Welcome to the New Asbestos Scandal - Continued

The first channeling injunction was imposed in the Johns-Manville bankruptcy in the late 1980s. Johns-Manville put about $2 billion in cash and other assets into a trust, including 80% of the stock of what was to be the reorganized company, called Manville. The idea was that the reorganized company, when freed of asbestos liability, would thrive again. Once it thrived, its stock would rise in value and throw off dividends that would benefit the trust. The trust, in turn, would then be able to pay Johns-Manville's asbestos claimants as they came down with diseases in the future. By contrast, if Johns-Manville had kept its liabilities and had been forced to liquidate, its future asbestos claimants would have had no Manville-related entity to recover from.

The channeling injunction was a great idea, but no one was sure if it was legal, since the judge had improvised it. In the early 1990s, when the trust wanted to sell its Manville stock and diversify its investments, it found no buyers; investors feared they might be buying Johns-Manville's asbestos liabilities if the channeling injunction was later found to have been beyond the judge's power to impose.

So the Manville Trust went to Congress and, in 1994, got an amendment to the bankruptcy code that retroactively ratified what the judge had done. (Warren Buffett then bought Manville's stock from the trust.) But the amendment also set up a procedure for issuing channeling injunctions in future asbestos bankruptcies.

The forward-looking provision, known as Section 524(g), did some highly unusual things, we now realize. Most important, it specified that the bankruptcy judge could not issue the precious channeling injunction to a company unless 75% of the current asbestos claimants voted to approve the company's bankruptcy reorganization plan.

Providing asbestos claimants with a voice on the company's reorganization plan was not in itself unusual, since creditor classes always get to vote on whether to approve a Chapter 11 debtor's plan. But the bankruptcy judge always retains the ultimate power to override a creditor class's veto if he feels that the plan is "fair and equitable." The bankruptcy judge can, in the evocative legal phrase, "cram down" the plan on dissenting creditors. The judge's cram-down power acts as a check on creditor greed, encourages compromise, and promotes consensual plans.

But the 75% approval required for a 524(g) channeling injunction is not subject to a cram-down. The omission has astounding consequences for the dynamics of an asbestos bankruptcy. Since bankruptcy is worthless to an asbestos defendant if the company can't get a channeling injunction, the asbestos claimants--or to be more precise, the plaintiffs lawyers who control 75% of them--effectively have more power than the bankruptcy judge! "[Section] 524(g) creates an unlevel playing field and gives the asbestos claimants virtually an absolute veto over a consensual plan," says former U.S. district judge Alfred Wolin. Wolin presided over five large Delaware asbestos bankruptcies from late 2001 until this spring. "You could have 99 other issues to deal with," Wolin continues, "but ultimately it's going to boil down to, Can the debtor get a 524(g)? And if the debtor can't get a 524(g), everything else is for naught." (Wolin can speak freely now, because in May a federal appeals court disqualified him from three of his asbestos cases for the appearance of pro-plaintiff bias. Wolin, 71, then stepped down after 17 years on the federal bench. But that's another story.)

The 75% requirement has another consequence: It favors one type of plaintiffs law firm over another. Though there are hybrids, asbestos law firms gravitate toward one of two economic models. At one extreme are the firms that pursue a low-margin, high-volume strategy. They sign up thousands of claimants of whom the overwhelming majority are unimpaireds. They then seek "inventory settlements"--settlements of all their cases at once--which are typically accomplished at discount prices in which the ratio between what a fatal cancer victim gets and what a totally unimpaired claimant gets can fall as unconscionably low as four to one--or less.

At the other extreme are the high-margin, low-volume boutiques that specialize in representing only severely sick people--mostly people with mesothelioma (a 100% fatal cancer of the pleura) or lung cancer. They represent far fewer clients but seek multimillion-dollar recoveries for each.

Obviously the 75% requirement favors the mass filers who cater to the unimpaireds. Such lawyers are "very interested in the 90% [who are] asymptomatics receiving compensation," Judge Wolin explains, "or else they're not going to be compensated. And without compensating the 90%, you're never going to get a consensual plan, because you're not going to get the votes."

So there's no two ways about it. If a company wants a channeling injunction, it needs a 75% vote, and to get the 75% vote, it needs to get the mass filers on board. Which is where Joe Rice comes in.

Tanned and fit, with a full head of tousled hair, Joe Rice, 50, has star power. In a courtroom full of workaday bankruptcy and insurance lawyers, Rice looks like George Clooney at a Rotary luncheon. Though Rice's law firm is based in Mount Pleasant, S.C., rather than in Chicago or New York City, nobody in the room mistakes him for a country rube. Rice doesn't handle slip-and-falls. His forte is big-picture wheeling and dealing, and his practice has come to resemble a species of investment banking.

Rice is in a unique position to corral the 75% vote that companies need, because his firm has long maintained a network of consulting and co-counsel arrangements with scores of other asbestos plaintiffs firms around the country. Historically a local firm would work up the particulars of a case while engaging Ness Motley to handle recurring liability issues common to every asbestos suit. Rice's stature in the field now enables him to craft global settlement deals that both he and the defendants know will very likely gain acceptance from most of the asbestos plaintiffs bar.

Rice understands that a conventional bankruptcy--or "free fall" bankruptcy, as he pejoratively calls it--would be devastating to a company with asbestos liability. Free-fall bankruptcies take too long--they average around six years in asbestos cases--and they are money barbecues, costing as much as $15 million a month. It's hard for a company to stay competitive under the drag of Chapter 11, and some companies don't make it.

Fortunately for asbestos defendants, most bigtime asbestos plaintiffs lawyers don't like free-fall bankruptcies either. For one thing, they don't like the way bankruptcy judges split up the money available for asbestos claimants. Bankruptcy judges do it equitably and rationally, based solely on disease category, with sick people getting much more than the unimpaireds. By contrast, in the tort system lots of other factors can trump disease category in importance--like which county the case is filed in, which law firm represents the plaintiff, and how close the case has gotten to a judgment.

There's a still graver problem with free-fall bankruptcy from a plaintiffs lawyer's perspective. Bankruptcy judges have to treat current claimants the same way they treat "futures"--i.e., claimants who don't yet exist but who can be anticipated due to the long latency of asbestos diseases. Since there could easily be five or ten times as many future as current claimants, a bankruptcy judge will have to set aside a lot of assets for them. Every dollar set aside is a dollar diverted from the current claimants and, more important, about 40 cents diverted from their contingency-fee lawyer. As a consequence, most plaintiffs lawyers would much prefer that a company hand over a big chunk of its most liquid assets to them before going into bankruptcy. That way they can get a bigger kitty than a bankruptcy judge would give them, they can get it sooner, and they can divvy it up without being scrutinized by a nannyish judge. Hence the prepack.

There are many aspects of these prebankruptcy settlements that no bankruptcy judge could stomach. In the prebankruptcy settlement in the Combustion Engineering case, for instance, the value of some claimants' cases fetched as much as 20 times what others' fetched--even though they had exactly the same diseases--simply because of the identity of the law firm bringing the claimants' case. (The sums were set according to each firm's average historical settlement values with Combustion Engineering.)

Then there was the odd situation involving a company called the Clearing House. When a corporation settles thousands of claims in a prebankruptcy agreement, it needs to have an administrator sift through all the paperwork to make sure that each individual claimant has supplied all the proof required for payment. The claims-processing function for the prebankruptcy settlements in each of Rice's first three prepacks--involving contractors Shook & Fletcher, J.T. Thorpe, and AC&S--was assigned to a consulting firm. (Rice was one of eight plaintiffs lawyers who put together J.T. Thorpe.) That's a good idea, since it looks better to have an independent, disinterested party handle that function. But then the consulting firm subcontracted the work to another company, called the Clearing House. The Clearing House was incorporated by a Ness Motley lawyer in December 2001 on behalf of its sole proprietor, Benee Wallace. Wallace is Rice's longtime paralegal, personal assistant, and friend. In early 2002, Wallace went on "sabbatical" from Ness Motley to run the Clearing House. That year Wallace cleared "just under a million dollars" from running that company, she testified in a subsequent deposition. (Wallace did not respond to interview requests.) Wallace then sold the Clearing House for $100,000 to the consulting firm that had subcontracted the work to it, and returned to Rice's law firm by February 2003. Rice maintains that the arrangement barely involved him. A principal at the consulting firm offered to help Wallace set up her own business, Rice says. "She was interested but wasn't sure if she wanted to do it permanently," he continues. She took a leave of absence, ran the business for a while, and then "decided it was not what she wanted to do," so she returned to his firm. "That was it."

While the prebankruptcy settlement will take care of most of the current claimants, there will always be a few left over. Some of them may not qualify for the settlement for various technical reasons, and others won't like the settlement's terms. The latter group will typically be composed of severely injured claimants, who often find global settlements too cheap. In either case, under the grand design of the prepack those leftover "currents" will be tossed in with the futures, who are then relegated to seeking their recoveries from a separate pool of assets--the bankruptcy trust that will be set up after the Chapter 11 petition is filed.

As a rule of thumb, the bankruptcy trust will pay less, and pay later, than the prebankruptcy settlement. Because many of the assets set aside for the bankruptcy trust will be illiquid and risky--like notes or stock--they may not be there at all by the time a future mesothelioma victim finally arrives to make a claim upon it several years from now. The bankruptcy trusts in the Combustion Engineering and Congoleum cases are funded heavily with disputed insurance proceeds that may or may not exist, depending on whether the debtor ultimately wins contested coverage litigation against its insurers.

Some attorneys reading this story may want to interrupt here with a technical question: If a company forks over a huge treasure chest of its most liquid assets to a privileged subgroup of creditors right before filing for bankruptcy, isn't that a classic "preferential transfer" that can be reversed by the bankruptcy judge? The answer is yes. That's why Rice will have the company count off at least 90 days between the time it funds the prebankruptcy settlement and the time it files for Chapter 11 protection. Legally, that 90-day buffer makes it tough for a judge to void the prebankruptcy settlement. (And as a practical matter no judge is going to try to force thousands of asbestos claimants to return settlement money after they've received it.)

The company will also use that 90-day waiting period to unveil the upcoming bankruptcy reorganization plan and seek the all-important 75% approval needed for the channeling injunction. This prebankruptcy vote is the defining feature of a prepack. It is precisely because all necessary creditor classes will have approved the plan before filing for bankruptcy that the company can then sail through Chapter 11.

Now obviously, if the only claimants voting on the plan are the ones who either missed out on the better prebankruptcy settlement or refused to join it, a company might have real trouble scraping together 75% approval. Rice foresaw that problem. As he noted in an early memo mapping out the proposed Combustion Engineering prepack, the company has to "create a 'creditor' status" for those who participate in the prebankruptcy settlement so that they will retain the right to vote on the bankruptcy plan. So instead of paying off those prebankruptcy settlement participants completely, the company will pay them only 95% or 85% of their claims, say. That will leave them with an unpaid "stub claim" against the bankruptcy trust, and that stub will entitle them to vote on the bankruptcy plan. That way the company can be assured that the votes of those who settled prebankruptcy (mainly unimpaireds) will swamp the votes of the dissenting stragglers (mainly severely sick people), and the company will get its 75%.

Despite the harrowing picture just painted of them, asbestos prepacks evolved in a natural and logical way, at least when viewed against the bizarre backstory that spawned them. That backstory is about insurance, and the best person to tell it is Scott Gilbert. Gilbert has spent the past 25 years becoming, hands down, the nation's premier attorney for asbestos defendants seeking reimbursement from reluctant insurance carriers. On a Tuesday morning in Washington, D.C., Gilbert greets a reporter dressed in comfy slacks and what looked like a bowling shirt, bearing the Harley-Davidson logo in brown piping. The shirt is no surprise, since a rare silver water-cooled Harley and a fire-engine-red limited-edition Ducati are on display in his firm's seventh-floor lobby. (Though the two bikes belong to the firm, Gilbert has six motorcycles at home.)

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