Introduction

On March 30, 2009, the United States Supreme Court heard oral argument in Travelers Indemnity Co. v. Bailey,1 a case that addresses the jurisdiction of bankruptcy courts to authorize third-party releases in the context of a debtor’s plan of reorganization.

For many entities involved in a chapter 11 proceeding, this could prove to be a vitally important ruling. The decision could affect the often-sensitive negotiations that take place between a debtor and its affiliates, creditors and advisors in structuring a chapter 11 plan, and could potentially limit a debtor’s ability to emerge from bankruptcy. If the Supreme Court upholds the Second Circuit Court of Appeals’ decision, it may limit the benefits available to potential exit financing lenders and other key non-debtor parties, thus reducing those parties’ incentive to participate in and consent to a plan of reorganization. For example, if an insurance company or pension fund can be directly sued for its role in the events that triggered a company’s bankruptcy filing, and the Supreme Court has prohibited its release from this liability in the debtor company’s plan of reorganization, it will be far less likely to contribute money to fund a chapter 11 plan. Similarly, if a company’s employees or directors can be sued for their actions before and during the bankruptcy, those employees may be less motivated to work for the company’s successful reorganization. It is anticipated that the Supreme Court will rule on this matter before the end of its term in June, and we will provide a further update at that time.

Background

Travelers Indemnity involves a bankruptcy court injunction barring suits by certain asbestos claimants against the debtor’s insurers. The United States Bankruptcy Court for the Southern District of New York entered the injunction as part of the order confirming the Johns-Manville chapter 11 reorganization plan in 1986. The bankruptcy court barred both direct lawsuits and claims for contribution and indemnity against Travelers related to its insurance of Johns-Manville. Despite these restrictions, certain claimants commenced lawsuits against Travelers, asserting that Travelers was directly liable to the claimants because the insurer had actual knowledge of the dangers of asbestos, intentionally misled claimants about those dangers, and conspired with Johns-Manville and others to conceal asbestos-related risks.

Johns-Manville, once the largest asbestos manufacturer in the United States, filed for bankruptcy in 1982. During the course of its reorganization, Johns-Manville entered into a $770 million settlement with its primary liability insurers, including a settlement with Travelers under which Travelers contributed approximately $80 million to the debtors’ estates in exchange for “full and final release of all Johns- Manville-related claims.”2

In October 1986, the bankruptcy court issued its confirmation order, confirming the plan of reorganization and approving the settlement and release between the debtor and its insurers. The confirmation order included an injunction channelling all claims related to the liability insurance policies to a settlement trust, and enjoining “all persons” from commencing any action against the settling insurers “for the purpose of[] directing or indirectly” recovering on any asbestos-related claims.3

Subsequently, multiple groups of plaintiffs filed lawsuits against the Johns-Manville insurers, including Travelers. These plaintiffs asserted various statutory and common law “direct” claims against the insurers based on the insurers’ alleged failure to disclose information on the hazards of asbestos, and purported conspiracy with Johns-Manville to misrepresent these dangers. The complaints alleged that the insurers were liable to the claimants due to the insurers’ own misconduct, separate from their indirect obligations on the Johns-Manville insurance policies, which all parties acknowledged had been settled and released.

In response, Travelers petitioned the bankruptcy court to enjoin the lawsuits as having been commenced in violation of the Johns- Manville confirmation order. The bankruptcy court referred the matter to mediation, which resulted in a new settlement with some of the claimants that required Travelers to pay an additional $500 million to the plaintiffs, and pursuant to which the bankruptcy court would issue a clarifying order specifying that the direct claims were in fact enjoined by the confirmation order, and releasing Travelers from any further liability on the claims. The bankruptcy court approved the settlement, and issued the clarifying order. Certain plaintiffs appealed the order.

The United States District Court for the Southern District of New York affirmed the bankruptcy court’s decision, approving the bankruptcy court’s determination that the direct suits were “creatively pleaded attempts to collect indirectly against the Manville insurance policy” and concluding that “barring these claims was a proper exercise of jurisdiction” by the bankruptcy court.4 The district court determined that the direct action suits were within the jurisdiction of the bankruptcy court because the factual basis of the claims – Travelers’ knowledge of the dangers of asbestos and its conduct in defending Johns-Manville – arose from the Johns-Manville insurance policies at issue in the bankruptcy case.

In February 2008, the United States Court of Appeals for the Second Circuit reversed the bankruptcy court and the district court. The Second Circuit held that because the claims sought direct recovery from the insurers based on the insurers’ conduct, and because the claims were unrelated to the insurers’ obligation to pay on the Johns-Manville insurance policies, the plan included an improper release of nondebtor third parties.5 Specifically, the Second Circuit concluded that “the district court lacked subject matter jurisdiction to enjoin claims against Travelers that were predicated, as a matter of state law, on Travelers’ own alleged misconduct and were unrelated to Manville’s insurance policy proceeds and the res of the Manville estate.”6 Although third-party releases may be practically useful in connection with a plan, the Second Circuit stated that “[a] court’s ability to provide finality to a third-party is defined by its jurisdiction, not its good intentions.”7

The Second Circuit held that a plan’s release of creditors’ claims against third parties is only permissible in limited circumstances, and that a “financial contribution to a debtor’s estate” is not enough to justify the release.8 If prosecution of claims against a third party would not affect the debtor’s estate, the bankruptcy court lacks jurisdiction to release or enjoin actions against such third parties.

Supreme Court Argument

On March 30, 2009, the Supreme Court heard oral argument with respect to two petitions for certiorari seeking review of the Second Circuit’s decision.9 The petitioners asserted that the Second Circuit’s decision impractically restricted a bankruptcy court’s ability to grant releases to third parties pursuant to a plan of reorganization. At oral argument, the Justices concentrated on the scope of bankruptcy court jurisdiction to enjoin suits against non-debtors, and whether curtailing those powers would hinder the ability of debtors to reorganize. The focus of the briefs, and of the discussion before the Court, was on where to draw a line in the gray area where legal theory intersects pragmatic necessity.

A bankruptcy court only has jurisdiction over claims between non-debtors if the outcome of that litigation has a conceivable effect on the bankruptcy estate. Although it might be expedient for a bankruptcy court to issue orders relating to claims between third parties, the Bankruptcy Code does not provide this power. Focusing on this point, which the Second Circuit had expressed as a key issue, Justice Stevens wanted to know whether “any of the plaintiffs’ cases seek recovery from assets of the estate that would reduce the payments to creditors of Manville.”10 When counsel for Travelers said they would not, Justice Stevens further asked what basis there was for bankruptcy court jurisdiction, notwithstanding the fact that the respondents had conceded that in certain circumstances third party injunctions would be permissible. In response, counsel for Travelers noted that the direct action cases had never been sustained in state courts because they “relate to the discharge by Travelers of Travelers’ obligations as Manville’s insurer.”11

In addition to exploring the legal principle involved, the Supreme Court was interested in the real-world effect of its decision. Certain Justices expressed concern that, if the Supreme Court adopts the Second Circuit’s position and restricts third party releases, companies may have difficulty reorganizing. Justice Breyer, for example, queried whether insurers would be willing to cooperate with bankrupt companies to settle litigation claims if they are not assured they will be immune from future lawsuits.

Focusing on the practical issues, Justice Breyer posited that third party releases might be justified in limited circumstances where there are “special reasons,” such as where “you want to reorganize the company” and “the employees’ pension fund’s worried about claims which are related directly [to the pension fund]”, or where there are potential claims against officers and employees.12 Like releases of insurance companies, these types of releases may have an “enormous practical impact on the debtor” and the ability of the debtor to reorganize.13 At the conclusion of the argument, Justice Breyer reiterated that if the Supreme Court “start[s] mucking around and giv[ing] narrow meaning to these things now, there are going to be hundreds of thousands of people who won’t get compensated.”14

The Supreme Court also considered the extent to which it should limit a bankruptcy court’s ability to release third parties. Chief Justice Roberts asked what would happen if, as a condition to participating in a bankruptcy settlement, a third party demanded immunity from traffic accident liability, and the bankruptcy court included such immunity in its confirmation order.15 Justice Scalia posed the question of whether it would be appropriate for a bankruptcy court to order “a totally unrelated company [ ] to pay a certain amount of money [where] this company has no relationship to the bankruptcy, but the court says, this is a national problem and this other company ought to contribute.”16 Justice Scalia argued that “[s]urely there are some things that simply do not fall within the bankruptcy power.”17

Potential Implications

We expect the Supreme Court to rule on this matter shortly. Although the Supreme Court may decide Travelers Indemnity on a number of narrow grounds and avoid the issue of third party releases altogether, it is possible that the Court will issue a potentially controversial ruling that broadly addresses the circumstances under which a bankruptcy court may confirm a plan that provides for the release of claims against parties other than the debtor.

Lenders, equity investors, and other third parties regularly make financial contributions to debtors’ estates pursuant to a plan of reorganization, and those plans regularly release such participants from liability to the debtor’s creditors. Under the Second Circuit’s decision, those contributors would be required to justify any third party release by demonstrating that the release itself was crucial to the debtor’s ability to reorganize. If the Supreme Court upholds the Second Circuit’s ruling in Travelers Indemnity, it will place in doubt the ability of bankruptcy courts to approve plans including third party releases. This could have a significant chilling effect on a debtor’s ability to secure needed funding and other concessions that facilitate an orderly exit from bankruptcy.