Order holding that Garlock should set aside $125 million for its claimants, an amount that was only a tenth of the $1 to $1.3 billion the creditors committee of asbestos claimants sought.[28]
 
On 15 August 2018, NGP’s creditor’s committee filed a motion to have the case dismissed, accusing Georgia-Pacific of “subversion of the bankruptcy process,” calling it a “sham” and a “farce.” And again, in August 2019, the committee accused Georgia-Pacific of delaying the bankruptcy process and asked the North Carolina bankruptcy court to either dismiss the case or set a deadline to confirm the bankruptcy plan by the end of March 2020, asserting that Georgia-Pacific was seeking “a ‘bankruptcy discount’ despite its professed ability to pay the asbestos liabilities in full.”[29] 
 
However, the creditors motions to dismiss the bankruptcy case were denied for lack of cause.[30] And ultimately, on 25 September 2020, the bankruptcy court approved a settlement whereby Georgia-Pacific agreed to fund the section 524(g) trust with $1 billion to resolve asbestos claims.[31]
 
Johnson and Johnson, (“J&J”): Similar to the process used in Bestwall; on 14 October 2021, J&J created the subsidiary LTL Management LLC to absorb its talc litigation liabilities and just two days later had the new company declare bankruptcy in North Carolina, staying all the litigation pending against it.[32] On 16 November 2021, the case was transferred[33] from North Carolina to New Jersey[34]
 
Subsequently, the Official Committee of Talc Claimants filed a motion seeking dismissal of the case, alleging that the case had been filed in bad faith. In its motion, the Committee stated that the purpose of the creation of LTL and filing of the bankruptcy was pretextual and in order to “protect J&J and its other valuable non-debtor affiliates. Specifically, the Committee stated that the case was filed to shield J&J from liability for the production, marketing, and sale of carcinogenic products for decades, and to remove its valuable operating assets from the reach of a single group of creditors (the talc claimants). All of this, of course, without J&J and its operating entities having to subject themselves, and their assets, to the transparency and scrutiny of Chapter 11.”[35]
 
Coming to the Committee’s support in February 2022 was an amicus brief filed by more than a dozen law professors stating that “the strategy employed here — manufacturing an undercapitalised company solely to file for bankruptcy for that entity— is a novel and dangerous tactic that represents a “significant departure from the use of Chapter 11 to validly reorganise financially troubled businesses.” The Amici Professors believe this strategy is a direct attack on the fundamental integrity of the Chapter 11 system, which is intended to protect honest but unfortunate debtors who are willing to subject themselves and their assets to the supervision of the Court. The Professors concluded that “solvent tortfeasors, like J&J should not be permitted to use Chapter 11 as a tool to shield assets from the claims of their victims.”[36]
 
In response, J&J maintained that the LTL bankruptcy and subsequent creation of a settlement trust fund with $2 billion is the most efficient and equitable way to handle its talc litigation liability and ensure all claimants are able to recover.[37]
 
Notwithstanding the Claimants’ and the Professors’ opposition; again, similar to the outcome in Bestwall, on 25 February 2022, after a five day trial, the bankruptcy court, affirmed J&J’s use of a divisive merger to create LTL Management LLC to resolve the talc-based litigation pending against it. In its 56-page opinion[38], the court rejected the claimants’ argument that the divisive merger was an abuse of the Chapter 11 bankruptcy system, finding  “that the bankruptcy court is the optimal venue for redressing the harms of both present and future talc claimants in this case — ensuring a meaningful, timely, and equitable recovery.”[39]Further, the court stated that “defending just the 38,000 pending ovarian cancer claims through trial would cost up to $190 billion” and that “the Court simply cannot accept the premise that continued litigation in state and federal courts serves best the interest of their constituency” instead finding that there were “substantial risks” to be faced by plaintiffs in the tort system who have been denied any recovery at all or whose verdicts have been reversed on appeal.[40]
 
InfoWars and Alex Jones: On 17 April 2022, three entities[41] owned, controlled or otherwise associated with media host and conspiracy theorist Alex Jones (“Jones”) filed for bankruptcy in the United States Bankruptcy Court for the Southern District of Texas, Victoria Division.[42] Neither Jones nor his other owned, controlled or otherwise associated entity Free Speech Systems, LLC (“FSS”) joined in the filing although both Jones and FSS where found liable in the underlying defamation lawsuits that prompted the bankruptcy. Using the expedited and debtor-controlled, debtor-friendly provisions of Subchapter V of the Bankruptcy Code, described above, Jones set in motion a process that by judicial decree allows him to separate some of his and FSS’s personal assets from those he has allocated to the three remote entities established as the only repositories of funds available to satisfy any and all judgments against him or FSS in favour of the Sandy Hook Victims that courts in Connecticut and Texas have found he and FSS had defamed.
 
As a result of the debtor-favoured provisions of Subchapter V that place Jones in the drivers’ seat throughout the case, the Sandy Hook families will not be able to form a creditors committee pursuant to § 1181(b). Nor will their votes against the plan end the case pursuant to the interplay between §§1183(c) and 1191(a)if the plan is consensual and §§1183(c) and 1191(b)if the plan is contested and due to several case saving provisions and the overall expedited confirmation process. As such, the case may be over within six months or so. This is especially the case where Jones and his lawyers have established a trust pre-petition that would purportedly hold the funds that would be used to pay the claimants. InfoWars’ bankruptcy lawyers set up a trust that would pay people suing the Jones-controlled companies, and Jones handed over his equity in the entities to the trust. “Accordingly, the primary purpose of the [InfoWars] Litigation Settlement Trust is to liquidate the Litigation Settlement Trust Claims and accomplish payment in full, with no objective to continue or engage in the conduct of a trade or business”[43] and its only liabilities are the litigation claims of the defamation lawsuit plaintiffs. By establishing a trust to settle legal claims in bankruptcy, Jones’s companies are following a controversial process used by other corporations facing significant lawsuit liability, such as Koch Industries and J&J, above. Here, Jones self-funded the trust with $725,000 to cover the cost of the case filing and his professional service providers, with a purported additional funding of $2 million to pay the claimants.[44] In addition, the trust contains a provision stating that after payment in full to the claimants with allowed claims, there will be “recognition of the Resulting Releases to the Third-Party Contributor(s),”[45] which just happens to be Jones and FSS.[46]
 
However, on 21 April 2022, the Office of the United States Trustee (“OUST”), the subdivision of the United States Department of Justice that acts as the watch dog of the bankruptcy process and thereby the guardians of its integrity, filed an Objection[47] to one of InfoWars’ key stratagems needed to manipulate the process to its will by attempting to gain the court’s approval of the settlement trust and trustees InfoWars will use to hold and administer the funds to be used to pay Jones’ and FSS’ claimants on an expedited basis the and keep the bankruptcy on its fast-track pace.
 
In its Objection, the OUST gave legal arguments against InforWars’ emergency motion seeking “the authority to appoint the Litigation Settlement Trustees for a Litigation Settlement Trust that was established on 14 April 2022, just days prior to the Petition Date.”[48]
 
Further, the OUST stated that “Most of the terms of the Proposed Order are simply a restatement of what the Declaration of Trust already provides for, including:
• Exculpation of claims against Litigation Settlement Trustees;
• Powers and duties of the Litigation Settlement Trustees;
• Reimbursement and compensation of the Litigation Settlement Trustees;
• Resignation notice requirements for the Litigation Settlement Trustees; and
• Removal of the Litigation Settlement Trustees.[49]
 
Still further, the OUST informed the court that if InfoWars’ requested relief was granted by the Court, “the Motion will not only authorise the appointment of the Litigation Settlement Trustees but will also put the Court’s imprimatur on the exculpation and release of the Litigation Settlement Trustees, their employees, agents, advisors, and professionals from liability for their acts or omissions connected to these chapter 11 cases. Such exculpations and releases would be premature, given that the Litigation Settlement Trustees have not yet performed their duties under the Litigation Trust Settlement Agreement.”[50]
 
Still further, the OUST states that “Debtors also argue that the Litigation Settlement Trust is an integral part of a consensual plan and that the Litigation Settlement Trust needs the Litigation Settlement Trustees in place to make a consensual plan achievable. But while confirmation of a consensual plan is an important element of any chapter 11 case, there is no plan on file. These cases were filed only days ago. As discussed above, there is much that is still unknown about these cases and much that will need to be known before negotiations toward a consensual plan can even begin. And under the statute, the appointed Subchapter V Trustee will have a vital role to play in the negotiation and development of that plan, along with the Debtors. See 11 U.S.C. § 1183(b)(7). There is no need to immediately appoint these Litigation Settlement Trustees to perform that role.”[51]
 
And getting to the heart of the matter, the OUST states; “In any event, Debtors should not be permitted to stack the deck prepetition to create the perceived necessity for a certain outcome like that sought by the Motion. There was no requirement that the Alex Jones Entities transfer the equity of the Debtors into the Litigation Settlement Trust and set these cases up as they have. The Alex Jones Entities could instead have chosen to file bankruptcy, received the benefit of the automatic stay provisions of section 362 of the Bankruptcy Code, and directly been a part of the negotiations and facilitation of a consensual plan (which plan may have utilised the vehicle of a settlement trust). Were the cases set up this way, all parties in interest would have had transparency into the assets and liabilities of all the parties, including Alex Jones and FSS, that are relevant and necessary for successful completion of these cases. Instead, Debtors and the Alex Jones Entities have tried to precast the outcome with the creation of the Litigation Settlement Trust to avoid shining a light on the entities left out of this filing — entities that are at the very fulcrum of these cases and the disputes that led to them — without input from the Sandy Hook Plaintiffs or any other party in interest.”[52]
 
Wow!
 
As a side bar, I would add that inasmuch as the contract between the debtors, the trust and the Third-Party Funding Contributors (Jones and FSS)[53] mandating that the court “enter an order approving the appointment of Litigation Settlement Trustees on or before 30 April 2022” and that date has passed; the Plan Support Agreement holding Jones and FSS responsible for funding the trust appears to have terminated by its own provisions. [54]
 
Notwithstanding the rulings in bankruptcy courts to date, there are some limits on this madness
 
1.            Harmed creditors should undertake fraudulent transfer litigation to vindicate their rights.

While the Texas Business Organization Code and the Delaware statute permit companies to engage in divisive mergers, a business may do so as a prelude to filing for bankruptcy protection with the goal of limiting its responsibility to pay some or all of its liabilities. A bankruptcy petition filed by the entity holding the liabilities may then stop the creditors’ lawsuits from moving forward. Because the statues in question do not recognise an actual transfer during a divisive merger, the transaction my not be actually classed as a fraudulent transfer. However, if a creditor provides proof of intent that a debtor used a merger specifically to evade his financial liabilities, a court my void the transaction. Under the applicable statute, such as the Texas Business and Commerce Code’s Chapter 24, the responsibility in such a lawsuit rests with the plaintiff to provide admissible evidence that a debtor intentionally transferred or removed assets to defraud his creditors.[55]

How can a credit meet this burden of proof? Fraudulent intent may arise when a debtor engages in a divisive merger immediately after a creditor pursues legal action, according to the Texas Uniform Fraudulent Transfer Act (a similar statute is on the books in Delaware). In Texas, creditors have four years to pursue their claims. So, while a company may divide its assets and liabilities into several entities through a divisive merger, the law recognises these transactions only when the business owner does not intend to conceal or hide assets from their creditors. As such, a creditor may choose to pursue legal action against a debtor with proof that the divisive merger reflects fraudulent intent.[56]
 
2.            There is some congressional action in play
 
As the repository of the bankruptcy powers granted under Article 1, Section 8, Clause 4 of the United States Constitution, the United States Congress has the plenary power needed to address these issues. And as such, on 3 November 2021, the House Judiciary Committee voted to send the Nondebtor Release Prohibition Act of 2021[57] to the floor of the house for vote. If passed by both Houses of Congress, the bill would introduce two major amendments to the Bankruptcy Code. As foreshadowed by its title, the bill seeks to end the ability of non-debtor-third-parties from obtaining a release in a Chapter 11 case of their affiliated entity and would also terminate the use of “divisive mergers” as discussed above.
 
As for third-party releases, the bill would introduce section 113 to Chapter 1, Title 11 of the United States Code. The new section provides three major changes to the Bankruptcy Code. First, § 113(a) would restrict a court from approving any provision in a “plan of reorganisation or otherwise” that discharges or modifies the liability of a non-debtor entity. Second, § 113(b)(5) includes what would produce a carve-out to subsection (a), whereby the court is reserved the power to approve the “disposition of a claim or cause of action” plan of a non-debtor to the extent that each non-debtor affected by a proposed release consents in writing to the release and the consent or lack thereof does not affect its treatment under the plan. Finally, § 113(c) limits the effect of any order or decree under Chapter 11 temporarily staying the commencement or continuation of a proceeding against a non-debtor to 90 days except on the affected creditors’ consent.[58]
 
As for divisive mergers, under the proposed amendment to 11 U.S.C. § 1112, contained in the bill, a court should dismiss a Chapter 11 case if the debtor or its “predecessor” was subject to, “formed[,] or organised in connection with a divisional merger or equivalent transaction” which “had the intent or foreseeable effect of separating material assets from material liabilities” and “assigning or allocating all or a substantial portion of those liabilities to the debtor” during the 10 year period before the date of filing the petition.[59]
 
So, perhaps through good lawyering a plaintiff who was harmed can succeed in showing a court that the transformative devices used by the entity or entities that harmed her will be determined to be out of bounds, or the corpus of the devices will be determined to have been fraudulently transfers and better still hopefully Congress will put an end to these practices by amendment to the Bankruptcy Code. However, it is imperative that we as a society accomplish an end to the ability of well-healed, well-lawyered tortfeasors to first behave badly resulting in great harm to the public and then use our bankruptcy courts to hide their assets in plain sight, but just out of reach of the parties they sometimes knowingly and intentionally injured.
 
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Selwyn D. Whitehead Esq. [JD, LLM Tax Law, LLM IP Law, California Bar Bankruptcy Law Certified Specialist] is a San Francisco Bay Area bankruptcy, finance and tax attorney whose practice focuses on helping her clients manage their wealth through effective estate and tax planning and/or manage their debt through debt restructuring or bankruptcy. Selwyn also helps her clients facing foreclosure and represents clients with emotionally and financially “taxing” issues before the Franchise Tax Board, the IRS and the U.S. Tax Court.
 
Selwyn also produces and hosts her weekly talk show, SELWYN’S LAW, which discusses the law as related to consumer and small business finance airing Saturday mornings at 10:00 AM on the Christian Radio Station KFAX, located at AM 1100, whose broadcast footprint includes the San Francisco Bay Area and nationwide on the Internet. And beginning in April 2020, Selwyn expanded the reach of SELWYN’S LAW when her show was picked up by World-Wide Christian Radio, WWCR, which rebroadcasts her shows world-wide over short-wave on Friday afternoons.