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Finding that its “pre-packaged” bankruptcy plan was riddled with flaws, the 3rd U.S. Circuit Court of Appeals has rejected a corporate defendant’s bid to resolve all of its outstanding asbestos claims by establishing a $1.2 billion trust. The 136-page decision in In re Combustion Engineering Inc. is the first appellate court ruling on a growing trend among asbestos defendants to pre-package a bankruptcy by filing a disclosure statement and reorganization plan that has already been voted upon by impaired creditors. Now the 3rd Circuit has ruled that lower courts were too quick to approve an attempt by Construction Engineering Inc. to utilize just such a strategy. In addition to Combustion Engineering, similar pre-packaged bankruptcy plans were filed in the past few years by Shook & Fletcher Insulation Co., J.T. Thorpe Co., Mid-Valley Inc. and Congoleum Corp. A unanimous three-judge panel concluded that the process used to confirm the plan may have been unfair because it was approved by a group of asbestos claimants who had already been paid 95 percent of their claims, but would provide as little as 18-percent recovery to some of the other claimants. The ruling is a setback for Combustion Engineering’s parent company, ABB Ltd., a Swiss-Swedish engineering firm, and reverses decisions by the Delaware Bankruptcy Court and district court that approved the plan. Although the appellate court did not close the door on possible future approval of the plan, it ordered extensive hearings and fact-finding on issues related to the plan’s fairness. Chief U.S. Circuit Judge Anthony J. Scirica found that Combustion Engineering “made a pre-petition side arrangement with a privileged group of asbestos claimants, who as a consequence represented a voting majority despite holding, in many cases, only slightly impaired ‘stub claims.’” By winning approval from a group of creditors who had only a fragment of their claim remaining, Scirica found that Combustion Engineering may have violated a provision of the Bankruptcy Code that allows for the establishment of a trust to pay off asbestos claims. “This type of manipulation is especially problematic in the asbestos context, where a voting majority can be made to consist of non-malignant claimants whose interests may be adverse to those of claimants with more severe injuries,” Scirica wrote in an opinion joined by Judges Thomas L. Ambro and Julio M. Fuentes. Scirica found that since some of the asbestos claimants received as much as 95 percent of the full liquidated value of their claims, they had “little incentive to scrutinize” the terms of the proposed plan. “Rather, their incentive appears to have been otherwise, given that the favorable prepetition settlements were conditioned, at least implicitly, on a subsequent vote in favor of the plan,” Scirica wrote. The ruling is a victory for attorneys Gregory M. Harvey of Montgomery McCracken Walker & Rhoads and Steven Kazan of Kazan McClain Abrams Fernandez Lyons & Farrise in Oakland, Calif., who represented a group styled “Certain Cancer Claimants.” Combustion Engineering was represented in the appeal by a team of lawyers from Kirkland & Ellis led by attorneys David M. Bernick and John Donley of the firm’s Chicago office. LONG ARGUMENT When the case was argued in June, the judges had allotted three hours for the sides to be heard but repeatedly added time to the clock. By the end of the session the seven lawyers who stepped up to the podium had logged more than six hours of argument with just one 10-minute break. According to court papers, Combustion Engineering defended asbestos-related litigation for nearly four decades until mounting personal injury liabilities eventually brought the company to the brink of insolvency. In the fall of 2002, Combustion Engineering and its parent company, ABB, attempted a final resolution of its asbestos problems, as well as those of two U.S. ABB affiliates — ABB Lummus Global Inc. and Basic Inc. — through a pre-packaged Chapter 11 bankruptcy reorganization. Combustion Engineering contributed half of its assets to a pre-petition trust to pay asbestos claimants with pending lawsuits for part, but not the entire amount, of their claims. The remaining, unpaid portion of these claims, known as “stub claims,” provided pre-petition trust participants with creditor status under the Bankruptcy Code. Combustion Engineering then filed a prepackaged bankruptcy plan of reorganization, the centerpiece of which was an injunction in favor of Combustion Engineering that “channels” all of its asbestos claims to a post-confirmation trust created under �524(g) of the Bankruptcy Code. The plan also extended the asbestos liability shield to the non-debtor affiliates Basic and Lummus. Section 524(g) was enacted in 1994 to codify the manner in which asbestos personal-injury claims were resolved in the Johns Manville bankruptcy. The law allows for the establishment of a trust to pay present and future asbestos claims, enjoining such claims from being asserted against the debtor and discharging the debtor from such liabilities. Combustion Engineering set out to take advantage of �524(g) by initiating negotiations in October 2000 with Joseph Rice, a prominent asbestos claimants attorney. With an eye toward the ultimate bankruptcy filing, the company entered into a “master settlement agreement” that established a prepetition settlement trust to resolve a portion of its asbestos liabilities. The trust procedures split the pending asbestos claims into three categories based on the status of the claim as either settled, resolved but without a documented settlement agreement, and all other claims. The trust paid the first group 95 percent of the agreed value for their claims. The second group was paid 85 percent of the claim value, and the third group was paid 75 percent of the claim value. As a result, each claimant was left with an unsecured “stub” claim that ultimately was impaired under Combustion Engineering’s soon-to-be-filed bankruptcy plan. The plan was advanced with the support of the claimants’ representative and the “future claimants’ representative,” who was appointed as required by �524(g) to represent the interests of those persons who did not have an existing asbestos personal injury claim but who would have such a claim in the future. Under the plan, a trust was established to satisfy the “stub” claims left over from the pre-petition settlement trust and all future asbestos claims, thereby insulating Combustion Engineering and its affiliates from asbestos claims going forward. But the plan met significant opposition from a group of insurers and certain asbestos personal injury claimants. Both the Bankruptcy Court and the district court overruled the objections and approved the plan. WORD OF CAUTION Senior U.S. District Judge Alfred M. Wolin of the District of New Jersey, who had been specially assigned to the case, said he recognized that some claimants would receive more than others, but found that the plan was nonetheless fair. In his opinion approving the plan, Wolin (who has since stepped down from the bench) said the objecting claimants were arguing that the plan represented “a corrupt attempt by solvent companies to obtain the benefits of a channeling injunction under the Bankruptcy Code by bribing the plaintiffs’ bar.” The “supposed bribe,” Wolin said, was “immediate payment to present claimants, from whom counsel will recoup their fees, at the expense of future claimants, who may be far sicker but who represent a far less certain source of revenue for counsel.” Wolin rejected the arguments, but offered a word of caution in his district court opinion. “That does not mean that this is a perfect plan. Nor does it mean that the court is enamored with the process by which it evolved. The courts and the public deserve a process that is not so easily impugned with charges of conflicts of interest and tainted votes, whether those charges are ultimately proved or not,” Wolin wrote. On appeal, the lawyers for the “Certain Cancer Claimants” argued that the trust “artificially impaired” or contrived the stub claims in order to garner sufficient votes in favor of confirmation. Now the 3rd Circuit has ruled that the bankruptcy court must take a closer look at that claim. Scirica found that artificial impairment occurs “when a plan imposes an insignificant or de minimis impairment on a class of claims to qualify those claims as impaired.” The “chief concern” with such conduct, Scirica said, “is that it potentially allows a debtor to manipulate the Chapter 11 confirmation process by engineering literal compliance with the code while avoiding opposition to reorganization by truly impaired creditors.” Other courts “have found this practice troubling,” Scirica said, and “in the context of this asbestos-related bankruptcy, so do we.” Unlike the ordinary commercial bankruptcy, where stub claims may be used to facilitate a workout plan in the overall best interests of creditors, Scirica found that “the use of stub claims in this case may constitute ‘artificial impairment.’”

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