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Course: PERRY 396, Fall 2009

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Corporations, Bankruptcies, and Takeovers Economics 396 Martin K. Perry Outline of Lectures: Corporate Bankruptcy 2 Spring 2009 XII. Texaco (1988) A. At the time, the bankruptcy of Texaco was the largest in history. Texaco's business operations were fine, but it actions in the takeover of Getty Oil generated a massive tort judgment against the corporation. The tort judgment arose from a little known provision of...

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Corporations, Bankruptcies, and Takeovers Economics 396 Martin K. Perry Outline of Lectures: Corporate Bankruptcy 2 Spring 2009 XII. Texaco (1988) A. At the time, the bankruptcy of Texaco was the largest in history. Texaco's business operations were fine, but it actions in the takeover of Getty Oil generated a massive tort judgment against the corporation. The tort judgment arose from a little known provision of the common law called &quot;tortious interference of contract&quot;. This tort arises when a third party intentionally induces one of the two parties to a contract to breach that contract. Usually this would occur by the breaching party entering into a more favorable contract with the third party. The non-breaching party can then sue for contract damages from the breach and for punitive damages from the tort. In this case, Pennzoil and Getty had an agreement to merge in which the public shareholders of Getty would receive $112.50 in cash for their shares, Gordon Getty (heir of J. Paul Getty) would receive 57% (4/7) of the shares of the merged corporation, and shareholders of Pennzoil, particularly the CEO Hugh Liedtke would receive 43% (3/7) of the shares of the merged corporation. This contract was made by a hand shake at a meeting in which the key players agreed to all the key terms were agreed. The attorneys for both sides only need to ratify the terms in writing over the next few days. Gordon Getty was the key to any merger with Getty because he owned 40% of the shares of Getty. Texaco contacted Gordon Getty after the merger agreement with Pennzoil and proposed a purchase of all the shares of Getty Oil for $125 in cash. Gordon Getty agreed to sell his shares, as did the other Getty shareholders, and the final acquisition price was $128 in cash. Pennzoil then sued Texaco for &quot;tortious interference of 1 B. C. contract&quot; and won a judgment in Texas state court (Harris County) for $7.5 billion in contract damages, $3 billion in punitive tort damages, and $600 million in interest on the judgment, for a total of $11.1 billion. The contract damages were calculated based on the lost value of acquiring Getty Oil by Pennzoil. Since Texaco was willing to pay $128 per share, the lost value was calculated as $128 minus $112.50 per share, times the number of outstanding shares of Getty Oil. On February 12, 1987, a Texas court of appeals affirmed the contract damages, but reduced the punitive damages (remittitur) to $1 billion from $3 billion. Texaco declared bankruptcy two months later on April 12, 1987. Pennzoil as an Unsecured Creditor: With this judgment of over $9 billion, Pennzoil had the same status as an unsecured creditor who had experienced a default and obtained a judgment for the balance due on its loan. The next step in state debt collection was to obtain a writ of execution on assets of Texaco. However, the entire net worth of Texaco was approximately $9.5 billion, measured in terms of the stock market capitalization or the appraised value of its assets such as refineries. Thus, Pennzoil could request the sheriffs in various states to levy on all the assets of Texaco and proceed to schedule a sheriff's sale to pay the judgment. This forced Texaco to declare bankruptcy and take advantage of the Automatic Stay (Section 362) to stop the debt collection by Pennzoil. During the remainder of 1987, Texaco's management continued to operate the corporation, but did not pay its creditors for the debts incurred before the petition for bankruptcy. Texaco prepared a plan and negotiated with Pennzoil to settle its judgment against Texaco. Texaco also proceeded with its final legal options. Texaco's request (writ of error) to the Texas Supreme Court for review of the case was denied on November 2 and Texaco was then preparing a request for review (writ of certiorari) by the United States Supreme Court. On December 19, 1987, Texaco and Pennzoil reached a settlement of Pennzoil's judgment [2]. Pennzoil agreed to accept $3 billion. This settlement did not sound good for Pennzoil, but Texaco could have continued to fight the judgment for a year or more in the courts. 2 D. E. F. Two days after the settlement with Pennzoil, Texaco filed its reorganization plan with the bankruptcy court on December 21, 1987 [3]. The plan [4] was not typical because none of the creditors, including Pennzoil, were to be impaired. The debts of each secured and unsecured creditor would be &quot;cured&quot; by making all the payments that should have occurred during the bankruptcy period, with interest (at 9%), and reinstating the debt going forward from the effective date of the confirmation. For example, the bonds which had not matured (no face value due) during the bankruptcy would be cured by paying the overdue coupon payments plus interest, and reinstating the coupon payments and face value going forward. For the bonds that had matured during the bankruptcy period, the face value would be paid plus interest to the date of confirmation. Pennzoil was placed in a class by itself. Since Pennzoil had agreed to a settlement of $3 billion, its claim in bankruptcy was $3 billion, not $9 billion. The reorganization plan specified that this Pennzoil claim would be paid in full, in cash, at the effective date of the confirmation. Thus, Pennzoil was not impaired, and would be presumed to have accepted the plan under 1126(f). Shareholders of Common Stock: The most unusual aspect of the plan was that the shareholders retained their shares of Texaco. Normally, the shares of a bankrupt corporation are extinguished, and the old shareholders can only obtain shares of the new reorganized corporation by contributing new cash to the reorganized corporation. However, none of the creditors, including Pennzoil, are impaired under this plan, so the plan can allow the shareholders to retain their common stock. Even though the shareholders retained their common stock, the class of shareholders was deemed to be impaired so that they could vote on the plan. When the vote was taken, 96% of the voting shareholders voted in favor of the plan, well above the required two-thirds majority. Thus, the shareholders accepted the plan. Confirmation: The bankruptcy judge confirmed the plan as being in the best interests of all the creditors and shareholders, including Pennzoil. A group of Texaco shareholders lead by Carl Icahn (&quot;Icahn Group&quot;) objected to confirmation of the plan because it incorporated an agreement between Texaco and Pennzoil to settle and terminate all litigation (&quot;releases and 3 G. indemnifications&quot;) with respect to Texaco's &quot;tortuous interference&quot; with the merger agreement between Pennzoil and Getty Oil [5]. This would prevent Texaco's shareholders from filing derivative lawsuits against the management of Texaco for breach of their duties to protect the corporation. Derivative lawsuits allow shareholders to recover damages to the corporation caused by the management [9]. Pennzoil bargained for these provisions terminating all future litigation [6-7]. The bankruptcy judge confirmed Texaco's plan with this agreement stating that the outcome of any derivative lawsuit would be uncertain [14-15] and that any recovery from Texaco's management in a derivative lawsuit would probably be subject to indemnification by Texaco [16]. Thus, Texaco as a corporation and its shareholders could not benefit from such litigation. In sum, the bankruptcy judge confirmed the Texaco reorganization plan because the creditors are unimpaired, and shareholders benefit from this settlement of the Pennzoil judgment because the outcome of an appeal to the U.S. Supreme Court is uncertain [10-13]. The Texaco bankruptcy is one of the first illustrations of how the bankruptcy courts will be asked to resolve the massive liabilities that can arise from tort litigation. The tort liability in the Texaco case arose from a very unusual set of circumstances, but the Pennzoil judgment approximately equaled the entire net worth of Texaco. In subsequent cases such as Johns-Manville, the tort liabilities will arise from the harm to consumers or employees caused by dangerous or defective products. XIII. Johns-Manville (1988) A. The Johns-Manville bankruptcy was the first of the corporate bankruptcies triggered by the tort liabilities from the manufacture of asbestos products. Since then, nearly every corporation that made asbestos products has been forced to declare bankruptcy in order to deal with its tort liabilities to workers and consumers who were exposed to their asbestos products. Johns-Manville (JM) declared bankruptcy on August 26, 1982. At that time, there were 12,500 lawsuits with 16,000 plaintiffs, and new suits were being filed at over 400 per month. 4 B. Studies estimated that there could an additional 50,000 to 100,000 plaintiffs. Asbestos is a fibrous metal that is resistant to fire. Thus, it was used for insulation and siding. However, exposure to asbestos fibers causes asbestos diseases in the lungs (mesotheliama, asbestosis, and cancer) ultimately causing death. In 1982, the average jury verdict was $50,000 per plaintiff. The bankruptcy court estimated the potential liability as $2 billion, but the potential liability could have been up to $5 billion [3]. This figure does not include the estimated costs of cleaning up the asbestos installed in many buildings over the years. With assets worth $1.8 billion and debt of $700 million, the net worth of JM was only $1.1 billion. Thus, even though JM was paying its debts on time, JM declared bankruptcy because the estimated future asbestos liabilities exceeded its net worth. The bankruptcy filing triggered the Automatic Stay (Section 362) which stopped all the lawsuits by the asbestos plaintiffs, forcing them to file claims with the bankruptcy court. The petition of bankruptcy by JM was challenged by the tort claimants because JM was still able to pay the judgments and settlements of these claims. These tort claimants want to pursue the litigation against JM rather than file claims with the bankruptcy court. The decision by the bankruptcy judge to allow this bankruptcy was upheld in the federal appeals courts and JM proceeded with a reorganization plan. The case Kane v. Johns-Manville, arose when members of the class of present asbestos health claimants challenged the confirmation order by the bankruptcy judge for the JM reorganization plan [1]. Their appeal ended with the decision by the Second Circuit Court of Appeals (federal court) which sits in New York City. These plaintiffs were members of that class who voted to reject the JM reorganization plan. The case provides the outline of the JM reorganization plan. Note that the bankruptcy filing occurred in August 1982 [4], but that the reorganization plan was not submitted until June of 1986 [7]. The classes were the similar to other bankruptcies except for the present and future asbestos health claims. Class 1 was the administrative claims, Class 2 was the secured claims, Class 6 was the unsecured claims, Class 7 was the preferred shareholders, and Class 8 was the common stockholders. Class 4 was the &quot;present asbestos health claims&quot; which included the 5 C. D. current plaintiffs who had filed tort lawsuits against JM. The &quot;future asbestos health claims&quot; were persons who were exposed to asbestos at JM's plants or to its products, but who had not experienced any signs of asbestos disease [2]. The future asbestos health claimants were not designated as a class, but the plan treats them the same as the present asbestos health claimants. The bankruptcy court could not identify the members of the future asbestos health claimants, or their claims, because these future claimants do not know themselves that they have been injured by exposure to asbestos. Thus, there would no natural way for a class of future asbestos health claimants to vote to accept or reject the plan. Representatives of the Asbestos Health Claimants: Each class of claims must be represented by attorneys who would negotiate on their behalf. The present asbestos health claimants naturally had representatives because they were already represented in their individual lawsuits by tort attorneys. Thus, these claimants were represented by the Asbestos Health Committee. However, the Committee declined to represent the future asbestos health claimants [4]. The interest of the present asbestos health claimants to obtain the full value of their settlements or judgments would only be harmed by sharing any recover from JM with the future asbestos health claimants. Thus, the bankruptcy judge had to appoint an attorney to represent these future asbestos health claimants. Asbestos Health Trust and Injunction [5-6]: The reorganization plan of JM would pay about half of the claims ($300 million) to the secured (Class 2) and unsecured creditors (Class 6) immediately and then issue new debt for the remainder of the creditor claims. The creditors classes were surly impaired, but they voted for the plan. The present and future tort liabilities would have jeopardized the repayment of these creditors if the bankruptcy had been delayed. In addition, the plan allowed the common stockholders (Class 8) to retain their shares. Thus, the only issue was how to compensate the present and future asbestos health claims, and how to discharge the new JohnsManville corporation from these tort liabilities. The major innovation of this case was the creation of the Asbestos Health Trust. The Trust is designed to evaluate and compensate the present and future asbestos health claimants. The trustee hired 6 E. F. physicians and other experts to create standards for compensation of the asbestos health claimants. The trustee also manages the funds allocated to the Trust. The present and future asbestos health claimants had to submit their claims for compensation to the trustee. The claims can include compensatory damages, but cannot include any punitive damages that may have been awarded in any judgment. If a claimant could not reach an agreement with the trustee, the plan included provisions for mediation, binding arbitration, or even litigation against the trustee. In order to support the Trust and discharge JM from these tort liabilities, the bankruptcy judge issued the &quot;Injunction&quot;. The Injunction prohibited present or future asbestos health claimants from continuing existing lawsuits or filing new lawsuits against JM. Thus, all present and future health claimants can only seek compensation for their injuries from the Trust. Funding of the Asbestos Health Trust [5,19]: Under the plan, JM agreed to provide $2.5 billion over 25 years to the Trust. Not all of the details are in the case, but the funds were provided in the following manner. The Trust was initially funded with approximately $650 million in cash from JM's insurance companies, $200 million in cash from JM, with newly-issued shares of JM's common stock to the Trust equivalent to 50% of the outstanding stock and an estimated worth of $323-585 million, and with newly-issued shares of preferred stock equivalent to 30% of the outstanding preferred stock (convertible into common stock). In addition, JM agreed to fund the Trust with an additional $75 million per year beginning in the fourth year (2000) and continuing through the twenty-seventh year (2023). Finally, JM agreed to contribute an additional 20% of its annual profits, if necessary. The cash payments and the new common stock would substantially reduce the market price of the common stock. For example, the newly-issued shares would have reduced the price of the common stock by half. Acceptance by Class 4 of Present Asbestos Health Claimants [7-8 and 13-15]: In order to expedite the vote on JM's plan, the bankruptcy judge allowed the present asbestos health claimants to file their claims at the same time that they voted on the plan. Since most of the claims had not been reduced to judgments in 7 G. state courts, the claims could have been challenged by the creditors or other claimants. In order to eliminate this time consuming process the bankruptcy judge decided to assign a value of $1 to each claim (whether from a judgment, a lawsuit, or simply a medical diagnosis). As such, the vote of this class by number of claimants is the same as the vote by the $1 amount of the claims. Since Section 1126(d) requires a majority vote by the number of claimants but a two-third majority vote by the dollar amount of the claims, acceptance effectively required a two-thirds majority of the number of claims. Over 52,000 claimants submitted their claims and votes, and 95.8% of these claimants voted for the plan. Thus, Class 4 accepted the plan. Except for Class 8 of the common stockholders, all the other classes voted for the plan. Kane and the other plaintiffs in Class 4 filed this lawsuit objecting to the voting procedure for Class 4 because it did not provide an opportunity to challenge the validity of the other claims in the class. In particular, invalid claims would not be entitled to a vote. The Second Circuit Court of Appeals rejected Kane's argument primarily because an overwhelming majority of the present asbestos health claimants voted for the plan. In the footnote to paragraph [15], the Second Circuit Court of Appeals pointed out that the plaintiffs would have to invalidate over 90% of the claims from the members of Class 4 that voted to accept the plan, an &quot;improbable circumstance&quot;. Confirmation of the Plan [16-19]: The primary objection of Kane and the plaintiff class was that the plan was not adequately funded to compensate the present and future asbestos health claimants. This challenge was made in terms of the bankruptcy judge incorrectly confirming the JM plan when the provisions 1129(a)(7) or 1129(a)(11) were not satisfied. On appeal, the Second Circuit Court of Appeals upheld the decision of the bankruptcy judge to confirm the JM plan. Provision 1129(a)(7) requires that the plan is better for the classes than a liquidation. This challenge was rejected based on some calculations that Class 4 would receive 100% of its claims under the plan, but only 56-81% under liquidation [17]. Provision 1129(a)(11) is the feasibility requirement. This challenge was also rejected because the Second Circuit held 8 H. I. that the funding of the Trust was sufficient to compensate the present and future health asbestos claimants. Postscript: Even though the JM plan was confirmed and the Trust implements, the bankruptcy judge maintained jurisdiction over JM and the plan in case it was necessary to revisit any of the issues surrounding the Trust. Five years after confirmation in 1991, the Trust had distributed all of its initial funds and ask the bankruptcy judge to order JM to make new contributions to the Trust. The bankruptcy judge then ordered JM to contribute an additional $500 million to the Trust. Thus, the plaintiffs were correct that the Trust was underfunded. Conclusion: The bankruptcy of Johns-Manville generated several new innovations that became the model for future bankruptcies triggered by tort liabilities. First, corporations can legitimately petition for bankruptcy to stay the tort lawsuits when the estimated tort liabilities exceed the net worth of the corporation. Thus, the corporation need not be pushed to the point where it cannot pay its debts in a timely manner in order to file for bankruptcy. Second, a reorganization plan can define classes of present and future tort claims and allow them to be represented in negotiating the plan. Third, the reorganization plan can create a Trust Fund in order to compensate the present and future tort claimants. Moreover, the bankruptcy judge can discharge these claims by enjoining the tort claimants from filing or continuing their lawsuits. In effect, the tort claimants can only seek compensation for their injuries with the Trust, and the Trust has to set up a mechanism to handle these claims in a fair manner. This trust mechanism created by the bankruptcy judge in this case what codified in Section 524(g) of the Bankruptcy Code in 1994. Finally, the bankruptcy judge can maintain jurisdiction over a reorganized corporation after confirmation of the plan. Five years after confirmation of the JM plan, the bankruptcy judge ordered JM to contribute more cash to the Trust. Thus, JM has never been completely discharged from the asbestos health claims. 9 XIV. Kmart (2007) A. Kmart Leases: Kmart petitioned for bankruptcy in 2002. Kmart had entered into many leases for its stores around the country. Kmart leased its stores from the owners of shopping centers. When a shopping center is developed, the stores would be built to Kmart specifications and then Kmart would enter into a long-term lease of the building. When Kmart petitioned for bankruptcy, many of these stores had become unprofitable. Thus, the business reorganization plan required a reduction in the number of stores in various parts of the country. Prior to bankruptcy, a tenant like Kmart could move out of a store and stop paying the rent. But the landlord would then have a lawsuit for breach of contract and the court would enter a judgment for damages. The damage calculations on a lease can be complication, so leases often contain a &quot;liquidated damage&quot; clause that allows the tenant to end the lease in return for a damage payment specified in the contract. Either way, Kmart would owe damages for ending the lease. However, after Kmart petitioned for bankruptcy, the circumstances shift dramatically. Assumption and Rejection: A lease is an executory contract that can be assumed or rejected under Section 365(a). An executory contract is one in which both promises will be executed in the future. In the case of a lease, the landlord promises to allow the tenant to use the building, and the tenant promises to pay the rent. If a lease is assumed, Section 365(b) requires that Kmart must cure any prior defaults (non-payment of rent), and provide assurance that it will pay the future rent. If a lease is rejected, the landlord can request that the bankruptcy judge calculate the damages that would have been awarded outside of bankruptcy. These damages then become an unsecured claim in the bankruptcy. Thus, the landlord is more vulnerable after bankruptcy because he will receive the same low percentage of his claim as the other general unsecured creditors. Kmart can shed its unprofitable leases with no future consequences for the reorganized corporation. Thus, assumption and rejection of leases or other contracts becomes an important part of the business reorganization plan under Section 1123(b)(2). 10 B. C. D. What Leases to Reject: Kmart rejected many of its leases. Three conditions are necessary for rejection of the lease to be the right economic decision for Kmart. First, the landlord would not renegotiate the lease for a lower rental rate; second, the Kmart store on that location was unprofitable at the rent under the lease; and third, the store could not be sublet to another retailer at a rent that would exceed the rent under the lease. Otherwise, Kmart would assume the lease. First, if the landlord was willing to renegotiate a lower rent, the store could be profitable and Kmart would enter into the new lease modifying the original lease. Many landlords were willing to renegotiate the rents because if the lease was rejection they would only have an unsecured claim in the bankruptcy and might receive pennies on each dollar of their claims. Even for profitable leases, Kmart threatened to reject the lease in order to induce the landlord to renegotiate for a lower rent. Second, if the Kmart store was profitable, then Kmart would cure and assume that lease. Third, even if the Kmart store was unprofitable and the landlord would not renegotiate the rents, Kmart would still assume the lease if Kmart could sublet the store to another retailer at a rent higher than the lease rent. Thus, even though Kmart closed a store, Kmart could make money by subletting the store at a higher rent. Background Facts for the Rubloff Case: This case arose because Kmart had sublet thirteen of its closed stores to Rubloff, a real estate development company, prior to its petition for bankruptcy. In turn, Rubloff had leased the stores to other retailers such as Old Navy, again prior to Kmart's petition for bankruptcy. Presumably, Kmart was having financial problems, was closing some stores, but then subletting the stores to others such as Rubloff. After Kmart petitioned for bankruptcy, Kmart requested a hearing with the bankruptcy judge to reject many of its leases. Note that Section 365(a) requires approval of the bankruptcy judge for rejection. Kmart's list of leases to be rejected (Schedule A) included the leases to the original landlords (Master Landlords) for the buildings that had been sublet to Rubloff. When Rubloff discovered this, Rubloff offered to pay a higher rent to Kmart for these subleases. As a result, Kmart agreed to assume these original leases from the Master Landlords, and accept a higher 11 E. rental payment from Rubloff. Presumably, the new rent paid by Rubloff on the renegotiated subleases was now higher than the rental payments that Kmart was required to make to the Master Landlords under the original leases. Thus, when Kmart exited from bankruptcy, Kmart would be earning a profit on the difference between the rents received from Rubloff and the rent paid to the Master Landlords. Decision in the Rubloff Case: The Rubloff decision arose because Rubloff wanted to file a claim with the bankruptcy court for the increase in rent that Rubloff agreed to pay Kmart on the subleases. The bankruptcy judge rejected this argument, holding the Rubloff voluntarily renegotiated the higher rent in order to avoid the consequences from a rejection of the original lease by Kmart. Note that Rubloff wanted to file claims for $28 million from the higher rental payments to Kmart. Thus, Kmart was able to negotiate significantly higher rents from Rubloff. Claims arising from rejection of contracts are valid unsecured claims. But the bankruptcy judge held that claims arising from the renegotiation of assumed leases would interfere with the ability of the debtor-in-possession to reorganize the corporation. In sum, the ability to assume or reject leases and other executory contracts is an important power for the corporation to reorganize its business plan and make the new corporation more successful when it exits bankruptcy. 12 XV. Wheeling-Pittsburgh Steel Corporation (1986) A. <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> s: This is the first major court decision after Congress adopted Section 1113 on the rejection of <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> s. A <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> is a contract between a labor union and a corporation which defines the wages, benefits, pensions, working conditions, and grievance procedures governing the workplace for the members of the union. In general, <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> s are defined by the provisions of the National Labor Relations Act (1934), and the regulations adopted by the National Labor Relations Board (NLRB), a federal agency. An important theme in the statute and regulations is the mutual obligation for the management and labor union to negotiate in good faith before either can take action to close the business, a strike by the union or a lockout by the corporation. NLRB v. Bildisco (1984) [1]: Decisions by bankruptcy judges rarely reach the Supreme Court on appeal. The issues in a major bankruptcy are too complex for federal judges to make a practice of overturning the decisions of bankruptcy judges. The Bildisco case reached the Supreme Court because it involved the controversial issue of whether Section 365(a) allowing the rejection of contracts within bankruptcy applied to <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> s. The Supreme Court held that a <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> is a contract and can be rejected, subject to approval by the bankruptcy judge. The Supreme Court also articulated a test for such approval, stating that the bankruptcy judge must &quot;balance the equities&quot; in approving the rejection of a <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> . In other words, the bankruptcy judge must the interests of the workers as well as the traditional interests of creditors. Congressional Reaction and Section 1113 [14-26]: The decision in the Wheeling case provides a nice discussion of the Congressional reaction to the Bildisco decision and the adoption of the Section 1113 to the Bankruptcy Code. The debates in Congress make it clear that Section 1113 was intended to require a new round of negotiations within bankruptcy and to set a higher standard for the rejection of <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> s. Section 1113(b)(2) requires a period of negotiation between the management and the union 13 B. C. D. before the management can make a application to the bankruptcy judge for rejection of the <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> . Sections 1113(b)(1) and 1113(c)(3) set a higher standard to be used by the bankruptcy judge before approving a rejection, but the language is not completely clear. This is the reason why the Wheeling case reached the Third Circuit Court of Appeals. Facts in the Wheeling Case [2-13]: The Wheeling case provides a typical set of facts for corporations in certain industries which have labor costs from <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> s that are higher than their domestic or foreign competitors using non-union labor. Wheeling's financial difficulties arose from a capital modernization program in the late 1970's, followed immediately by the major recession that occurred in the early 1980's. The 1980 <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> with the unions resulted in average gross labor costs of $25 per hour [2]. Wheeling negotiated wage concessions from the Steelworkers Union, as well as deferral of loan payments from its creditors. But the recession continued and Wheeling was forced to petition for bankruptcy on April 16, 1985. The management and union then entered into a dispute about the failure of the management to provide financial information about the corporation, and the management applied to the bankruptcy judge for rejection of the <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> on May 31, 1985. Rejection of <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> s is not designed to fire or layoff all of the workers. To the contrary, rejection is intended to allow the management to lower wages and increase the operating profits of the corporation. The bankruptcy judge approved the rejection of the <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> , and Wheeling reduced the wages so that its average gross labor costs were $17.50 per hour [10]. The union appealed the decision to the District Court which upheld the rejection. The union then appealed that decision to the Third Circuit Court of Appeals. While that appeal was pending, the management and union negotiated a new <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> with average gross labor costs of $18 per hour [11]. Despite this new agreement, the union continued the appeal in order to preserve its ability to obtain back wages for certain members. 14 E. F. Section 1113: Section 1113(a) makes it clear that <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> s can be rejected, but only under the provisions of this section and not under the provisions of Section 365. Section 1113(b) creates new obligations for the management before it can apply for rejection. Section (b)(1)(A) requires that the management make a proposal to the union which provides for the &quot;necessary modifications&quot; in wages and benefits that are &quot;necessary to permit the reorganization&quot; and that assure that the creditors and &quot;all of the affected parties&quot; are treated &quot;fair and equitably&quot;. The primary group of other &quot;affected parties&quot; is the employees, either union or non-union. Section (b)(1)(B) requires that the management provide the union with the financial information about the corporation that is &quot;necessary to evaluate the proposal&quot;. Finally, Section (b)(2) requires the management to negotiate in good faith with the union in an attempt to reach a new <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> that would avoid the need to apply for rejection of the existing agreement. Once management has satisfied the requirements of Section 1113(b), and failed to reach a new <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> , the management can apply to the bankruptcy judge for rejection of the agreement. Section 1113(c) provides the criteria which allow the bankruptcy judge to approve the rejection. Section 1113(c)(1) states that the management must have satisfied the requirements under Section 1113(b)(1). Section 1113(c)(2) states that the union has refused to accept the management's proposal and that the refusal was not in good faith. For example, if the union refused to accept any modifications of its existing <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> , this would be bad faith negotiations. Finally, Section 1113(c)(3) specifies a standard for rejection. In particular, the bankruptcy judge must find that the &quot;balance of equities clearly favors rejection&quot;. The standard in Section (c) (3) clearly invokes the language of Section 1113(b)(1)(A) in which the management's proposal must be &quot;necessary to permit the reorganization&quot; and be &quot;fair and equitable&quot; to the creditors and the union employees. The primary question in the appeal was whether the bankruptcy judge properly applied this standard in approving the rejection. Decision by the Third Circuit [21-24]: This is an important decision because it clarifies the standard that bankruptcy judges 15 G. should use in approving the rejection of <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> s. There are two related questions. The first question involves the meaning the word &quot;necessary&quot; that appears twice in Section 1113(b)(1)(A). The Third Circuit clarified this question by holding that the primary goal of reorganization is to avoid a current or future liquidation of the corporation. Liquidation would typically harm creditors, especially unsecured creditors. But more importantly for Section 1113, liquidation would clearly harm the employees because they would lose their jobs with the corporation. Thus, the Third Circuit held that &quot;necessary to permit the reorganization&quot; means a successful reorganization that will allow the new corporation to avoid a future liquidation. In economic terms, this would mean that the wage and benefit modifications should be such that the reorganized corporation would have a cost structure that allows it to be competitive with other corporations in its industry, either domestic firms or foreign firms. The second question addressed by the Third Circuit involves the meaning of the &quot;balance of equities&quot; between the debtor, creditors, and other &quot;affected parties&quot; which primarily includes the employees. Normally, the bankruptcy process is focused on the equitable treatment of creditors. This is particularly apparent in the criteria for confirmation under Section 1129. However, the purpose of Section 1113 is to ensure that union employees are treated equitably. Thus, the modifications to the <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> cannot be designed solely to allow the creditors to receive a higher percentage of their claims under the financial reorganization. Conversely, the modifications to the agreement cannot be designed to make the new reorganized corporation more profitable after confirmation. Remand to the Bankruptcy Judge [25-41]: The Third Circuit held that the bankruptcy judge erred in the application of Section 1113 to the Wheeling case and remanded the case to the bankruptcy judge. This is a less important part of the case, and not very surprising since this was one of the first interpretations of Section 1113 by a bankruptcy judge. The Third Circuit held that the bankruptcy judge erred by not providing an adequate justification that the wage and benefit reductions were fair and equitable relative to the losses of the creditors. In particular, the creditors would receive 50% of their $500 million in claims 16 H. over 10 years, losing $250 million. On the other hand, the union employees would sacrifice $600 million in wages and benefits over 5 years [37]. The Third Circuit also found that the bankruptcy judge did not address that fact that the wage and benefit modifications did not provide for a &quot;snap back&quot; provision in which some of the concessions would be restored if and when Wheeling became more profitable. Conclusion: This case clarified the new standards under Section 1113 for the rejection of <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> s. In subsequent bankruptcies, the corporation and the unions typically reach a new <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> that lowers wages without the bankruptcy judge having to reject the <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> . This is the clear intent of Section 1113, and preferable for the bankruptcy judges. The corporation and the union prefer to reach an agreement between themselves, rather than submit to the uncertain decision of the bankruptcy judge and ultimately the courts on appeal. XVI. U.S. Airways Group (2003) A. Pension Plans: Pension plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA). This federal law is designed to protect the private pension plans created by corporations. In addition, the statute created a federal agency called the Pension Benefit Guarantee Corporation (PBGC) to regulate and insure private pension plans. ERISA defined two types of pension plans: defined benefit plans and defined contribution plans. Under defined benefit plans, corporations must set aside funds that will be used to pay a specified amount to each retiree based on criteria such as the age at retirement, the length of service with the corporation, and the earnings during the final years prior to retirement. In contrast, under defined contribution plans, corporations make payments into a retirement fund for each employee while they are working. These plans are typically structured as matching contributions in which the amount contributed by the corporation depends on how much the employee contributes from his own wages or salary. When an employee retires, the corporation does not pay anything to the retiree, and instead, the retiree now draws on his 17 B. investment account. The significant difference between the two types of pension plans is that the investment fund created to pay the retirees under a defined benefit plan is technically the property of the corporation, while the investment accounts created for the employees under a defined contribution plan are the property of the employees. Termination of Pension Plans [24-26]: ERISA created provisions for the &quot;distress termination&quot; of a pension plan. In order to qualify for a distress termination, the corporation must have filed for bankruptcy and reorganization under Chapter 11. ERISA then delegates the responsibility for approval of a distress termination to the bankruptcy judge, but provides the standard for approval. In order to approve a distress termination, the bankruptcy judge must determine that &quot;unless the plan is terminated, the employer will be unable to pay all its debts pursuant to the plan of reorganization and will be unable to continue in business outside the Chapter 11 reorganization process&quot;. This standard is relatively strict in that the corporation must convince the bankruptcy judge that &quot;any&quot; plan for a successful reorganization will require termination of the obligations under the pension plan. However, this standard is similar to the standard for rejecting a <a href="/keyword/collective-bargaining-agreement/" ><a href="/keyword/collective-bargaining/" >collective bargaining</a> agreement</a> under Section 1113(b)(1)(A). If there were no pension plan regulations under ERISA, bankruptcy judges would have been forced to deal with pension plan commitments made by bankrupt corporations. The likely outcome of that process would have been the creation of a Trust Fund similar to the one created in Johns-Manville to handle the asbestos claims. The Trust Fund would have initially received the existing funds that had be set aside by the corporation for its pension obligations, and the corporation would have been required to contribute new funds over time into the Trust Fund. The bankruptcy judge would have then appointed a trustee to manage the Trust Fund and pay pensions to the workers that had been covered by the plan. The trustee would have the same problem of deciding how to use the Trust Fund to pay pensions to current retirees versus investing the Trust Fund to pay the future pensions of the employees. However, bankruptcy courts did not have to create such Trust Funds because ERISA specified an alternative process to handling the terminated 18 C. pension funds and obligations. Once a bankruptcy judge approves a distress termination, the funds that have been set aside for the pension plan are transferred to the PBGC, and all of the pension obligations to both retired and active employees covered by the plan are assumed by the PBGC. The typical problem is that corporations with financial problems have not set aside enough funds in order to cover the future pension obligations. In particular, their pension plans were &quot;underfunded&quot; relative to the actuarial requirements of the PBGC. The PBGC has regulates these funds, but has not been effective in requiring corporations to maintain sound funds. Thus, the PBGC will not receive enough funds to pay the full pensions promised to the current retirees or the future retirees. As a result, once the terminated plan is taken over the PBGC, the pension payments must be reduced to an amount that the funds can actuarially support. In the case of U.S. Airways, the retired pilots would receive between one-third and one-half of the promises made under the pension plan. Facts in the U.S. Airways Case [5-19]: This case is very similar to other recent cases in the airline and steel industries. The events of 9/11/01 dramatically reduced the demand for airline travel. The financial impact of this shift in demand was confounded with the subsequent increases in the prices of jet fuel. Almost every airline was eventually forced into bankruptcy. The airlines negotiated wage concessions from the various unions for pilots, mechanics, and stewards. However, these concessions were not sufficient for the airlines to cover the operating costs and still pay the debt service. Thus, termination of the pension plans became an important part of the reorganization plan. In the U.S. Airway case, the required contributions into the pension fund over the subsequent seven years under the regulations of the PBGC would have exceeded the projected operating profits of the corporation in several of those years. In order to avoid termination of the pension plans, U.S. Airways initially proposed to the PBGC that the required contributions to its pension fund over the next seven years be amortized evenly over 30 years. This proposal was called &quot;restoration funding&quot;. However, the PBGC rejected this proposal. U.S. Airways was then forced to request that the bankruptcy judge approve a distress termination of the pension 19 D. E. plan of its pilots. In order to emerge from bankruptcy, U.S. Airways needed an infusion of new cash. Under a federal loan program created after 9/11, U.S. Airways had a loan commitment from the Air Transportation Stabilization Board (ATSB) for $900 million. In addition, U.S. Airways had already borrowed $300 million from the Retirement Systems of Alabama (RSA) under Section 364 as a post-petition loan, called a debtor-in-possession (DIP) loan. Furthermore, RSA had agreed to purchase 37% of the common stock in the new reorganized corporation for $240 million. All of this financing was dependent on the termination of the pilot's pension plan, because otherwise U.S. Airways would not be able to repay the loans or earn a profit for the new shareholders. Bankruptcy Judge Approves the Distress Termination [29-37]: The opinion is the ruling of the bankruptcy judge on the application by U.S. Airways to terminate the pilot's pension plan. In light of the facts, the bankruptcy judge sees no alternative to the termination of the pilot's pension plan. The unsecured creditors are receiving only two cents on each dollar of their claims. Although the case does not discuss the secured creditors, they are probably receiving deferred payments with a present value no larger than the appraised value of their collateral. The required contributions to the pension fund for the pilots are twice as large as the required contributions for the pension plans of the other union employees, and the PBGC has refused to amortize these contributions over a longer period of time. Finally, the loans from the ATSB and the equity investment of the RSA are likely to evaporate without the termination of the pilot's pension plan. Thus, the bankruptcy judge concludes that pilot's pension plan must be terminated in order to have a successful reorganization, and avoid liquidation of U.S. Airways. Therefore, the bankruptcy judge approves the distress termination. Appeal of the Termination: The retired pilots of U.S. Airways have an association to represent their interests, and the association appealed the decision of the bankruptcy judge to terminate their pension plan. The U.S. District Court dismissed this appeal because the association did not object to the confirmation of the reorganization plan. The association appealed to the Fourth Circuit Court of Appeals, and this court 20 F. upheld the termination of the pilot's plan by the bankruptcy judge. The Appeals Court agreed that the termination was essential for the reorganization of U.S. Airways. In addition, the Appeals Court pointed out that the objections of the retired pilots should have been raised during the bankruptcy process, and not after U.S. Airways had already reorganized. This appeal is interesting because it highlights the different treatment of the active and the retired pilots. The pension plan for both was terminated and each will receive less than half of what they were promised. However, after the termination, U.S. Airways created a new defined contribution plan for its active pilots [20]. U.S. Airways had to do this in order to remain competitive with other airlines in hiring and retaining its pilots. The goal of this new defined contribution plan was that the combined contributions of the active pilots and U.S. Airways be sufficient so that the payments from the PBGC and the withdrawal from their new defined contribution plan could be similar to what they would have received from the original defined benefit plan. Thus, the retired employees are particularly vulnerable to distress terminations. The management is concerned about the retired employees because their work for the corporation has ended. Moreover, the union is much less concerned about the retired employees than it is about the active employees. Postscript: After terminating the pension plan of its pilots, U.S. Airways emerged from bankruptcy, but only briefly. Within two years, U.S. Airways petitioned for bankruptcy again and obtained approval to terminate the pension plans of the other union employees, particularly the mechanics and stewards. 21

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