The purpose of the federal bankruptcy laws, known as the Bankruptcy Code, is to enable individuals, families and businesses who are hopelessly in debt to get a new start after paying what they can of what is owed.

Strictly speaking, the ordinary definition of bankruptcy, if you look it up in an old law dictionary, is that of being broke — i.e., no money. A slightly more nuanced version is that your "net" worth is zero or less, i.e., your liabilities equal or exceed your assets. This is, again, too simplistic. Under this definition, for example, the average couple starting out in life with a new home would be bankrupt — they owe hundreds of thousands of dollars on the mortgage and have few assets: their net worth is less than zero. The difference is, they have a job or jobs that provide income, and the obligation under the mortgage is due in periodic payments over a period of fifteen or thirty years. As long as the payments can be made, everything is OK, hence no bankruptcy. The same is true for companies — as long as a business is able to make its obligations (payments to suppliers, loan payments, payroll, etc.) when they become due, everything should be OK. What generally triggers bankruptcy for companies and individuals both is something called insolvency. When you are insolvent it basically means you don't have the cash income to cover your current bills as they come due. This is true for the ordinary individual and it is true for General Motors — if you can make your monthly payment you are not bankrupt, period.

Insolvency can be caused by a drop in income or an increase in liabilities or both. Insolvency triggers all kinds of bad things. If you fail to make the monthly payments on the mortgage it is declared to be in default, and the lender is empowered under the loan agreement to accelerate the loan. That means that instead of paying that $300,000 mortgage over the next thirty years, you have to come up with it all next week. Meanwhile, the power is getting shut off, etc. You get the picture.

Another aspect of the public policy underlying the United States Bankruptcy Code is the goal of interrupting the cascade effect that a wave of business and personal insolvencies (they go together — when a company becomes insolvent and lays people off, those folks become insolvent too) can have on the economy at large (think the Great Depression, etc.).

The Bankruptcy Code has separate set-ups for individuals and businesses — it is the business side that concerns us here.

The different sections of the Bankruptcy Code are called "chapters." The two chapters available to companies with asbestos liabilities are 7 and 11. Chapter 7 is for liquidations. Liquidation in this setting means exactly what it sounds like — the company's assets are taken over by a qualified person appointed by the bankruptcy court (called the trustee), and the company's assets are sold on the open market for whatever cash they will bring. That cash is then split up among the creditors. There are actually two kinds of creditors — "secured," meaning that there is collateral to cover the debt, and "unsecured," meaning that you get paid out of whatever is left over. Mesothelioma and other asbestos-disease claimants are always, naturally, unsecured (trust us on this one).

Chapter 11 is fundamentally different. The idea in Chapter 11 is to give the company breathing room to reorganize and continue on as a viable entity, and, hopefully, to pay off a decent portion of its debts. If the plan of reorganization fails, then the bankruptcy court can order that the Chapter 11 proceeding be converted to a Chapter 7 liquidation proceeding. The official name for this is, big surprise, "conversion" (because the bankruptcy code really only goes back about a century, its terminology, with words like "conversion," "cramdown," etc., is far more commonsense than that of traditional tort law, which goes back at least eight hundred years and which is consequently loaded with archaic terms from Latin, Greek, French and the like).

When a company files for bankruptcy under Chapter 11, its attorneys file paperwork in the federal bankruptcy court. That paperwork is called a petition. Once the petition is filed, all of the lawsuits are suspended and new lawsuits against the company are prohibited by federal law. This is what's known as a bankruptcy stay, and it is enforced by a type of court order known as an injunction.

While the official start of asbestos-disease litigation as we know it was with the appeal of the trial result in the case of Clarence Borel vs. Fibreboard Paper Products in 1973, the tide really didn't turn against the defendant companies (at this time they were mostly manufacturers and distributors of construction products) until the beginning of the 1980's. The first company to file for bankruptcy, on July 29, 1982, was UNR Industries. UNR's UNARCO division (short for the Union Asbestos and Rubber Company), had made, among other things, the Unibestos product line prior to its sale to Pittsburgh Corning in 1962. This filing really didn't cause that much of a blip on the radar screen — UNR was not a huge company at the time, and all concerned knew that its insurance coverage was limited. The filing did, however, raise some interesting issues.

Traditionally, the only debts that could be wiped clean (called a discharge) were those that were liquidated — i.e., reduced to a sum certain. Debts, like tort liabilities that have not been settled or gone to judgment, cannot be calculated with any degree of certainty, and are, hence, unliquidated. This situation meant that if a debtor had substantial unliquidated debt, that debtor really couldn't get the "fresh start" that the bankruptcy laws were supposed to be providing. Congress stepped in to fix this as part of major overhaul of the Bankruptcy Code in 1978. The new law provided for the discharge of future debts that were unliquidated. So, for example, if you were an individual down on your luck and one of your big debts was liability for a car accident that wasn't covered by insurance, that debt could now be discharged. Everybody thought this was well and good, only it really wasn't.

It wasn't good because it radically changed the definition of what it means to be eligible to file for bankruptcy protection — you no longer really had to be insolvent.

For an asbestos company the spring/summer of 1982 was not a good time to be around. In addition to getting clobbered in court and having to sue your insurance companies (which were, in turn, suing each other), you also had to deal with the fact that the economy of the United States was mired in a very deep recession. There is no more vulnerable business to be in during an economic downturn than that of construction products. Companies in the position of UNR were facing the wall and looking for a way out. Their lawyers found it in the 1978 revisions to the bankruptcy code. Even though UNR was still a healthy operating company with cash flow adequate to meet its current obligations (remember that the adverse jury verdicts were, for the most part, on appeal, which can delay their collection for years, and, sometimes, forever). But because it could prove that it was facing a looming mountain unliquidated liabilities that, if left unchecked, would be terminal, UNR was eligible to file for bankruptcy protection.

The following month, on August 26, 1982, Johns-Manville, the largest asbestos-products company in the world, filed Chapter for Chapter 11 protection. Johns-Manville was ranked 185th on the Fortune 500 list, had mining and manufacturing operations all over the planet, exported or sold its products to 58 countries, and had a corporate history going back to 1858. It would be a huge understatement to say that the Johns-Manville filing was a shock to the business world.

It was also rude shock to the other asbestos manufacturers who were still defendants in the approximately ten thousand cases that were then pending. Under a legal doctrine know as joint and several liability, the other defendants were responsible for Manville's share of responsibility, so long as they were found to have at least some liability themselves. These companies asked the courts to stay all the pending lawsuits until JM emerged from bankruptcy (which would not be for years). The courts, quite rightly, told them to get lost.

The enormous transactional costs and loss of shareholder value experienced by UNR and JM that resulted from the 1982 Chapter 11 filings made other companies reluctant to follow the same course of action, unless there was no other course available. Forty-Eight Insulations, for example, filed in 1985, but it was a Chapter 7 liquidation — there just wasn't anything left. Eagle-Picher Industries, one of the major manufacturers of insulating cements, filed 1991 when its insurance coverage was largely exhausted.

In the meantime, the JM and UNR bankruptcies ground forward at a snail's pace, with most of the attention focused on JM, because there was so much more at stake. In a Chapter 11 case, the debtor must come up with a plan of reorganization. That plan must be approved by Bankruptcy Court. Prior to that approval, any and all creditors have a right to object to the plan. If the plan is approved, any creditor (this includes everyone from mesothelioma plaintiffs to suppliers to employee pension plans to holders of corporate bonds — you get the picture) can appeal the plan to the local federal trial court, known as the district court. If the district court signs off on the plan, it can be appealed to the United States Court of Appeals for the Circuit in which the district and bankruptcy courts reside. Ultimately, it can be appealed to the United States Supreme Court. If any court along the way rejects the plan, everybody goes back to square one. That is one of the reasons that these types of proceedings take so long.

The UNR and JM plans presented a new wrinkle in that there were projected liabilities that were not only not liquidated but also not even in existence — the filings were based in part on epidemiological studies about how many people were going to get sick in the future and at what rate. These future victims would become creditors but there was no way of knowing exactly who they were going to be. The Bankruptcy Courts in both cases dealt with this issue by appointing a representative for future claimants. These were the first bankruptcy proceedings where there were attorneys representing plaintiffs who only existed in theory, but it was a sound decision — otherwise the current plaintiffs would have gotten everything and people who got sick in the future would have had no recourse.

The plans had to deal with two objectives: first, the survival of the debtor company; and, second, the provision of compensation for those who were sick and those would get sick in the future. The solution was to take to the old company and create two new entities out of it — first, a new version of the debtor company and, second, a type of legal entity called a trust. The new company would continue the business of the old company — making and selling things and thereby making money. That new company would be immune from being sued, ever, for asbestos-related diseases. The trust would stand in the shoes of the old company and pay the sick people as they got sick and/or died. In order that the trust would have the money to pay sick people in the long term, the trust would be funded with all of insurance money that had been available to the old company, along with as much cash as could be spared without saddling the new company with a crippling amount of debt. In order be able to compensate sick people in the long term the trust would essentially own most of the new company — the trust would be the owner of most of the new company's stock, which the trust could either hang onto or sell to raise cash as needed. Claims against the old company would redirected to the new trust by way of a permanent court order called a channeling injunction.

These arrangements were finally approved and all appeals exhausted at the end of the 1980s. In 1994, congress codified these arrangements under Section 524(g) of the United States Bankruptcy Code, giving retroactive approval to the UNR and Johns-Manville trust arrangements.

In 1995-96, the federal courts, and ultimately the United States Supreme Court, rejected the Georgine Class Action that had been the other approach for forcing a nationwide settlement without resort bankruptcy protection.

At the end of the 90s, claims were coming at a larger rate than anyone had imagined just a few years before. It goes without saying that many of these claims met only the most dubious of medical criteria. In the meantime, the insurance coverage was running out. Moreover, the failure of the Georgine approach essentially dried up the credit markets — if you were a company with serious asbestos liability nobody wanted to own your stock or loan you money. If you have ever run a business, you know that this can be the end. In 1999, it finally started. Pittsburgh-Corning, Babcock & Wilcox, Owens-Corning, GAF (which changed its name to G-I Holdings just before filing), Armstrong World Industries, Combustion Engineering, and W.R. Grace all filed within a 24-month period. Those were the big ones — a host of smaller entities also filed at this time. Since then, Harbison-Walker, A.P. Green, North American Refractories, Flintkote, and host of others have filed, and there is no end in sight.

It is important to remember that most of these companies were in relatively good health when they filed, and remain in good health today. The shareholders of those companies did get hurt, however, as they saw much, if not all of their ownership value transferred to the new 524(g) trusts. In essence we are now going to have two parallel systems of compensation — one in bankruptcy and one the tort system. The 524(g) trusts that are the spawn of the 1999-2002 wave of filings are just beginning to come on line now, and it will be interesting to see how things turn out.

Since then, Dow Corning has used this setup for silicone implant litigation, and other firms are using it in other kinds of mass tort situations. Even more intriguing, companies like General Motors that have huge "legacy" pension and health care liabilities are looking to the 524(g) trust to get these liabilities off their books and onto trusts administered by employee unions.
 

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