Determining when a claim arises

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Journal of Corporate Renewal 28 October 2012

D

etermining when a claim arises

under the Bankruptcy Code is a deceptively complicated issue with significant implications for debtors and their creditors. Because claims are discharged under Sections 727(a) and 1141(d) of the Bankruptcy Code, a broad interpretation of a claim enables a debtor to shield itself and its successors from liability against a wide range of claims. Over the past several years, the 3rd U.S. Circuit Court of Appeals has been reshaping its decisional authority with respect to when a claim arises, and it recently

adopted a new standard in Wright v.

Owens Corning, 679 F.3d 101 (3d Cir. 2012), an opinion published this spring that fleshes out its evolving standard in this area of bankruptcy law. Section 101(5) of the Bankruptcy Code defines a claim as “[a] right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured . . . .”. The U.S. Supreme Court has stated that “claim” is intended to have “the broadest available

definition,” FCC v. NextWave Pers.

Comm’cns Inc., 537 U.S. 293, 302

(2003). It is widely accepted that Congress contemplated that “‘all legal obligations of the debtor, no matter how remote or contingent, will be able to be dealt with in the bankruptcy’” to permit the “‘broadest possible relief in

bankruptcy court.’” Grady v. A.H. Robins

Co., Inc., 839 F.2d 198, 200 (4th Cir. 1988) (quoting H.R.Rep. No.

595, 95th Cong., 1st Sess. 309 (1977), S.Rep. No. 989, 95th Cong., 2d Sess. 21-22 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5807-08 and 6266)). The Bankruptcy Code’s broad definition of a claim includes contingent claims, which, although not defined by the

Bankruptcy Code, are commonly held to include claims that a debtor will be required to pay only upon the occurrence of a future event triggering the debtor’s liability. The inclusion of a contingent right to payment in the definition of a claim under Section 101(5) of the Bankruptcy Code clarifies

that a right to payment that is not yet enforceable

under non-bankruptcy law at the time of a

bankruptcy filing may still constitute a claim

that is dischargeable in

bankruptcy.1_{The broad}

and sweeping notion of a claim is an easy

concept to grasp, but is much more

difficult to apply. A broad definition of a claim is consistent with Bankruptcy Code Section 502’s claims-allowance process, which provides for the estimation of contingent and unliquidated claims to allow Bankruptcy Courts to deal comprehensively with all claims in a case. Without this broad authority to address claims of a wide-ranging nature, a debtor’s ability to reorganize

would be seriously threatened by the survival of lingering contingent

3rd Circuit Expands

Bankruptcy Claims Test

BY MICHAEL KLEIN & BRENT WEISENBERG, ASSOCIATES, COOLEY LLP

Briefly

FEATURE

continued on page 30 Journal of Corporate Renewal 28 October 2012

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claims and potential litigation rooted in the debtor’s prepetition conduct. However, defining a claim too broadly means that claims of individuals not identified, or even possibly identified, at the time of the bankruptcy filing and plan confirmation could be subject to discharge in bankruptcy. For example, problematic due process issues arise when a debtor’s prepetition conduct first manifests in injury only after plan confirmation. If a court determines that the injured party held a claim at the time of injury, then it is almost axiomatic that the creditor was not provided with actual notice of a claims bar date because its injury had not even been apparent at that time. In balancing the due process rights of individuals against the need to broadly define a claim to assist a debtor in reorganizing, many courts conclude that there are outer limits to what constitutes a claim dischargeable in bankruptcy, even when the claim is tied to prepetition conduct of a debtor. With respect to contingent claims, courts often discuss the need

for adequate notice to creditors and procedural due process requirements found in the Fifth Amendment: A fundamental right guaranteed by

the Constitution is the opportunity to be heard when a property interest is at stake. Specifically, the reorganization process depends upon all creditors and interested parties being properly notified of all vital steps in the proceeding so they may have the opportunity to protect their interests…. [The court] will not require [a creditor] to subject its claim to a confirmed reorganization plan that it had no opportunity to dispute.

In re Federated Dept. Stores, 158 B.R. 103, 105 (Bankr. S.D. Ohio 1993) (movant authorized to proceed with personal injury suit against debtor without regard to debtor’s discharge because movant had not received notice of debtor’s bankruptcy) (quoting

Reliable Elec. Co., Inc. v. Olson Constr.

Co., 726 F.2d 620, 623 (10th Cir. 1984)).

Grappling with the competing interests of a broad definition of claim intended to protect a debtor’s fresh start and the requirements of due process,

courts have created three tests to determine when claims arise under the Bankruptcy Code: (1) the right to payment approach; (2) the conduct approach and (3) the relationship/ fair contemplation approach.

Under the right to payment approach,

adopted by the 3rd Circuit in Avelino

& Bienes v. M. Frenville Co. (In re M. Frenville Co.), 744 F.2d 332 (3d Cir. 1984), a claim arises for bankruptcy purposes when a right to payment accrues or matures. A claim arises under the conduct test, applied by the 4th Circuit in Grady v. A.H. Robins Co., Inc., 839 F.2d 198, 200 (4th Cir. 1988), when the debtor engages in conduct that ultimately causes harm, even if the actual injury or accrual of a cause of action under state law does not take place until after the debtor’s bankruptcy filing. Because of the breadth of claims encompassed by the conduct test, some courts have proposed a modification to the test by requiring a prebankruptcy relationship between the debtor and the purported claimant. Commonly referred to as the “prepetition relationship test,” it provides that a claim exists under the Bankruptcy Code only if it arises

continued from page 28

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from the debtor’s prepetition conduct and the claimant had some prepetition relationship with the debtor, such as contact, exposure, impact, or privity.

See, e.g., Epstein v. Official Committee

of Unsecured Creditors of Estate of Piper Aircraft Corp., 58 F.3d 1573 (11th Cir. 1995). Courts outside the 3rd Circuit have

routinely declined to follow Frenville’s

right to payment test, reasoning that a test focusing exclusively on when a right to payment accrues or matures conflicts with the Bankruptcy Code’s expansive treatment of a claim. Indeed, the Frenville decision has long been “one of the most criticized and least followed precedents decided under

the current Bankruptcy Code.” See e.g.,

Firearms Imp. & Exp. Corp. v. United Capital Ins. Co. (In re Firearms Imp. & Exp. Corp.), 131 B.R. 1009, 1015 (Bankr.

S.D. Fla. 1991); see also Emons Indus.,

Inc. v. Allen (In re Emons Indus., Inc.),

220 B.R. 182, 193 (Bankr. S.D.N.Y. 1998).

Changing Course

In the wake of Frenville, courts generally

adopted the conduct test or the prepetition relationship test. Perhaps as a result of this criticism, the 3rd Circuit departed from its prior jurisprudence,

overruling in Jeld-Wen, Inc. v. Van

Brunt (In re Grossman’s Inc.), 607 F.3d 114 (3d Cir. 2010), its prior adoption of the right to payment approach. In Grossman’s, a claimant was allegedly exposed to asbestos when she used the debtors’ products in 1977, 20 years before the debtors filed their Chapter 11 cases. In 2007, after the commencement of the debtor’s bankruptcy, the claimant was diagnosed with mesothelioma, a cancer linked to asbestos exposure. Shortly thereafter, the claimant commenced a state court tort and breach of warranty action against the debtors’ successor-in-interest and other companies that allegedly manufactured the asbestos-containing products. In response, the debtors’ successor commenced an adversary proceeding in the Bankruptcy Court to enjoin claimant’s action and for a determination that any liability on the claims had been discharged pursuant to the debtors’ Chapter 11 plan of reorganization.

Relying on the Frenville decision,

the Bankruptcy Court held that the asbestos claims were not discharged by the debtors’ Chapter 11 plan

because they arose subsequent to the plan’s effective date, according to state law. On appeal, the District Court affirmed the Bankruptcy Court’s holding with respect to the tort claims, and the debtors’ successor appealed the decision to the 3rd Circuit.

The 3rd Circuit concluded that Frenville

had too narrowly construed what constituted a claim and, in effect, had disregarded the “contingent” and “unmatured” language in the Bankruptcy

Code’s definition of claim. In re

Grossman’s Inc., 607 F.3d at 121. The 3rd Circuit concluded that “[i]rrespective of the title used, there seems to be something approaching a consensus among the courts that a prerequisite for recognizing a ‘claim’ is that the claimant’s exposure to a product giving rise to the ‘claim’ occurred pre-petition, even though the injury manifested

after the reorganization.” Id. at 125.

The 3rd Circuit thus struck down the longstanding accrual test established in Frenville and held that a claim arises when an individual is exposed prepetition to a product or other

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conduct giving rise to an injury, which underlies a “right to payment” under the Bankruptcy Code.

Even though the 3rd Circuit appeared to sharply limit the claimant’s rights to assert a claim against the debtors’ successor-in-interest based on its conclusion that the claim at issue arose prepetition under the conduct

test, the Grossman’s court declined to

decide whether the claimant’s claim was discharged. Before the court would conclude whether the claimant’s prepetition claim was discharged by the debtor’s confirmed plan, the court held that it had to determine “whether discharge of the claim would

comport with due process.” Id. at 127.

Accordingly, the court remanded the case to the Bankruptcy Court for determination of whether the claimant had sufficient notice of the bankruptcy case and its implications to justify a discharge and insulate the debtors’ successor from liability.

Due Process ‘Re-Do’

Recently, in Wright v. Owens Corning,

679 F.3d 101 (3d Cir. 2012), the 3rd Circuit

extended its holding in Grossman’s to

claims arising after the commencement of the bankruptcy case, but prior to the confirmation of a plan of reorganization. In Owens Corning, two plaintiffs commenced a class action seeking damages related to defects in roofing shingles manufactured by the debtors. One of the plaintiffs, who did not file a proof of claim in the bankruptcy case, asserted damages first discovered in 2009, but arising from the 2006 installation of the shingles. The installation date was after the commencement of the debtors’ Chapter 11 cases, but prior to the effective date

of the plan of reorganization that was ultimately confirmed in the case.

Under Frenville, the plaintiff would not

have possessed a claim for bankruptcy purposes because the product defect that caused the purported damages did not become apparent until after the plan had been consummated. Nonetheless,

based on Grossman’s, the District Court

ruled that the plaintiff held a claim for damages that could be discharged under the plan because his relationship with the debtors and the defective product arose prior to the confirmation of a plan. In granting the debtor’s summary judgment on the grounds that the plaintiffs’ claims were discharged under the plan of reorganization that was confirmed in the debtors’ bankruptcy case, the District Court extended the

test set forth in Grossman’s to

post-petition claims. The court held that the published notices of the debtors’ Chapter 11 cases in numerous national publications constituted adequate notice of the claims bar date and afforded them procedural due process. The 3rd Circuit agreed with the District

Court’s extension of the Grossman’s

test to post-petition, preconfirmation claims, but disagreed that the plaintiffs’ due process rights were satisfied. It is generally held that with respect to unknown claimants, such as the plaintiffs, notice by publication in national newspapers is sufficient to satisfy due process requirements. However, and as the 3rd Circuit noted, at the times that notice of the claims bar date was received by the plaintiffs,

Frenville was still good law in the 3rd Circuit. Therefore, the plaintiffs had no reason to believe that they held claims that were subject to discharge if they were not timely asserted and

continued from page 31

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The extension of the test set forth

in Grossman’s to post-petition,

preconfirmation conduct demonstrates

the 3rd Circuit’s commitment to

moving away from the oft-criticized

Frenville decision and its progeny.

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Michael Klein (top) and Brent Weisenberg (bottom) are associates in the Bankruptcy & Restructuring Group at Cooley LLP in New York. Klein’s practice focuses on litigation and transactional work, including the representation of debtors, creditors’ committees in Chapter 11, and secured creditors. He has a law degree from the University of Pennsylvania Law School and a bachelor’s degree from Cornell University. Weisenberg’s practice focuses on both litigation and transactional work, and focuses on representing creditors’ committees and debtors in Chapter 11 bankruptcy proceedings, as well as in out-of-court restructurings and workouts. Weisenberg holds a law degree from Boston University School of Law and a bachelor’s degree from the University of Wisconsin-Madison.

liquidated in the debtors’ bankruptcy.

Owens Corning, 679 F.3d at 108.

It was not until Frenville was overturned

in 2010, after confirmation of the debtors’ plan, that the plaintiffs could have reasonably understood the impact of those proceedings on their contingent and unmatured claims. According to the court, in these situations “[d]ue process affords a re-do . . . to be sure

all claimants have equal rights.” Id.

Both elements of the 3rd Circuit’s ruling in Owens Corning are noteworthy in their own right. The extension of the test

set forth in Grossman’s to post-petition,

preconfirmation conduct demonstrates the 3rd Circuit’s commitment to moving away from the oft-criticized

Frenville decision and its progeny. Moreover, the court’s holding regarding the insufficiency of due process underscores the difficulty that debtors

face post-Grossman’s in providing

adequate notice of key case deadlines to all holders of claims, especially to future unknown claimants and other holders of contingent and unmatured claims. As the 3rd Circuit remarked

at the conclusion of its decision in Owens Corning, “The shadow of Frenville fades, but more slowly

than we would like.” Id. at 109. J

1_{A “right to an equitable remedy” that “gives rise} to a right to payment” also constitutes a “claim” under Section 101(5)(b) of the Bankruptcy Code. See, e.g., Ohio v. Kovacs, 469 U.S. 274 (U.S. 1985) (a claim exists if a debtor can perform an obligation only by means of paying money).

ABT-11101-2 TMAoct_final_7.125x5.0625.indd 1 8/23/12 1:22 PM