The Tobacco Companies and Bankruptcy
An issue that has haunted the debate over the tobacco deal is bankruptcy.
Today, the mass of litigation against the tobacco industry has raised the possibility that one or more of the tobacco companies may declare bankruptcy because of verdicts against them or because of the continued threat of litigation. Indeed, some supporters of the deal have argued that the deal is necessary because it would ensure the industry's continued financial viability and avoid a tobacco bankruptcy. Although there is little doubt that bankruptcy would change the dynamics currently at play, and could make it more difficult for current and potential creditors to be paid, it is unlikely that these changes would favor the tobacco industry over the broader public health agenda. The industry would probably not be able to use bankruptcy to continue business as usual and bankruptcy would probably not permit the industry to stop litigation growing out of the government's police powers. While there are great uncertainties associated with bankruptcy, these uncertainties probably impose greater risks for the tobacco industry than for the public health. In short, a bankruptcy by one or more of the tobacco companies should be approached cautiously, but it should not be feared and is not a reason to enter into an otherwise insufficient and possibly damaging deal.
What is bankruptcy?
The bankruptcy laws set out a series of procedures by which persons (including both individuals and corporations) can obtain support from the federal courts in managing their creditors. The motivation behind the bankruptcy laws is twofold. First, it is to assure equitable distribution to the creditors. If, for example, a business did not have sufficient assets to pay all of its creditors, bankruptcy would protect the creditors so that no single creditor would have access to the assets at the expense of the other creditors. Second, the bankruptcy laws provide a 'fresh start' for the debtor. Once a debtor has satisfied its debts through bankruptcy then it will be able to start anew. The debtor corporation is given time to design a reorganization plan that will not only resolve current problems, but will avoid problems in the future. One of the advantages of entering into bankruptcy is that it buys time for the debtor. Instead of a debtor being subject to the continuing crush of collection actions and litigation, a bankruptcy will automatically stay (put a hold on) all such actions. This arrangement provides breathing room for the debtor, the creditors, and the bankruptcy court to fully evaluate the situation.
What are the types of bankruptcy?
There are many ways to enter into a bankruptcy. The two most common forms of voluntary bankruptcy, the process by which a debtor actively seeks protection from its creditors, are Chapter 7 and Chapter 11. Each of these procedures is initiated with the filing of a petition with a Bankruptcy Court. Bankruptcy Courts are a part of the Federal Judicial System and are constituted in order to supervise and administer bankruptcy proceedings. Under a Chapter 7 bankruptcy, the result is a liquidation of assets. The assets of the corporation are sold with the proceeds of the sale given to the creditors and the corporation ceases to operate. Creditors are paid in the order of their 'priority,' based on a ranking of the debts as established under the bankruptcy code. Under a Chapter 7 bankruptcy a corporate debtor does not receive a discharge of whatever debt remains unpaid after the liquidation process. Hence, contrary to the general policy of providing debtors with fresh starts, Chapter 7 denies that benefit to corporate debtors.
Under a Chapter 11 bankruptcy, the debtor in consultation with the Court and its creditors, develops a 'reorganization plan' by which it meets its credit obligations in a manner acceptable to all parties of interest and emerges in a form that will increase the chances of the debtor succeeding in the long run. The goal of a Chapter 11 bankruptcy is to have a reorganized company that is able to satisfy past and future credit obligations. To accomplish this goal, the Bankruptcy Court, in conjunction with the company and the creditors, reviews and confirms a plan for reorganization which will protect the interests of the company and the creditors. The creditors' interests are represented by a 'Creditor's Committee.' There can be more than one such committee and the Courts attempt to appoint them in such a manner that all creditors' interests are represented.
Some of the reasons a creditor would accept a Chapter 11 bankruptcy plan by a debtor, as opposed to forcing a debtor into a Chapter 7 bankruptcy, would be if the corporation were worth more as a viable concern than if it were dissolved. Thus, if the company were reorganized, it would better be able to protect the creditors' interests. For example, if a company had $1 million in assets but could enter into a contract by which it would be able to receive a net income of $10 million over the next year, the creditors would be better served by allowing the company to keep its assets and enter into the contract. They would then have a larger pool from which to draw their relief.
Bankruptcy as a result of mass tort litigation.
It is conceivable that the tobacco companies could be forced into a Chapter 7 bankruptcy by litigation, should they find themselves subject to large verdicts. Since the current tobacco companies present a barrier to improved public health, the dissolution of the current corporations could only be seen as a benefit for the public health. The problem with a Chapter 7 bankruptcy is that it would allow the brand names and cigarette manufacturing equipment to be sold to a new corporation. If that new corporation were, for some reason, not subject to the same liability exposure of the current corporations, it may be able to continue the production of tobacco products. This risk is unlikely to be a realized, simply because future tobacco companies would likely be subject to the same, or similar liability, as those companies sent into Chapter 7 bankruptcy.
It is also possible that as a result of the litigation the tobacco companies could file for reorganization under Chapter 11 of the bankruptcy code. They could do this prior to having any verdicts against them, because under Chapter 11 there is no requirement that the debtor presently be insolvent. The primary creditors would be the plaintiffs filing suit against the companies, and potential plaintiffs could be considered parties in interest to the bankruptcy. The companies' bankruptcy would be the result of many adverse verdicts as well as the cost of defense, exceeding the assets likely to be available.
There are three historical examples where a company that faced mass tort litigation sought protection from the bankruptcy courts: asbestos manufacturers, the manufacturer of the dalkon shield intrauterine device, and a manufacturer of silicon breast implants. In the largest of the asbestos bankruptcies, Johns-Manville Corp. (In re Johns-Manville Corp., 36 B.R. 743 (Bankr. S.D.N.Y. 1984)) filed under Chapter 11 even though it was a viable billion dollar corporation. The problem was twofold: the predicted liability of the asbestos litigation, which likely exposed it to up to $5 billion worth of adverse verdicts, and the cost of defending those suits. The Court allowed the bankruptcy to continue and included as represented creditors 'future claimants.' Dow Corning (breast implants) stressed the cost of defense was exorbitant and a significant reason that it sought bankruptcy protection.
The tobacco companies currently face crippling litigation, with the estimated cost of tobacco-induced illness running around $100 billion per year in liability for medical costs and lost wages (excluding punitive damages and attorneys' fees) [Bartlett, 1994 #2]. Based on the three historical precedents, there is a reasonable likelihood that they could petition for bankruptcy protection. Although there is a 'good faith' requirement within the bankruptcy laws, i.e. the companies seeking reorganization actually need it and are not seeking simply to avoid debt or litigation, the historical precedents and the magnitude of the claims against the tobacco companies suggest that this requirement would not present a high barrier to a claim for bankruptcy. Because of the solvent nature of the tobacco companies, however, they would likely need to argue that it was the verdicts and threat of verdicts that create the need for protection, rather than simply the cost of defense.
Why would the tobacco companies file for bankruptcy?
Because the goal of a Chapter 11 bankruptcy is to allow the debtor to continue as a viable concern, the companies may consider bankruptcy if they could improve their chances for corporate survival. In particular, the tobacco companies seem to be seeking predictability. For example, creating a situation in which their liabilities and costs would be manageable and predictable is one of their main motivations for engaging in settlement discussions and supporting the national deal. If the national deal fails, they may consider whether they can gain predictability through the bankruptcy courts.
In the Johns-Manville bankruptcy, the asbestos company sought protection less from debts that had been incurred than for debts that might have been incurred through the litigation process. The court gave them that protection by holding future claimants as parties in interest, and creating a special fund for their claims. The tobacco industry would like the same protections. If the relief provided by a bankruptcy court to the tobacco companies includes current and future litigants, then the tobacco companies may have the predictability they seek. At the least, the automatic stay of the lawsuits would stop or dramatically slow the pace of the current litigation, which will have value to the tobacco companies, even if it only provides slightly improved predictability. An additional value could be a reduction in the constant negative public exposure that the companies have been receiving as a result of ongoing litigation.
Why would the tobacco companies not file for bankruptcy?
The tobacco companies are unlikely to file for bankruptcy unless or until they start getting hit with large verdicts because bankruptcy itself presents an unpredictable set of circumstances which will subject the tobacco companies to great risk. In order for a reorganization plan to be acceptable, the plan must be feasible. In other words, the plan must present an alternative which will relieve the company of its debts and not likely result in the company suffering the same financial constraints that sent it to bankruptcy in the first place. Given the large amount of potential liability associated with tobacco products, it is not clear that a plan would be 'feasible' if the company continued to sell tobacco products. Although it is impossible to determine the exact outcome of any bankruptcy, we can explore some of the arguments that can be made on behalf of the various creditors.
The Reorganization Plan Must Present a Feasible Solution
The most damaging exposure that the tobacco companies face is that a reorganization plan that would protect them from future liability must treat claimants, current and future, as parties in interest who must be satisfied. The total damages caused by the tobacco industry each year have been conservatively estimated to be $100 billion [Bartlett, 1994 #2]. If the Bankruptcy Court were to approve a plan that established a trust fund which reimbursed the plaintiffs at 50 cents on the dollar the tobacco companies would have to finance $50 billion per annum. This figure, which does not include punitive damages, is beyond the theoretical profits of the tobacco companies and could as a result force the tobacco companies into a Chapter 7 bankruptcy [Harris, 1996 #11]. Furthermore, the damage estimates given above do not include possible liability from international sales of tobacco products or for claims based on harm which has not yet been incurred or related to tobacco use. These additional costs will increase the total exposure for the tobacco companies and make the development of a feasible plan to eliminate the risk of liability less likely.
Moreover, the risks would likely rest with the tobacco industry. In the Johns-Manville bankruptcy there was a trust fund established for future claimants, but this fund was later found to be woefully underfunded. Efforts to later repair the fund were largely unsuccessful. With the nature of tobacco litigation threatening higher damages and more uncertainty than the asbestos litigation, a court is likely to be more conservative about how it approaches a tobacco industry bankruptcy so it can better protect claimants.
A second argument that the tobacco companies could face is that a reorganization plan should require the tobacco industry to fundamentally change the way in which it does business in order to eliminate future liability. A court and creditors could argue that tobacco is inherently dangerous and that no change in corporate behavior can eliminate future liability. Therefore, an order requiring the tobacco companies to cease production of the hazardous product which created the liability in the first place is a possibility. (In each of the three historical examples, asbestos, the dalkon shield, and silicon breast implants, the debtor ceased or seriously restricted the manufacture of the product which resulted in the litigation.) Even if a much narrower view of the litigation is taken, that it was the tobacco industry's specific market behavior which caused the liability exposure, the reorganization plan could require a fundamental change in behavior which would eliminate such exposure. Some of the actions which could be demanded of the companies are that they: fully disclose all research regarding the health hazards of tobacco, that they create and market safer products, cease all marketing and distribution which recruits new smokers or encourages current smokers to continue smoking, provide full disclosure of all additives, and provide clear and complete warnings. Furthermore, because the tobacco companies face risks from international litigation, a reorganization plan could require that whatever actions the tobacco companies take, they do so worldwide to prevent liability in other countries. In sum, creditors could argue that unless the tobacco companies take extraordinary measures, they could not say they were taking the necessary steps to limit future liability and that any reorganization without provisions for such measure would be unsuccessful. It is possible that a bankruptcy would require much greater changes in industry behavior than the proposed national deal.
Not All Lawsuits Will Be Stayed
The tobacco industry is also unlikely to have complete certainty under a bankruptcy because not all lawsuits will be automatically stayed. Although the general rule is that a debtor is protected from collection claims and lawsuits while it is in bankruptcy, there are exceptions which may prove especially damaging to the tobacco companies. For example, one of the exceptions to the automatic stay is in a situation where a governmental body -- such as the Attorneys General or local authorities -- uses its police power or enforces a regulation (11 USCS Â§ 362(b)(4)). The claims for injunctive relief under the state lawsuits, such as those including advertising and marketing restrictions, and those requesting the dissolution of the Tobacco Institute and the Council for Tobacco Research, would probably not be stayed. Similarly, the state claims for monetary relief couched in terms of enforcing the consumers' protection, antitrust, and other laws would also probably not be stayed (although the state or local entity would not be able to sue to collect the monetary part of the judgment outside the bankruptcy proceeding). There are also provisions within the Bankruptcy Code which give the courts the ability to eliminate a stay if a party's interests would not otherwise be protected in the bankruptcy. With the wide range of lawsuits against the tobacco companies, many presenting novel legal theories, it is conceivable that a plaintiff class could be found to be in a unique position such that the bankruptcy court would allow the case to proceed. It is not difficult, for example, to imagine that the courts would not stay private lawsuits which sought to eliminate 'Joe Camel,' such as the one settled in California in September, 1997. (See Janet C. Mangini v. R.J. Reynolds Tobacco Co. et al., Case No. 939359, Superior Court of the State of California County of San Francisco, Settlement and Consolidation Agreement, 9/8/97).
The Corporate Uncertainties
There are also uncertainties related to bankruptcy that affect the corporation itself. For example, entering into bankruptcy because of the threat of liability will probably be seen as a tacit admission of the dangers of tobacco products. If so, this tacit admission will affect the marketing of their products both domestically and internationally, and will reduce the inherent value of the company.
In addition, if a single tobacco company declares bankruptcy it faces the risk of being saddled with the bulk of the liability while leaving the remaining companies to defend the lawsuits in court. It could also risk alienation from the other tobacco companies by breaking ranks and leaving them to defend the lawsuits. Up until now, with the exception of Liggett, the tobacco companies have maintained a solid block. For one to splinter off would risk corporate alienation. (The possibility that the tobacco companies would file bankruptcies at the same time is even less likely. Besides the problems with respect to coordination and administration, the simultaneous filings of multiple bankruptcies could violate the antitrust laws.)
Ultimately, bankruptcy could affect the financial viability of the companies themselves, as well as the value of the parent companies. In a bankruptcy, shareholders will have a lower priority than creditors holding a judgment against the company. Therefore, the value of the stock will be affected considerably as the assets decrease. Because the tobacco companies represent a profitable business for their corporate parents, it is likely that the stock value of the parent corporations would suffer, as would the ability to obtain future financing. The likelihood that the companies' stock would drop substantially represents probably the strongest disincentive to declaring bankruptcy.
Who wins and who loses with bankruptcy?
Although it is impossible to predict the exact winners and losers with bankruptcy, it is likely that the tobacco companies would face greater risks than the public health community.
One of the concerns about litigating the companies into bankruptcy is that it would reward only those entities who sued it first. For example, if one or more states or other plaintiffs obtain large verdicts against the industry and it is forced to dissolve, the remaining states and other potential plaintiffs will not obtain financial compensation for their Medicaid claims and future plaintiffs will not have anyone to sue. This 'first in time' concern is relevant from a policy perspective, but may be irrelevant from a public health perspective. If the companies cease to do business as usual, there may be a net increase in the number of lives saved even if the monetary damages recovered are divided inequitably.
Another concern about bankruptcy is that the better represented and more sophisticated creditors will likely fare better under a reorganization plan. Thus individuals who are more disenfranchised, such as individual plaintiffs, are likely to struggle in their attempts to influence the reorganization plan. Again, the public health advantages of the bankruptcy may make these concerns less relevant. But even so, we should look at the current system to see whether the bankruptcy presents a worse alternative. Both the civil liability system and the political process (necessarily a part of having Congress enact the deal) are notorious for favoring those with resources. Often these interests are protected at the expense of the disenfranchised. With the oversight of the bankruptcy Court, bankruptcy is unlikely to prove less equitable than the current system, and may actually produce a more equitable outcome.
A third concern is that bankruptcy would allow the tobacco companies to continue in business profitably. Although there is a chance that the tobacco companies could reorganize in a manner that they end up conducting business as usual, that risk is not unique to bankruptcy. The same result could occur with continued litigation should the industry prove successful. The deal would guarantee the future profitability of the tobacco companies while simultaneously restricting many public health measures.
Some also feel that the negotiated deal to settle all of the litigation is necessary because it would ensure that the debts incurred under the deal have priority and that the agreements made by the tobacco companies to support the public health measures would not be discharged by a Bankruptcy Court. These promises are insignificant. First, provisions do not protect against a Chapter 7 bankruptcy. Second, the money provided for under the deal represents a dramatic underfunding of the damages incurred as a result of tobacco that claimants are likely to recover a higher proportion of the actual damages under a Chapter 11 bankruptcy than under the deal.
Some public health advocates are also concerned that in a bankruptcy, the tobacco companies would be able to manipulate the system in their favor. The fear is that the tobacco companies and the shareholders would somehow corrupt the system and work together to defraud creditors. This outcome is unlikely. It is more likely that the creditors and the Bankruptcy Court would be cognizant of efforts at corporate self-protection and would guard against it. This is likely because of widespread beliefs that the corporate officers have placed the industry at risk by concealing the dangers of tobacco. In addition, congressional action in general, and the deal in particular, provide a number of corporate advantages for the tobacco industry which it could not obtain in the course of a bankruptcy. For example, a Bankruptcy Court could not weaken the FDA jurisdiction over tobacco or the regulations it issued, preempt state and local laws, or change the tax code in ways favorable to the tobacco industry. A bankruptcy might better protect the public health than the deal by allowing other public health measures to go forward concurrently.
The attorneys representing the various plaintiff groups could be worse off if the industry goes into bankruptcy. Under a bankruptcy, the Court is able to control the flow of recovery to plaintiff attorneys. This situation may result in much lower fees than the attorneys would receive under either the litigation system or the deal. Because private attorneys have occupied a visible role in both the prosecution of cases against the tobacco industry and the negotiation of the deal, the effect of fee reimbursement could be a significant motivating factor for those encouraging the deal over bankruptcy. From a public health perspective, however, the relative difference between the fees is not enough to outweigh the likely advantages. While it is important to reward the attorneys who have at great effort and risk prosecuted these cases, once they have been reasonably compensated, their rights to additional funds should not be superior to their clients nor the public health.