The Lessons of the Example

[3](2): Federal Bankruptcy Act (1978) • Debtor Corporation voluntarily petitions for bankruptcy – Provisions for involuntary petition by creditors are difficult • Liquidation: Chapter 7 – Trustee is appointed to sell the assets of the corporation (Section 704) – Creditors submit claims and Trustee pays the claims based on Priorities – What are the Priorities? • • • • secured creditors receive their collateral or its value administrative expenses: legal fees and post-petition loans unsecured creditors receive pro rata distribution of their claims shareholders typically receive nothing (unless they contribute new money) • Reorganization: Chapter 11 – “Debtor in Possession”: existing management retain control over the corporation, have the powers of the trustee (Section 1106 and 1107), and the right to propose a reorganization plan Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [3](3): Automatic Stay • (a) All civil actions against the corporation are “stayed” (halted in their tracks) by the petition for bankruptcy – – – – – (1) (2) (3) (6) (7) filing a case or continuing a case to recover a claim against the corporation enforcement of a judgment against the corporation any act to obtain possession of property of the corporation any act to collect a claim against the corporation setoff any debt owed to the corporation • Tort cases and judgments are stayed, just as any case by a creditor • (b) Criminal actions are NOT stayed by the petition • Corporation must discontinue making interest and principal payments to creditors, judgment or settlement payments, etc. • All claims and judgments become bankruptcy claims Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [3](4): Claims in Bankruptcy • Claims by creditors: balance due on the debt – Debt contracts have “acceleration” clauses which make the balance due immediately upon default of any single payment – Claim from a mortgage would be the unpaid principal – Claim on a bond would be the face value due at the date of maturity • Claims by trade creditors – Amount due from corporation as a result of the sale of good or services – Creditor cannot retain money owed to the corporation in order to setoff the claim • Claims by tort claimants: – If judgment from some court, then the claim is the amount of the judgment – If no judgment, then trustee (debtor on possession) must evaluate the claim • Claims from rejection of leases and collective bargaining contracts – Unsecured claims Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [3](6): Financial Reorganization • Section 1123(a)(1): Designate classes of claims (creditors and tort claimants) and classes of interests (shareholders) • Section 1123(a)(3): Specify the treatment of each class – Treatment defines what the class will receive after bankruptcy in return for discharge of their claim – A class is not impaired if its treatment has a value equivalent to the claim – For impaired classes, each creditor in the class must be treated the same • What about tort claimants? – Unsecured claims – But some have judgments and some do not – And those without judgments have different types of injuries and claims • What about future tort claimants who do not know they have been injured at the time the corporation declares bankruptcy? Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [1](1): Torts - Breach of Legal Duty • State Common Law Judges Create Civil Duties – Decisions create tort duties NOT based on property or contract obligations – Breach of the duty by person with duty (defendant D) allows an injured person (plaintiff P) to recover damages from the defendant who caused the injuries • What is the duty? – Take care to avoid causing injuries to certain types of persons – Defendant must exercise some minimum level of care to prevent such injuries • What is a breach? What is the minimum standard of care? – – – – Intentional: D intentionally causes harm to P Recklessness (gross negligence): D recklessly disregards potential harm to the P Negligence: D did not exercise “reasonable care”, and caused harm to the P Strict Liability: D has an absolute duty to avoid harming the P irrespective of the level of care taken by the D Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [1](2): Torts - Background • Early English Torts – Crimes: first torts created for battery, theft, and trespass of land – Nuisance: early tort for damage to the property of others – Fraud: early tort for misrepresentations in contracts • Examples of Torts relevant for topics in this course – breach of fiduciary duties such as the board of directors of a corporation – product liability for manufacturers, beyond contractual warranties – fraud for misrepresentations by corporations • Many Common Law Torts have become Statutory – Statutes define civil liabilities for particular actions – Statutes have also created criminal liabilities for the same actions Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [2](1): Product Liability in Tort Law Restatement of Torts • (1) Manufacturing Defects – Strict Liability: No level of production or marketing care can eliminate liability for harm to consumers (or foreseeable plaintiffs) • (2) Design Defects – Negligence Standard on design: the product design is not reasonably safe if there is a reasonable alternative design which could reduce or avoid the foreseeable risks of harm to consumers • (3) Failure to Warn: – Even if the design is not defective, there remains a duty to warn consumers of the remaining foreseeable risks of harm from using the product – Negligence Standard on warnings: the product is defective if the manufacturer fails to adequately warn consumers of the foreseeable risks of harm – Instructions and warnings must be reasonable in light of the risks Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [2](2): Product Liability in Tort Law Defenses for Manufacturers • (1) Manufacturing Defects: Strict Liability – Misuse: If the product is misused or used for a purpose that it is not intended, then the manufacturer would not be liable for the injuries • (2) Design Defects: Negligence – Unforeseeable Risks – Contributory Negligence: plaintiff’s injuries were caused by negligence in the use of the product by the plaintiff, rather than the design of the product – Automobiles must be “crashworthy” because automobile accidents are foreseeable risks • (3) Failure to Warn: Negligence – Unforeseeable Risks – Clear and Obvious Danger of the product Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [2](4): Knowledge and Foreseeability • Does knowledge mean that the defendant actually knew? • NO, but why not? – Conscious ignorance by the defendant would be a defense – Plaintiff’s case would degenerate into what the defendant actually knew • • • • So what does knowledge mean? Knew OR Should Have Known But what does it mean to “should have known”? Courts ask what a “reasonable person” should have known – Negligence standard for knowledge depending on who is the defendant • What is reasonable for a corporation to know about its products? – Key Question in Vassallo v. Baxter Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [3](7): Johns-Manville Bankruptcy (1986) • Asbestos Health Trust (1986) – Treatment of all claims by individuals with asbestos-related diseases – Injunction: tort claimants may only settle with the Trust and cannot sue JohnsManville or its insurance companies • Initial Funding of the Trust – $646.5 million in settlements with insurance companies – $200 million in cash and assets from Johns-Manville – 50% of the common stock of the reorganized Johns-Manville • Long-Term Funding of the Trust – $75 million per year for 22 years, beginning in year 4 (later year 6) – 20% of annual profits for all long as necessary – Preferred stock which can be converted into common stock if necessary • Amendments to Section 524 codify trusts for asbestos cases Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [3](8): Kane v. Johns-Manville (1988) • Why is Kane challenging this reorganization plan? – Kane is a present tort claimant and is concerned that inclusion of future claimants will reduce the amount of money he will receive from the Trust • So Kane challenges the injunction, the voting, and the confirmation • What is the issue about the Injunction? – Future tort claimants are unknown, and cannot protect their rights – Courts have rejected this challenge to the Trust and Injunction by appointing a legal representative for the future tort claimants • What is the issue about Voting? – Acceptance requires a two-thirds vote of the dollar approved claims – Problem: Court allowed all present tort claimants (at one dollar each) to vote these claims without evaluating whether they were valid claims and without allowing other creditors to challenge the validity of the claims – Court rejects this challenge because of the overwhelming vote of the class Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [3](9): Kane v. Johns-Manville Confirmation of the Plan • Key Provisions of Confirmation of a Plan • Section 1129(a)(3): Good Faith by Corporation – Bankruptcy and reorganization is necessary – J-M was not in default on its debts when it petitioned for bankruptcy, but the estimated value of its tort liabilities exceeded its net worth • Section 1129(a)(7): Reorganization under Chapter 11 is better for the creditors than Liquidation under Chapter 7 – Present value of treatment under Chapter 11 is greater than the estimated onetime payment that the creditors would receive under Chapter 7 • Section 1129(a)(11): Business Plan can fund the Financial Plan so that the corporation is not likely to be followed by another bankruptcy – Court discusses the adequacy of the funding of the Trust Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [3](12): Continuing Asbestos Litigation • Consolidated Tort Lawsuits – 1991: All federal cases were consolidated the Eastern District Court of Pennsylvania - Philadelphia – 1993: Committee of defendants reaches a settlement agreement with representatives of the present plaintiffs • Schedule of payments for asbestos diseases, includes future plaintiffs • Administrative mechanism to administer the payments – District Court certifies one large class and approves the settlement – But Reversed by Court of Appeals and Supreme Court • Amchem Products v. Windsor (1997) • Consolidated Bankruptcies – Several of the defendants have declared bankruptcy since 1997 • Armstrong, Federal-Mogul, Owens Corning, USB, and W.R. Grace – 2002: Cases consolidated in New Jersey District and Bankruptcy Court Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [3](13): Rejection of Contracts • In Bankruptcy, the corporation my reject executory contracts or unexpired leases, subject to court approval (Section 365(a)) – Executory contracts are contracts in which one or both sides has not completed the performance promised – The corporation may “assume” and “cure” contracts on which it has defaulted • Outside bankruptcy: if a contract is breached, the other party to the contract could sue for damages as a remedy • Inside bankruptcy: if a contract is rejected, the other party must file a claim for the same damages – Such a claim would be an unsecured claim and only a small percentage would be received by the other party in the financial plan • This provision was used by several airlines in the 1980’s to reject their union contracts and convert their workforce into non-union employees Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [3](15): Rejection of Commercial Leases • Bankruptcy Code was amended in 1984 to add some special provisions for commercial leases • Commercial leases are not loans so that the corporation must continue paying the rent until the lease is rejected (Section 365(d)(3)) • Claims by lessors from rejection of commercial leases are defined and limited so that it is not necessary to calculate the contract damages – Unpaid rent due from the past – Future rent limited by the larger of (1) one year’s rent OR (2) 15% of the rent due over the remaining term of the lease (but no more than three years of rent) – Such a claim would be an unsecured claim • Special protections for shopping center landlords and airport operators – Interesting paper topics for bankruptcies in the retail sector and airline industry Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [3](17): K-Mart and its Landlords • January 22, 2002: K-Mart declares bankruptcy • After Bankruptcy, K-Mart evaluated all its commercial leases for its stores and choose from three different options for each location • (1) Close the Store and Reject the Lease (214 stores) – Landlord recovers the property and has a claim in bankruptcy for rent – These stores were unprofitable AND had lease rates above the local market rate • (2) Close the Store and Assume the Lease (70 stores) – K-Mart can “cure” defaults and nullify lease restrictions on assignment – K-Mart then auctions (assigns) these leases for $46.6 million – These stores are unprofitable but have lease rates below the local market rate • (3) Operate Store, Assume Lease, but Renegotiate Rent (1800 stores) – K-Mart sends letters to landlords requesting lower rent, threatens rejection – These stores are profitable but may have lease rates above the local market rate Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [3](14): Rejection of Collective Bargaining Contracts • Congress added Section 1113 to the Bankruptcy Code – Increase the requirements for rejecting of collective bargaining contracts • (b)(1) the corporation must make a proposal to the union representative of the modifications necessary for a successful reorganization (and provide information) • (b)(2) the corporation must negotiate with the union in good faith • (c) If a new agreement is not reached, the court can approve the rejection of the contract, if the union has refused to accept a proposal without good cause, and the balance of equities favors rejection • (e) After a hearing, the court may authorize interim changes in the collective bargaining contract if it is essential to the continuation of the business Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry [3](16): United Airlines and its Unions • December 9, 2002: United declares bankruptcy • Before Bankruptcy, United renegotiated wage concessions in order to reduce yearly costs by $1.2 billion and obtain a Federal loan guarantee • After Bankruptcy, United renegotiated larger wage concessions in order to reduce yearly costs by $2.4 billion and obtain new postpetition financing from it bank lenders • Union Before Bankruptcy After Bankruptcy • Pilots accepted 18% accepted 29% • Attendants accepted 4% accepted 9% • Machinists rejected 7% court ordered 14% • Other Unions accepted ??% accepted 13% • January 10, 2003: Bankruptcy court orders interim cut for Machinists Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry