The bankruptcy process is a historically quiet part of the US legal system that works well for the most part and doesn’t usually get much attention. Tight circles of lawyers in each geographic area usually keep things running smoothly, and there’s rarely anyone breaking the rules.
But fraud in the bankruptcy system does happen, and when I was director of the executive office of US administrators in 2002, we restructured the office and created civil and criminal enforcement divisions to fight fraud. Then, Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act in 2005 with the goal of preventing fraud and leveling the playing field in the individual bankruptcy process.
Now there seems to be trouble on the business side of the bankruptcy system due to the recent increase in mass liability issues.
Business bankruptcy process
At its most basic, the process of corporate reorganization involves restructuring the business in such a way as to maximize its value and then effectively redistributing that value to creditors. But trial attorneys have sensed an opportunity to exploit the bankruptcy claims process using mass tort destruction strategies when companies fail due to tort.
The scheme used by the trial lawyers is simple, if devastating. They have set up a complete sales operation with sophisticated “lead generation” teams that source new potential enquirers and “lead conversion” specialists that turn leads into claims with maximum value. Social media ads, TV ads, radio ads, they do it all.
The The plan is to bring a pile of overwhelming potential claims to the table – if there are $8 billion in assets and $10 billion in traditional liabilities, lawyers would be looking to bring billions more in tort claims unexpected.
This scheme effectively puts a damper on traditional restructuring, forcing the debtor and all other creditors to deal with a burgeoning new class of unsecured creditors. The insurance companies, the debtor, the creditors and sometimes the principals of the debtor are forced to go back to the drawing board.
But never fear, litigators usually come up with a simple solution: create a separate bucket of money to be held in trust as the sole source for resolving mass tort claims (including mountains of attorneys’ fees). The creation of this fund (and payday) dislodges the wrench thrown by trial attorneys, essentially frees attorneys and the new class of unsecured creditors from the field, and allows restructuring to proceed in the traditional way.
For example, the current bankruptcy of the Boy Scouts of America in Delaware is a perfect vignette. The judge has just concluded a trial on whether to uphold the proposed plan. A decision is expected soon.
At the center of the Boy Scouts bankruptcy are claims of sexual abuse. At the time of the initial bankruptcy filings, the number of actual lawsuits filed by abuse plaintiffs was less than 300, with the number should grow to around 2,000. That was in 2020.
Mass tort attorneys sit at the table
Then the mass tort attorneys came in, turned on the scheme machine, and turned everything upside down by bringing over 80,000 new sexual abuse complaints into the case. There have been allegations of lawyers cutting corners to generate these claims and skirmishes over ad content, with warnings from the judge.
But the result of this scheme has been that mass tort attorneys have been given a seat at the table where they take control of the proceedings and shake up other parties for huge paydays. The costs are real.
If the plan confirmation hearing does not serve as a springboard for the judge to deny final approval of the plan and demand further review of these claims, the resulting mess will undoubtedly be dilute funds available to the first victims whose claims led to the filing for bankruptcy.
Don’t get me wrong, we have the start of a real problem here. This shakedown scheme takes enormous value away from creditors, including, as in the Boy Scouts bankruptcy, the real victims. And the opportunities don’t seem to go away, just look at the rapid succession of Purdue Pharma’s opioid bankruptcy, the Boy Scouts of America bankruptcy, and J&J’s new talc bankruptcy.
Possible Solution—Judicial Conference
Congress could, of course, tackle systemic solutions. But a more viable avenue is the United States Judicial Conference, which prescribes official rules and forms governing bankruptcy practice and procedure. The Judicial Conference could quickly change claim forms to require greater initial disclosures and increased certification requirements for attorneys (and others) who help file claims on behalf of tort plaintiffs.
In the meantime, and as changes to the longer merged rules continue, bankruptcy judges could appoint claims reviewers in cases where a large number of mass tort claims are brought into the bankruptcy proceeding. bankruptcy. These reviewers would shed light on how tort claims are sought and reveal whether victims are abused or mistreated in the submission process.
The courts could then take corrective action. The increased transparency resulting from the routine use of claims reviewers, coupled with Judicial Conference action, could deter future abuses and protect the real victims from being crushed in a mass gold rush.
This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Lawrence A. Friedman is the managing member of Friedman Partners LLC. He served as Director of the Executive Office for US Trustees from 2002 to 2005 and prior to that served as a trustee in bankruptcy under Chapters 7 and 11.