Three and a Half Rules for Tort Claims in (and out of) Chapter 11.

• Author: Sperduto, Luke

ABSTRACT

When a corporation files for bankruptcy due to tort liabilities, tort claimants often receive a smaller share of what they are owed than the company's secured creditors. This is because tort claims are unsecured and thus subordinate to secured claims under state and federal law. Many legislators and scholars, noting the injustice or social inefficiency of applying this priority rule to nonadjusting creditors, have proposed legal reforms to increase tort claimants' recoveries in bankruptcy. Unfortunately, each of the most common proposals suffers at least one glaring shortcoming. A common reform proposal among legislators--nondischargeability for tort claims--is inferior to the status quo to the extent it induces some otherwise profitable corporate tortfeasors to forsake reorganization in favor of liquidation, which jeopardizes recoveries on nondischarged claims. On the other hand, the most widely endorsed reform among scholars--superpriority for tort claims--is dogged by a lack of clarity over which level of government (state or federal) is best positioned to implement it and how.

This Article analyzes these two reform proposals in order to clarify their relationship to the status quo and advocate for reform at the federal level. Especially in mass tort bankruptcies, nondischargeability is a recipe for squandering going-concern value. Equally troubling, because it would encourage bankruptcy-remote financing arrangements and forum shopping without increasing tort claimants' recoveries, a half-implemented superpriority rule (effective in bankruptcy but not in non-bankruptcy insolvency scenarios) would likely be inferior to the status quo. In contrast, a fully-implemented superpriority rule (effective in both bankruptcy and non-bankruptcy insolvency scenarios) would likely be superior to the status quo to the extent it reduces the aggregate costs of corporate torts more than it increases costs associated with bankruptcy-remote financing arrangements. Due to coordination challenges between and within states that make state-level superpriority unlikely, Congress should pass a fully-implemented superpriority rule for tort claims.

TABLE OF CONTENTS INTRODUCTION I. THE STATUS QUO A. Allowance (i) What constitutes proof of a tort claim? (ii) How is the amount of the tort claim determined? (iii) How are future claims represented in the bankruptcy proceeding? B. Priority C. Discharge (i) To protect the freedom to contract, debts preserved by the reorganization plan are not discharged (ii) Because it is not necessary, debts of a liquidating corporation are not discharged (iii) To further the public interest in efficient bankruptcy proceedings, only certain debts owed to the government for fraud or tax evasion are not discharged (iv) Out of respect for procedural due process, inadequate notice precludes discharge II. NONDISCHARGEABILITY A. An Abridged History of Nondischargeable Tort Claims against Corporations (i) Unprovable (and thus nondischargeable) tort claims were difficult to distinguish from provable (and thus dischargeable) quasi-contract claims (ii) Nondischargeable tort claims "incapable of proof" were particularly susceptible to de facto discharge through liquidation (iii) Chapter-dependent nondischargeability encouraged litigation and gamesmanship B. The Political Economy of Nondischargeability (i) The dimensions of an optimal discharge rule are broad (ii) The sub-optimal BAPCPA Proposals were politically motivated C. Analyzing the Inefficiencies of an Optimal Discharge Rule (i) How does the application of the optimal discharge rule to non-governmental tort claims create a high risk of excessive litigation? (ii) How does excessive litigation squander going concern value? III. SUPERPRIORITY A. Distinguishing the Benefits of the Secured Creditor's Priority Right (i) Information Efficiency Benefits of the Secured Creditor's Priority Right (ii) Distributional Benefits of the Secured Creditor's Priority Right (iii) But-for Lending Made Possible by the Secured Creditor's Priority Right B. Arguing For Fully-Implemented Superpriority (i) The Social Costs of Fully-Implemented Superpriority for Tort Claims (ii) The Social Benefits of Fully-Implemented Superpriority for Tort Claims C. Arguing Against Half-Implemented Superpriority IV. IMPLEMENTATION A. State-level Coordination Challenges Confronting a Cooperative Approach (i) Coordination Challenges Between States Competition and the Race to the Bottom (ii) Coordination Challenges Within States--Legislative Capture by the Credit Industry B. Congress's Constitutional Authority to Pursue a Unilaterally Federal Approach (i) The Bankruptcy Clause authorizes Congress to fully implement tort-claim superpriority (ii) The Commerce Clause authorizes Congress to fully implement tort-claim superpriority CONCLUSION INTRODUCTION

When a corporation files for bankruptcy due to tort liabilities, tort claimants often recover a smaller share of what they are owed than the company's secured creditors. (1) This is because tort claims are general unsecured claims, which are subordinate to secured claims under state law (2) and the United States Bankruptcy Code (the "Code" (3)). Unless secured creditors agree otherwise, the value of the bankruptcy estate is distributed to them before anything gets to unsecured creditors. Once secured claims are satisfied in full, whatever value remains is distributed to tort claimants and other general unsecured creditors on a pro rata basis.

Fair or not, this is a socially inefficient distribution rule because tort claimants are involuntary, nonadjusting creditors ("INCs"). (4) Unlike other creditors, INCs cannot avoid becoming creditors and cannot adjust the interest rate or other terms of their claims to reflect the debtor's credit risk. As a result, INCs end up bearing some of the costs of the debtor's financing and operating decisions without any opportunity to influence those decisions at the time they extend credit. While prioritizing repayment of secured claims generally encourages lending to and monitoring of corporations that potentially benefits all corporate stakeholders and society at large, the costs of that prioritization are borne primarily by tort claimants and other INCs in the form of diminished recoveries when the debtor-tortfeasor goes insolvent. Instead of allocating corporate tort risk to those best able to minimize it, the status quo rule externalizes onto tort victims some of the costs of enterprise-threatening corporate accidents and frauds. (5)

Many legislators and scholars, noting the injustice or social inefficiency of the status quo rule, have proposed legal reforms to increase tort claimants' recoveries in bankruptcy. (6) Unfortunately, each of the most common proposals suffers at least one glaring shortcoming. A popular reform proposal among legislators is to make tort claims nondischargeable, so they remain enforceable against a reorganized debtor after the reorganization plan is confirmed. (7) This proposal is inferior to the status quo to the extent it induces some otherwise profitable corporate tortfeasors to forsake reorganization in favor of liquidation, which jeopardizes recoveries on the very nondischarged claims the proposal is intended to protect. On the other hand, the most widely endorsed reform among scholars would grant tort claims a superpriority status, so they receive payment on par with at least some portion of secured claims. (8) This proposal is dogged by a lack of consensus on two particulars: sphere of application (i.e., should it apply only in bankruptcy or in both bankruptcy and non-bankruptcy insolvency scenarios as well?) and means of implementation (i.e., should it be implemented through state and federal, or solely federal, legislation?). (9)

This Article analyzes these two reform proposals in order to clarify their relationship to the status quo and advocate for reform at the federal level. Without attempting quantification, the argument relies on reasonable theoretical assumptions buttressed by historical and hypothetical examples to identify a set of plausible propositions that, if empirically sound, would together imply the following ranking (from most to least socially efficient) among three (and a half) rules for tort claims against financially distressed corporate debtors: (1) superpriority effective both in and outside of bankruptcy (referred to as "fully-implemented superpriority"); (2) the status quo; (2 1/2) superpriority effective in but not outside of bankruptcy (referred to as "half-implemented superpriority"); and (3) nondischargeability. This ranking is the "demonstrandum" of this Article. (10) If true, the comparison between rules (1) and (2) suggests that some corporate debt in the United States is currently underpriced (which is one reason to believe that some corporations are overleveraged) relative to the price level (and leverage) that would obtain if the law encouraged corporate borrowers and lenders to more fully internalize the costs of accidents and frauds into their transactions with one another. (11) Due to coordination challenges between and within states that impede state-level superpriority legislation, Congress should pass a fully-implemented superpriority rule to rectify this market failure.

Much if not all of the reasoning behind the demonstrandum is already well established. Specifically, the relationship between rules (2) and (3) was recognized in the congressional debates that eventually led to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"). (12) The relationship between rules (1) and (2) has been repeatedly articulated by a host of legal scholars since the mid'1980s. (13) The relationship between rules (2) and (2V2), though not universally embraced, has also been vigorously defended. (14) Others have observed how competition between states and legislative capture within states deter the drafters of Article...