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Treating Latent Medical Tort Claims in Bankruptcy

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The problem: You are handling the bankruptcy of a medical company, which you intend to sell as a going concern by means of a chapter 11 liquidating plan. A major obstacle to maximizing the selling price of the company is that it is statistically certain that there are latent tort plaintiffs out there—i.e., persons who have received pre-petition1 medical care that will eventually result in tort claims that could be brought against any successor entity.2 A rational purchaser will take account of this circumstance, and discount its purchase bid accordingly. (Similar concerns are present if you intend to reorganize rather than conduct an asset sale.) How can you maximize the creditors' return in this situation?

One approach, obviously, is simply to sell the business cum onere and let the buyer discount as necessary. There are two reasons why this is sub-optimal: First, while a buyer might apply the laws of statistics to make an accurate prediction of the total probable liability (and then discount accordingly), those same laws of statistics say that, through the operation of random chance, there is a substantial possibility that the actual liability will come in much higher than projected. Since the buyer is not purchasing a "statistical universe" of companies (in which case any such individual deviations would even out), such a result could be financially ruinous. The buyer therefore will need to over-discount its purchase bid.

Of course, the buyer could simply insure against such inherited liability, thus shifting the risk of statistical abnormality onto an insurance company. But this leads to the second problem: If the buyer purchases insurance (or establishes a "self-insured" reserve) against these claims, it will necessarily do so on the basis of the full dollar amount of the claims, rather than the diminished payout that all of the other estate creditors will receive. Maximizing creditor returns requires that you find a way to place latent tort creditors in the same pool as all of the other unsecured creditors.3

What Is a "Claim"?

Expanding the pool of claims against the estate to include latent tort claims requires that the latter be made to qualify as "claims" in the bankruptcy sense. This in turn depends on the meaning of "claim:"

11 U.S.C. §101. Definitions: In this title—...(5) "claim" means—(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 legislative history states that, "by this broadest possible definition and by the use of the term throughout the title 11, especially in subchapter I of chapter 5, the bill contemplates that all legal obligations of the debtor, no matter how remote or contingent, will be able to be dealt with in the bankruptcy case. It permits the broadest possible relief in the bankruptcy court."4 As applied to latent claims, this language has spawned three (or possibly four) different judicial approaches:5

1. The Accrued State Law Claim/ Frenville Test: Under this theory, there is no "claim" for bankruptcy purposes until a claim has fully accrued and become actionable under applicable non-bankruptcy law. In re M. Frenville Co., 744 F.2d 332 (3rd Cir. 1984). Because the Frenville decision ignored the expressed intent of Congress to define "claim" in the "broadest possible" fashion, it has been rejected by all courts outside of the Third Circuit.6

2. The Conduct Test: Under this test (which arose out of the "mass tort" cases of the 1980s), regardless of when the creditor's claim "arises" under applicable non-bankruptcy law, a claim is a pre-petition "claim" if all of the debtor's conduct giving rise to the alleged liability occurred pre-petition. Thus, a creditor has a "claim" even though the harm suffered by that creditor does not become manifest until post-petition or even post-confirmation. See In re A.H. Robins Co., 839 F.2d 198 (4th Cir. 1988) (Dalkon shield); In re Parker, 264 B.R. 685 (10th Cir. B.A.P. 2001) (legal malpractice); In re Emons Industries Inc., 220 B.R. 182 (Bankr. S.D.N.Y. 1998) (diethylstilbestrol); In re Waterman S.S. Corp., 141 B.R. 552 (Bankr. S.D.N.Y. 1992) (asbestos), vacated on other grounds, 157 B.R. 220 (S.D.N.Y. 1993); In re Johns-Manville Corp., 57 B.R. 680 (Bankr. S.D.N.Y. 1986) (asbestos); In re Edge, 60 B.R. 690 (Bankr. M.D. Tenn. 1986) (dental malpractice).

3. The Pre-petition Relationship Test: This is a variant on the conduct test and contains the additional requirement of some type of pre-petition (or rather, pre-confirmation7) relationship—such as contact, impact, exposure or privity—between the claimant and the debtor's pre-petition conduct. Thus, for example, it is not sufficient that the pre-petition debtor has taken all steps necessary to introduce a defective product into the stream of commerce; the creditor must also have had some pre-confirmation involvement with that product which results (or will result) in harm. See In re Chateaugay Corp., 944 F.2d 997 (2nd Cir. 1991) (CERCLA liability); Lemelle v. Universal Mfg. Corp., 18 F.3d 1268 (5th Cir. 1994) (product liability); In re Piper Aircraft Corp., 162 B.R. 619 (Bankr. S.D. Fla. 1994), aff'd., 168 B.R. 434 (S.D. Fla. 1994), aff'd., 58 F.3d 1573 (11th Cir. 1995) (product liability); In re Piper Aircraft Corp. (Piper II), 169 B.R. 766 (Bankr. S.D. Fla. 1994) (same); In re Pettibone Corp., 90 B.R. 918 (Bankr. N.D. Ill. 1988) (product liability); In re Correct Mfg. Corp., 167 B.R. 458 (Bankr. S.D. Ohio 1994) (product liability).

Two important observations can be drawn here. First, all of the cases adopting the conduct test involved facts that would have satisfied the relationship test: In all cases, the injurious exposure (to asbestos, Dalkon Shields, DES, negligent dentists and attorneys) had occurred pre-petition, thus establishing the necessary "relationship" with the debtor's conduct; only a present manifestation of injury was lacking. Moreover, under the actual facts, there was no possibility of future exposures to new and currently unknowable plaintiffs because the offending products had in effect been removed from the stream of commerce. By contrast, in the relationship-test product liability cases, the offending products (defective aircraft, boilers, forklifts, mobile homes) are still at large, with the potential to inflict injuries in the future on unsuspecting and currently unknowable future plaintiffs. This factual distinction may be summarized as "future manifestation" cases vs. "future injury" cases.

Second, the limiting principle for all of these courts has been a concern for the due process rights of the latent plaintiffs. The basic requirements of due process are reasonable notice and a fair hearing. The hearing requirement can be filled by the appointment of a "special representative" for the latent plaintiffs, who is charged with the duty of making sure that any plan provisions made for them are fair and reasonable.8 The sticking point is "notice." In "future manifestation" cases, courts indulge the idea that publication notice, combined with the victim's own (presumptive) knowledge that he or she has at some point in life been exposed to the injurious product, are constitutionally sufficient to put the victims on notice that the current bankruptcy proceedings are dealing with their inchoate rights should an injury ever manifest itself. This notion cannot be indulged in "future injury" cases—it is simply not possible to put every person in the world on constitutionally meaningful notice that they may someday, for example, happen to be standing near a defective boiler when it explodes. Of course, as a practical matter, it is just as easy to make actuarial projections and financial provisions in future injury cases as it is in future manifestation cases; also as practical matter, tomorrow's plaintiffs are not paying any attention today in either type of case. Nonetheless, the courts adhere to the distinction because of the "notice" issue, and no court has ever allowed "future injuries" to be treated in bankruptcy.

Though not yet recognized as such, there is probably a fourth test, which might be called the "functional" test. Courts restricting the broad reach of the statutory definition of "claim" have done so out of concern for the due process rights of claimants, but Congress wanted the term "claim" to be as broad as possible. At least two courts (albeit in quasi-dicta) have put the horse back in front of the cart and suggested that a claim constitutes a "claim" precisely to the extent that it can be (or has been) dealt with during the bankruptcy proceedings in a manner that respects the claimants' due process rights. Fogel v. Zell, 221 F.3d 955 (7th Cir. 2000) (product liability); In re Fairchild Aircraft Corp., 184 B.R. 910 (Bank. W.D. Tex. 1995) (L. Clark, B.J.) (product liability).9 The analogy here would be to state statutes providing for "long-arm" jurisdiction: The court has personal jurisdiction to whatever extent its assertion comports with due process.

Meeting the Test

Under any test other than the Frenville test, it should be possible to deal with latent medical tort claims in a chapter 11 case. The debtor's conduct occurred pre-petition, at the time it treated (or failed to treat10) the plaintiff-patient. This same conduct establishes the required pre-petition relationship. As discussed below, steps can be taken to protect the due process rights of the latent plaintiffs. Thus, it should be possible to treat and discharge these claims in bankruptcy.

Getting It Done

Appointment of a Special Representative: The debtor can petition the court for the appointment (pursuant to 11 U.S.C. §§1102 and 1103) of a special representative of the latent plaintiffs, often referred to as a future claims representative (FCR). The debtor might nominate potential candidates for FCR, or the court might ask the U.S. Trustee for recommendations. This person will be charged with the fiduciary duty of ensuring adequacy of notice to the latent plaintiffs, the accurate estimation of the amount of the probable claims, and the soundness of the proposed mechanism for paying those claims.11 While it has sometimes been suggested that the appointment of an FCR is not necessary in all such cases,12 it may be a worthwhile expense, both to ensure that the "fair hearing" requirement of due process is satisfied, and also to give the court a level of comfort regarding the propriety of the proposed resolution of these claims.

Notice: The debtor must give notice to the latent tort plaintiffs that their claims are being dealt with in the reorganization plan. Due process requires "notice reasonably calculated, under all the circumstances, to apprise interested parties of the pendency of the action and afford them an opportunity to present their objections."13 In bankruptcy, it is well-established that "known creditors" must receive actual notice, while publication notice is sufficient for "unknown creditors."14 A "known creditor" is one whose identity is either known or "reasonably ascertainable by the debtor."15 An "unknown creditor" is one whose "interests are either conjectural or future or, although they could be discovered upon investigation, do not in due course of business come to knowledge [of the debtor]."16

Presumably, the debtor should have records of the patients it has dealt with, and therefore will be able to give them actual notice. Even if direct personal notice can be given to all prior patients, publication notice should also be used to cut off potential third-party claims. See In re Union Hospital Ass'n. of the Bronx, 226 B.R. 134 (Bankr. S.D.N.Y. 1998) (holding publication notice was sufficient to cut off third-party claims for indemnification).17

Interestingly, it may not be necessary for this notice to set a bar date for latent tort plaintiffs. In In re Emons Indus. Inc., 220 B.R. 182 (Bankr. S.D.N.Y. 1998), the debtor purposefully refrained from setting a bar date, and the reorganization plan covered future claims no matter when filed. Thus, a future claimant who appeared years later was allowed—in fact, required—to file a claim and receive the treatment provided by the plan, and could not assert a full-dollar claim against the reorganized debtor.

Claims Resolution Facility: Optionally, the plan might provide for a "claims resolution facility"—i.e., some speedy and cost-efficient alternative method of liquidating the actual claims as they arise. That issue is beyond the scope of this article. See Peterson, "Giving Away Money: Comparative Comments on Claims Resolution Facilities," Law & Contemp. Probs., Autumn 1990, at 113-36 (1990).

Creating the Payment Reserve: With input from suitable experts, the debtor, FCR and creditors' committee hopefully will be able to reach agreement on the total size of the latent tort claims;18 otherwise, an evidentiary hearing may be necessary.19 When added to the total present (known) claims, this gives the total pre-petition claims, which in turn establishes the creditors' percentage recovery. It is then necessary to establish some mechanism for paying the latent claims as they arise.

One alternative is for the debtor to "self-insure"—i.e., to set aside a fund to pay the latent claims. However, this again poses the risk that the latent claims will come in much higher than expected.20 A plan might not be confirmed over objection if it could result in the latent claimants receiving a smaller percentage distribution than the similarly situated commercial creditors. Thus, the plan would have to delay distributions to current creditors until the latent claims were ultimately liquidated (perhaps many years into the future), or else provide that the latent claims would not be discharged in the event they did not receive such proportional payment. See In re Dow Corning Corp., 211 B.R. 545, 567-569 (Bankr. E.D. Mich. 1997), which would defeat the purpose of doing all this in the first place.

Again, the solution is to shift the risk of statistical abnormality to an insurance company. As explained in a previous article,21 a peculiar type of insurance is available for this situation. Rather than paying claims in full up to a fixed coverage limit, this type of policy provides for payment of each claim in the same percentage amount that the post-petition debtor would have had to pay.22 In effect, it guarantees that the latent plaintiffs will receive the same treatment as the current creditors, who therefore can be paid immediately upon confirmation.


Footnotes

1 There will also, of course, be "gap" plaintiffs—persons who received potentially actionable medical care post-petition and pre-confirmation. Following the rule in Reading Co. v. Brown, 391 U.S. 471, 88 S.Ct. 1759, 20 L.Ed.2d 751 (1968), most courts would treat their tort claims as administrative expenses under 11 U.S.C. §503(b)(1)(A). For reasons that will appear shortly, their claims do not affect the analysis because they will in any event be paid their full dollar amount. Return to article

2 The availability and requirements of such theories of successor liability will depend on the applicable non-bankruptcy law, an issue beyond the scope of this article. See J. Markus and D. Quigley, "Conflict of Laws—Which State Rules Govern?," 18-Nov. Am. Bankr. Inst. J. 18 (Nov. 1999). Return to article

3 Even without regard to maximizing value for current creditors, it has been argued that fairness requires that a liquidating debtor make some provision for future claimants. National Bankruptcy Review Commission, Final Report, 321, 326, & 330-32 (1997). Return to article

4 H.R. Rep. No. 595, 95th Cong., 2d Sess. 309, reprinted in 1978 U.S.C.C.A.N. 5787, 5963, 6266. Return to article

5 For more thorough discussions of these approaches, see F. Tung, "Taking Future Claims Seriously: Future Claims and Successor Liability in Bankruptcy," 49 Case W. Res. L. Rev. 435 (1999), and Kewanee, infra. n.6 at 531-534. Return to article

6 But, see Kewanee Boiler Corp., 198 B.R. 519 (Bankr. N.D. Ill. 1996) (product liability) (applying test equivalent to Frenville test, but also ruling on independent basis of due process violation); In re UNR Indus. Inc., 29 B.R. 741 (N.D. Ill. 1983) (pre-Frenville case adopting same rationale), appeal dismissed, 725 F.2d 1111 (7th Cir. 1984) (circuit court cast doubt on correctness of Frenville test). Return to article

7 Piper Aircraft, infra., 58 F.3d at 1577. Return to article

8 See F. Tung, "The Future Claims Representative in Mass Tort Bankruptcy," 3 Chap. L. Rev. 43 (2000). Return to article

9 The Fairchild decision was subsequently vacated, 220 B.R. 909 (Bankr. W.D. Tex. 1998), following the settlement of related non-bankruptcy litigation; nonetheless, Judge Clark's characteristically thorough and lucid opinion retains its persuasive value. Return to article

10 In the case of an alleged failure to diagnose or failure to treat, a plaintiff might attempt to assert post-petition status under a "continuing tort" theory. Under existing law, it is not clear whether such an attempt would succeed. Compare In re Cox, 53 B.R. 829, 832 (Bankr. M.D. Fla. 1985) ("Although debtor's breach [of a non-compete covenant] is a continuing one, it still gave rise to only one [pre-petition] cause of action.") with In re Pettibone Corp., 90 B.R. 918 (Bankr. N.D. Ill. 1988) (where plaintiff's first contact with defective product occurred post-petition, debtor's post-petition breach of duty to warn gave rise to post-petition claim). Perhaps the better analysis here is under §503(b): If the debtor's duty to act first arose pre-petition, then the plaintiff did not in fact enter into any transaction with the post-petition debtor nor confer any benefit upon the estate, as required for an administrative expense claim. In re Jartran Inc., 732 F.2d 584 (7th Cir. 1984); In re Mammoth Mart Inc., 536 F.2d 950 (1st Cir. 1976); i.e., it does not arise out of the continuing post-petition operation of the debtor's business. Reading Co., supra n.1. Return to article

11 See, generally, Tung, supra n.8; Final Report, supra n.3, at 329-334. Return to article

12 Locks v. U.S. Trustee, 157 B.R. 89 (W.D. Pa. 1993); In re Dow Corning Corp., 211 B.R. 545, 598 n.55 (Bankr. E.D. Mich. 1997); contra, Final Report, supra n.3, at 332. Return to article

13 Mullane v. Cent. Hanover Bank & Trust Co., 339 U.S. 306, 314, 70 S.Ct. 652, 657, 94 L.Ed. 865 (1950). Return to article

14 Chemetron Corp. v. Jones, 72 F.3d 341, 346 (3rd Cir. 1995). Return to article

15 Tulsa Professional Collection Serv. Inc. v. Pope, 485 U.S. 478, 490, 108 S.Ct. 1340, 1347, 99 L.Ed.2d 565 (1988). Return to article

16 Mullane, supra, 339 U.S. at 317, 70 S.Ct. at 659. Return to article

17 It has been suggested (Final Report, supra n.3 at 331) that the debtor obtain a court finding that the notice was adequate. This, of course, is entirely circular; such a finding would bind only those who in fact received adequate notice that the finding would be made. Return to article

18 See In re Dow Corning, 211 B.R. 545, 602-03 (Bankr. E.D. Mich. 1997) (where parties filed cross motions after failing to reach agreement on method of estimation, court refused to grant either motion and required parties to reach consensus out of court). Return to article

19 Because estimation of a personal injury claim is not a core proceeding, 28 U.S.C. §157(b)(2)(B) and (O), it can be done by the bankruptcy court only with the consent of the parties. Return to article

20 Although there is a split of judicial authority, many courts hold that §502(c) does not authorize estimation for purposes of determining actual distributions. See Final Report, supra n.3 at 342 n.850 (collecting conflicting cases). Return to article

21 J. Cavanaugh and E. Stamm, "Reducing Product Liability Uncertainty in Bankruptcy Cases," 20 Am. Bankr. Inst. J. 1 (July/Aug. 2001). The author wishes to thank Cavanaugh and Stamm for providing additional background information regarding the situation discussed in their article. Return to article

22 Of course, insurers will not expose themselves to unlimited liability, so the policy will have a maximum payout cap well above the expected actual payout. Return to article

Bankruptcy Rule: 
Journal Date: 
Monday, July 1, 2002

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