Introduction

On June 27, 2024, in a highly anticipated ruling, the Supreme Court held that the Bankruptcy Code does not authorize the release of claims against non-debtors without the consent of affected claimants in a ruling springing from the Purdue Pharma bankruptcy. In the 5-4 decision, penned by Justice Gorsuch, the Supreme Court rejected confirmation of the Purdue Chapter 11 plan and remanded the matter back to Judge Sean Lane and the Bankruptcy Court for further proceedings consistent with the Court’s opinion. This is likely the most significant bankruptcy ruling by the Supreme Court since at least 2011 – one that will impact the negotiation and confirmation of bankruptcy plans – particularly, but not exclusively, in cases involving mass tort claims. Harrington v. Purdue Pharma L. P., No. 23-124, 2024 WL 3187799 (US June 27, 2024)

Background

Purdue Pharma, a manufacturer of branded opioid medications, including OxyContin, faced thousands of lawsuits after an affiliate plead guilty to misbranding OxyContin as a less-addictive and less-abusable alternative to other pain medication. To avoid the consequences of the onslaught of litigation, the Sackler family, which owned and controlled Purdue Pharma, withdrew approximately 75 percent of Purdue’s assets over a decade. Left in a significantly weakened financial state, Purdue filed for bankruptcy on Sept. 15, 2019.

Purdue’s original proposed Chapter 11 plan sought to resolve the opioid litigation by incorporating a settlement framework that included a release of claims, both current and future, against the Sackler family in exchange for a lump-sum settlement payment of $4.325 billion at the time of confirmation. The Plan additionally sought to release negligence claims as well as claims for fraud and willful misconduct, and included releases of the family by both consenting and non-consenting creditors.

Most voting creditors supported the plan, although there were a number of other creditors that included opioid victims who voted against the Plan. The Bankruptcy Court approved the Plan and entered a confirmation order on Sept. 17, 2021. Certain parties, including the US Trustee appealed the confirmation order. Pending appeal to the Second Circuit, the Sacklers agreed to contribute an additional $1.175 to $1.675 billion to Purdue’s estate if eight states and the District of Columbia withdrew their remaining objections to the plan. Those states and the District eventually consented, increasing potential recovery to $6 billion. The Second Circuit later affirmed the Bankruptcy Court’s confirmation of the Plan, allowing for it to contain nonconsensual releases of direct claims against the non-debtor Sackler family. After a subsequent appeal by the office of the US Trustee, the US Supreme Court granted certiorari.

Supreme Court Ruling

Majority Opinion

At the outset of its ruling, the Court made it clear that the Sacklers “ha[d] not filed for bankruptcy and ha[d] not placed virtually all their assets on the table for distribution to creditors, yet… [sought] what essentially amount[ed] to a discharge,” something usually reserved for debtors. Thus, the question for the Court boiled down to whether a bankruptcy court may extend the benefits of a Chapter 11 discharge to non-debtors. The majority’s decision approached this question in four ways — by: (1) conducting a textual/statutory interpretation analysis of Bankruptcy Code § 1123(b); (2) looking at related and relevant provisions in the Code to further interpret the meaning of section 1123(b); (3) taking notice of the history of Bankruptcy law; and (4) analyzing the parties’ policy arguments.

1. The Text of § 1123(b)

Section 1123(b) sets out, in a list, what a Chapter 11 plan may contain. As the Court observed, that list concludes with § 1123(b)(6) which states that a plan may “include any other appropriate provision not inconsistent with the applicable provisions of this title.” Proponents of the Plan interpret § 1123(b)(6) to allow “a debtor to include in its plan, and a court to order, any term not ‘expressly forbid[den]’ by the bankruptcy code as long as a bankruptcy judge deems it ‘appropriate’ and consistent with the broad ‘purpose[s]’ of bankruptcy.” Thus, Plan proponents believe that § 1123(b)(6) allows the plan to include the nonconsensual release of claims against the Sackler family.

In its analysis, the Court applied the doctrine of ejusdem generis, a statutory interpretation method that sets out that a “catchall must be interpreted in light of its surrounding context and read to ‘embrace only objects similar in nature’ to the specific examples preceding it.” More simply, ejusdem generis “seeks to afford a statute the scope a reasonable reader would attribute to it.”

The Court held that the common thread among the five preceding paragraphs to § 1123(b)(6) is that they all concern the debtor and authorize “a bankruptcy court to adjust claims without consent only to the extent such claims concern the debtor.” The Court thus held that “a bankruptcy court’s powers are not limitless and do not endow it with the power to extinguish without their consent claims held by nondebtors (here, the opioid victims) against other nondebtors (here, the Sacklers).”

2. Related Provisions

The Court next looked to various related statutory provisions for guidance.

First, the Court looked to Bankruptcy Code § 1141 to determine “what is and who can earn a discharge.” The Court noted that the Code “reserves the benefit [of a discharge] ‘to the debtor’”, and the Plan proponents’ interpretation of § 1123(b)(6) would be contrary to the Code by “affording to a nondebtor a discharge usually reserved for the debtor alone.”

Second, the Court noted §§ 541, 523, and 1141 for the proposition that the Bankruptcy Code constrains both the debtor and the discharge of claims against the debtor. More specifically, the Court noted that (1) “[t]o win a discharge…the code generally requires the debtor to come forward with virtually all its assets,” (2) a discharge “does not reach claims based on ‘fraud’ or those alleging ‘willful and malicious injury,’ and (3) a discharge cannot “‘affect any right to trial by jury’ a creditor may have ‘with regard to a personal injury or wrongful death tort claim.’” The Court then held that the settlement provision of the Plan transgresses the Code’s limitations.

Finally, the Court addressed § 524(g) – a “notable exception to the code’s general rules.” Under § 524(g), for asbestos-related bankruptcies (and only for asbestos-related bankruptcies), “courts may issue ‘an injunction…bar[ring] any action directed against a third party’ under certain statutorily specified circumstances.” The Court held that because “the code does authorize courts to enjoin claims against third parties without their consent, but does so in only one context, [it] makes it all the more unlikely that § 1123(b)(6) is best read to afford courts the same authority in every context.”

According to the Court, Plan proponents argued that the limits imposed on debtors and discharges are inapplicable because the Sacklers sought a release, not a discharge. Nonetheless, after looking to related Code provisions, the Court held that no matter how the Sacklers’ sought relief is classified, “nothing in the bankruptcy code contemplates (much less authorizes) it.”

3. History

The third component critical to the Court’s holding was that no party had directed them to a statute (including any prior versions of the Bankruptcy Code) or case “suggesting American courts in the past enjoyed the power in bankruptcy to discharge claims brought by nondebtors against other nondebtors, all without consent of the individuals affected.” According to the Court, “if Congress had meant to reshape traditional practice so profoundly in the present bankruptcy code, extending to courts the capacious new power the plan proponents claim, one might have expected it to say so expressly ‘somewhere in the [c]ode itself.”

4. Policy

Lastly, the Court’s opinion entertained both sides’ policy arguments. Proponents of the plan argued that without the releases, there would be no “viable path” for victims to recover. In the Brief for the Petitioner, the US Trustee disputed this, setting out that with the increased legal exposure resulting from potential lawsuits by individual victims, States, and other governmental entities, the Sacklers might be induced to negotiate consensual releases on more favorable terms. Moreover, the US Trustee argued that with the allowance of nonconsensual third-party releases, tortfeasors would be able to obtain immunity from claims that they normally could not discharge in bankruptcy, all the while failing to place “anything approaching all of their assets on the table.” This, according to the US Trustee, “would provide a ‘roadmap for corporations to misuse the bankruptcy system’ in future cases ‘to avoid mass-tort liability.’”

Despite acknowledging these perspectives, the Court held that it was the wrong audience for the policy arguments, which are for Congress to address. To further emphasize the limited nature of their ruling, the Court also explicitly stated that nothing in their decision should be “construed to call into question consensual third-party releases offered in connection with a bankruptcy reorganization plan,” and the Court was not expressing a view on what qualified as a consensual release. Finally, the Court set out that it would not address whether their reading of the Bankruptcy Code “would justify unwinding reorganization plans that have already become effective and been substantially consummated.”

Dissent

Writing for the dissent, Justice Kavanaugh emphasized that the Court’s decision essentially rewrote the text of the Bankruptcy Code and restricted “the long-established authority of bankruptcy courts to fashion fair and equitable relief for mass-tort victims.” Justice Kavanaugh also explained that because of a 2004 indemnification agreement where Purdue agreed to pay for the legal fees and liability expenses of its officers and directors, the non-debtor release provision would have protected the Purdue estate from being depleted by indemnification claims and would have ensured the victims receive compensation.

Justice Kavanaugh stated:

“[d]espite the broad term ‘appropriate’ in the statutory text, despite the longstanding precedents approving mass-tort bankruptcy plans with non-debtor releases like these, despite 50 state Attorneys General signing on, and despite the pleas of the opioid victims, today’s decision creates a new atextual restriction on the authority of bankruptcy courts to approve appropriate provisions.”

According to Justice Kavanaugh, non-debtor releases are “absolutely critical” to achieving the bankruptcy system’s overarching goal of fair and equitable relief for victims and creditors.”

Takeaways

There are a few key takeaways and considerations following this landmark decision.

• While the opinion likely will have a profound impact on bankruptcy cases, including mass tort bankruptcies, the parameters of that impact are yet to be determined. Non-debtor affiliates of debtors will clearly not be able to receive the benefit of a full release from non-consenting parties. However, those non-debtor affiliates can still use the bankruptcy process to negotiate litigation settlements – with whatever benefits or disadvantages a bankruptcy process could bring. Alternatively, those non-debtor entities can file for bankruptcy to take full advantage of the provisions of the Bankruptcy Code – including potential discharge or other debt resolution.
• The justices expressly avoided defining what constitutes a “consensual” release; future courts will have to make determinations on whether things like “opt-out” releases constitute consent.
• With respect to the Purdue bankruptcy itself, the Debtors have asked the Bankruptcy Court to re-enter mediation. In re Purdue Pharma L.P., et al., 19-23649 (Bkrtcy. Ct. SDNY, June 27, 2024), ECF Doc. 6498. It remains to be seen whether the parties will return to mediation and emerge with a new settlement or otherwise propose a new Chapter 11 plan.
  

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Authored by Douglas S. Mintz and Reuben E. Dizengoff.

If you have any questions concerning this Alert, please contact your attorney or one of the authors.

Introduction

On June 6, 2024, the Supreme Court – in a unanimous decision delivered by Justice Sotomayor – addressed the issue of whether an insurer holding financial responsibility for a bankruptcy claim qualifies as a party in interest under Bankruptcy Code § 1109(b). Reversing the Fourth Circuit decision below, the Court concluded that insurer Truck Insurance Exchange is sufficiently concerned with the proceedings so as to qualify as a party in interest because § 1109(b) is “capacious” and “asks whether the reorganization proceedings might directly affect a prospective party, not how a particular reorganization plan actually affects that party.” Truck Ins. Exch. V. Kaiser Gypsum Co., Inc., No. 22-1079, 2024 WL 2853106 (US June 6, 2024) (emphasis added).

Background

Debtors Kaiser Gypsum Company, Inc. and its parent company, Hanson Permanente Cement, Inc., produced and sold products containing asbestos, and consequently faced tens of thousands of asbestos-related lawsuits. To resolve these liabilities, Debtors filed for Chapter 11 bankruptcy and, under the proposed reorganization plan, created a § 524(g) Asbestos Personal Injury Trust. Section 524(g) “allows a Chapter 11 debtor with substantial asbestos-related liability to establish and fund a trust that assumes the debtor’s liability for ‘damages allegedly caused by the presence of, or exposure to, asbestos or asbestos-containing products.’” Here, the trust contains all present and future claims related to liability springing from asbestos use. In addition to the § 524(g) trust, the Plan also set out to transfer all of Debtors’ rights under their insurance contracts to the trust.

Truck Insurance served as Debtors’ primary insurer. Under the terms of Truck Insurance’s contract, transferred under the Plan, Truck Insurance is obligated to indemnify Debtors up to $500,000 per claim while Debtors must pay a $5,000 deductible per claim and assist in defending against the claims. At issue was the Plan’s provision treating insured and uninsured claims differently. While insured claims are to be filed in the tort system for the benefit of insurance coverage, uninsured claims are to be submitted directly to the trust for resolution. Most importantly, insured claims, unlike uninsured claims, lack disclosure requirements necessitating claimants to identify any related claims in order to reduce fraudulent and duplicative claims.

With the above discrepancy in mind, Truck Insurance filed an objection to the otherwise consensual Plan. Truck Insurance objected, asserting that the trust does not comply with § 524(g) and “the Plan would provide ‘anti-fraud’ protections to the trust in resolving uninsured claims but not to Truck Insurance in resolving insured claims,” subjecting Truck Insurance to potentially millions of dollars in fraudulent tort claims. In re Kaiser Gypsum Company, Inc., 60 F.4th 73, 80 (4th Cir. 2023). Truck Insurance had previously insisted to Debtors that the anti-fraud measures be applied to insured claims but Debtors declined, leading to Truck Insurance’s other contention that the Plan “appear[ed] to be collusive and in violation of [the Debtors’] duty to cooperate and assist,” and in breach of the implied covenant of good faith and fair dealing. Id.

In September 2020, the Bankruptcy Court for the Western District of North Carolina ruled against Truck Insurance and recommended that the District Court for the Western District of North Carolina confirm the Plan. In its recommendation, the Bankruptcy Court adopted Debtors’ Proposed Findings of Fact and Conclusions of Law and set out that Truck Insurance was not a party in interest and lacked standing to object to the Plan. More specifically, the Bankruptcy Court concluded that Truck Insurance could not object because the Plan is “insurance neutral” and returns Truck Insurance to the tort system exactly as it was prepetition. The Bankruptcy Court also stated that Truck Insurance lacked standing despite being a creditor in the case. Later in July 2021, the District Court adopted the Proposed Findings of Fact and Conclusions of Law and confirmed the Plan. Truck Insurance subsequently appealed to the Fourth Circuit.

The Fourth Circuit affirmed the District Court’s judgment. In its analysis, the Fourth Circuit held: “[i]n determining whether a particular reorganization plan sufficiently affects an insurer’s legal rights to render that insurer a party in interest, courts typically look to see whether the plan is ‘insurance neutral.’” In re Kaiser Gypsum Company, Inc., 60 F.4th at 83. Put differently, “[i]f a plan is insurance neutral, the objecting insurer ordinarily is not a party in interest under § 1109(b) and thus lacks standing to challenge the substance of the Plan.” Id.

According to the Fourth Circuit, a plan is deemed insurance neutral “if it doesn’t increase the insurer’s pre-petition obligations or impair the insurer’s pre-petition policy rights.” Id. Ultimately, the Fourth Circuit held that “the Plan was insurance neutral because it expressly preserved Truck [Insurance]’s coverage defenses and the Debtors’ assistance-and-cooperation obligations under the policies, thereby placing Truck [Insurance] in the same position as it was pre-bankruptcy.” Id. at 83-84.

Truck Insurance appealed to the Supreme Court and the Court granted certiorari.

The Supreme Court Reverses the Fourth Circuit’s Decision

The Court began its analysis by looking at the language, context and history of § 1109(b). This provision of the Bankruptcy Code sets out that “[a] party in interest, including the debtor, the trustee, a creditors’ committee, an equity security holder, or any indenture trustee, may raise and may appear and be heard on any issue in a case under this chapter.”

The Court held that a common thread among the parties listed in § 1109(b)’s definition of a party in interest “is that each may be directly affected by a reorganization plan either because they have a financial interest in the estate’s assets…or because they represent parties that do.”

As to context and history, the Court found the following. First, Congress uses the term “‘party in interest’ in bankruptcy provisions when it intends the provision to apply broadly,” and the “general theory behind [§ 1109(b)] is that anyone holding a direct financial stake in the outcome of the case should have an opportunity…to participate in the adjudication of any issue that may ultimately shape the disposition of his or her interest.” Second, “Congress consistently has acted to promote greater participation in reorganization proceedings.” Finally, drafters of the Bankruptcy Code hoped that with an expansive definition of party in interest, a broad range of individual/minority interests would be allowed to intervene in Chapter 11 cases and prevent dominant interests from controlling the restructuring process.

The Court next held that insurers with financial responsibility for bankruptcy claims are parties in interest given that reorganization proceedings can affect insurers’ rights in a variety of ways. For example, “a plan may be collusive, in violation of the debtor’s duty to cooperate and assist, and impair the insurer’s financial interests by inviting fraudulent claims.”

In the case at hand, the Plan, lacking disclosure requirements for insured claims, risks exposing Truck Insurance to millions of dollars in fraudulent claims and thus gives Truck Insurance an interest in the bankruptcy proceedings and the proposed Plan. Additionally, since the Plan eliminates the Debtors’ ongoing liability and claimants have no incentive to propose barriers to their recovery, Truck Insurance may be the only entity with the incentive to identify any issues with the Plan. Citing to In re Global Indus. Technologies, Inc., 645 F.3d 201, 204 (CA3 2011), the Court held that “[w]here a proposed plan ‘allows a party to put its hands into other people’s pockets, the ones with the pockets are entitled to be fully heard and to have their legitimate objections addressed.”

Lastly, in reversing the decision below, the Court also addressed the “insurance neutral” doctrine. According to the Court, “[t]his doctrine is conceptually wrong and makes little practical sense” because it “conflates the merits of an objection with the threshold party in interest inquiry.” More simply put, § 1109(b) evaluates whether a plan might affect a party, not how a plan actually affects a party. Thus, “[w]hether and how the particular proposed Plan… affects Truck [Insurance]’s prepetition and postpetition obligations and exposure is not the question.”

Analysis and Takeaways

• On the micro-level, this case broadens the ability of insurance companies to challenge proposed reorganization plans.
• More generally, by reversing the Fourth Circuit’s decision and holding that Truck Insurance is a “party in interest,” the Court has established that future § 1109(b) inquiries are to look not at the merits of an objection, but rather whether a prospective party may be affected by a proposed plan.
• The “insurance neutral” doctrine seemingly reached merits on the substance of a claim – before even considering the issue of standing. The Court roundly and unanimously rejected that approach.

Authored by Douglas S. Mintz.

If you have any questions concerning this Alert, please contact your attorney or one of the authors.

Executive Summary

On Feb. 6, 2024, the US Securities and Exchange Commission (“SEC” or “Commission”) adopted new Rules 3a5‑4 and 3a44‑2 (together, “Final Rules”)^[1] under the Exchange Act to further define what it means to be “engaged in the business” of buying and selling securities for one’s own account and, as such, required to register with the SEC as a “dealer” or “government securities dealer,” as applicable (collectively, a “Dealer”). The Final Rules establish two non-rebuttable qualitative standards — one that targets the regularity of a market participant’s expressions of trading interest (“Expressing Trading Interest” factor, as further defined below) and another that targets a market participant’s primary source of revenue (“Primary Revenue” factor, as further defined below) — to determine if a market participant is required to register as Dealer. While the Final Rules have been significantly scaled back from the SEC’s initial proposal (“Proposal”),^[2] based on the qualitative standards set forth in the Final Rules, certain private investment funds and their advisers may be required to register as Dealers.

The Commission declined to adopt the two most controversial provisions of the Proposal. The first was an additional qualitative standard that would have required any persons who “routinely [makes] roughly comparable purchases and sales of the same or substantially similar securities (or government securities) in one day” to register as a Dealer.^[3] The second was a quantitative standard that would have required any person who, in four of the last six calendar months, bought or sold over $25 billion in US Treasuries to register as a “government securities dealer.” However, in what appears to be a significant expansion from the Proposal, the Adopting Release notes market participants do not need to express trading interest continuously nor simultaneously be on both sides of the market to be captured by the Expressing Trading Interest test.

Additionally, the SEC declined to adopt the broad definition of “own account” included in the Proposal, which would have required that investment advisers aggregate activity across private funds and accounts managed by the adviser. Instead, the SEC adopted a definition of “own account” that focuses on the entity engaged in the dealer activity along with an anti-evasion prohibition designed to restrict circumvention of the Final Rules.

Final Rules

As adopted, the Final Rules require that, subject to limited exceptions, any person who “engages in a regular pattern of buying and selling securities [or government securities] for their own account that has the effect of providing liquidity”^[4] by engaging in the below activities must register as a Dealer:

• Regularly express trading interest that is at or near the best available prices on both sides of the market for the same security and that is communicated and represented in a way that makes it accessible to other market participants (“Expressing Trading Interest” test);^[5] or
• Earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives offered by trading venues to liquidity-supplying trading interest (“Primary Revenue” test).^[6]

While the SEC did not adopt the proposed “roughly comparable purchases and sales” qualitative standard, the SEC cautioned that such activity may still be “de facto market making under the [adopted] two qualitative tests or dealer activity under otherwise applicable precedent.”^[7] Further comments in the Adopting Release and a lack of clarity on key terms may permit broad interpretations of the two adopted qualitative tests to cover some of the activities previously captured by the “roughly comparable purchases and sales” test. The Commission also emphasized that the two adopted standards are non-exclusive, meaning that market participants must continue to assess their activities against existing SEC guidance and court precedent. This may be disappointing for market participants looking for additional clarity in light of recent court cases.^[8]

Expressing Trading Interest Test

Under the Expressing Trading Interest test, a person “regularly expressing trading interest that is at or near the best available prices on both sides of the market for the same security and that is communicated and represented in a way that makes it accessible to other market participants” is engaged in buying and selling securities for its own account “as a part of a regular business.”^[9] While the Commission stated it adopted this test largely as proposed, it made two significant textual changes. The first was to add the phrase “for the same security” to explicitly provide in the Final Rules that the expressions of trading interest must be for the same security. The second change replaced the term “routinely” from the Proposal with “regularly.” Additionally, the Commission provided guidance on a number of terms used under the Expressing Trading Interest. This guidance indicates that the SEC may take an expansive view of what activity is captured by the test.

“On Both Sides of the Market”

While the Final Rules clarify that the Expressing Trading Interest test requires a person’s trading interest to be “on both sides of the market for the same security,” the Commission declined to require that expressions of trading interest be simultaneous or provide a time horizon over which to evaluate single-sided expressions of trading interest. The Commission explained that “participants will need to assess the totality of their trading activity to determine if they are expressing trading interests on both sides of the market for the same security sufficiently close in time to have the effect of providing liquidity in the same security to other market participants,”^[10] including in determining whether their quoting activity meets the Final Rules’ “regularly expressing” standard.

“Regularly Expressing”

As proposed, the Expressing Trading Interest test would have required a person who “routinely” expresses trading interest at or near the best available prices on both sides to register as a Dealer. While the SEC noted that the term “routine” was “intended to capture significant liquidity providers who express trading interests at a high enough frequency to play a significant role in price discovery and the provision of market liquidity, even if their liquidity provision may not be continuous like that of some traditional dealers,”^[11] commenters expressed concern due to a lack of clarity and ambiguous nature of the term. Rather than directly addressing these concerns through a formal definition or clear guidance, the SEC replaced the term “routinely” with “regularly,” indicating the change was intended to mirror the statutory text.^[12] Notwithstanding the SEC’s note regarding its purpose, this change may result in additional activity being captured by the Final Rules. For instance, while the term “routine” indicates activity that is common and expected, the term “regular” could include activities that, while not routine, simply occur with some frequency (contrast one’s morning “routine” with “regularly” traveling for work).

The term “regularly” in the final rules will apply to a person’s expression of trading interest both “within a trading day and over time.”^[13] This requirement is intended to distinguish persons engaged in isolated or sporadic expressions of trading interest from persons whose regularity of expression of trading interest demonstrates that they are acting as Dealers. The Commission was clear, however, that a person does not need to be “continuously expressing trading interest” to be engaging in a “regular” business; rather, whether a person’s activity is “regular” will depend on the liquidity and depth of the relevant market for the security.^[14]

For example, while expressing trading interest “as part of an investment strategy on a one-off basis,” in a liquid market would not meet the requirements of the Expressing Trading Interest test,^[15] in less liquid markets (e.g., where it is more difficult to execute orders or large orders can significantly impact the price of the security), “regular” would include the “possibility of more interruptions or wider spreads for the best available prices.”^[16]

“At or Near the Best Available Prices”

While the Expressing Trading Interest test requires that quoting activity be “at or near the best available prices on both sides of the market,” the Final Rules and Adopting Release provide little guidance on this standard. Notably, statements by the SEC during the open meeting to consider the Proposal suggested that the SEC would look to the relevant facts and circumstances to determine if expressions of trading interest are at or near the best available prices.^[17]

Further, in the Adopting Release, the Commission explained that, in determining whether trading interest was expressed “at or near” the best available price, market participants should look to information typically used to make bids and offers, including “recently completed purchases and sales and the totality of indications of willingness to buy or sell at specified prices.”^[18]

The SEC did, however, clarify that a market participant seeking price information by requesting quotes on a security, without including prices, on both sides of the market would generally not satisfy this qualitative test because that trading interest, absent more, would not be “at or near the best available price.”^[19] Additionally, the Commission acknowledged that an adviser’s fiduciary duty may require it to submit “trading interests” throughout a trading day and explained that the Final Rules have been modified such that the trading interest expressed by an investment adviser for purposes of its fiduciary duty to its clients and their its accounts would not be activity captured by the Expressing Trading Interest test, unless the investment adviser itself is the account holder or the account is held for the benefit of the investment adviser.

“Trading Interest”

The term “trading interest” means: (i) an “order” as the term is defined in Rule 3b-16(c)^[20] or (ii) any non-firm indication of a willingness to buy or sell a security that identifies the security and at least one of the following: quantity, direction (buy or sell) or price.^[21] The SEC indicated that the second prong of this definition is intended to account for “the various and evolving ways in which buyers and sellers of securities are brought together.”^[22]

“Accessible to Other Market Participants”

The phrase “accessible to other market participants” reflects the requirement that a person’s trading interest must be expressed to more than one market participant to be captured under the test.^[23] The SEC notes, however, that the particular method of communication or representation is not controlling and that multiple individual communications could qualify if they are communicated to more than one market participant.^[24]

Primary Revenue Factor

The Commission adopted, as proposed, the Primary Revenue test, which requires a person to register as a dealer or government securities dealer if that person is “earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives offered by trading venues to liquidity-supplying trading interest.”^[25]

Revenue

While the SEC provided guidance indicating that generating the majority of one’s revenue from price appreciation, rather than capturing the bid-ask spread, would indicate somebody was not engaged in dealer activity, the Commission failed to clarify how “revenue” should be assessed under the Final Rules or adopt a “profitability” standard in its place (as suggested by commenters).^[26] However, the Commission made it clear that a person’s trading strategies would not need to be profitable to bring them within the rule.^[27]

Trading Venue

The term “trading venue” is intended to capture the full variety of venues on which market participants engage in liquidity-providing dealer activity, both today and as they evolve.^[28] The Commission explained that the particular venue matters less than the fact that a market participant provides liquidity on it.^[29]

Scope

The Adopting Release notes that the effect of a person’s trading activity, rather than its stated purpose, controls in determining whether the Primary Revenue test has been met. Accordingly, cash management strategies involving government securities could inadvertently trigger the Primary Revenue test.^[30]

Definition of “Own Account” & Aggregation

The Proposal would have defined the term “own account” to include both an account held by or for the benefit of such person and any account over which “that person exercises control or with whom that person is under common control.” This definition would have incorporated the definition of “control” from Exchange Act Rule 13h-1.

Additionally, the Proposal included the concept of a “parallel account structure,” which would have required separate legal entities not under common control to aggregate their activity where “one or more private funds …, accounts, or other pools of assets … managed by the same investment adviser pursue substantially the same investment objective and strategy and invest side-by-side in substantially the same positions as another parallel fund or parallel managed account.”^[31]

As adopted, the definition of “own account” does not include any account over which “that person exercises control or with whom that person is under common control.”^[32] Additionally, the Final Rules removed the concept of a “parallel account structure.” Rather, the Commission notes in the Adopting Release that it has elected to focus on activity on an entity-by-entity basis rather than aggregating accounts across entities based on control or commonality of investment objective and strategy.^[33] Accordingly, the adopted definition of “own account” no longer requires aggregating activity across accounts that constitute a “parallel account structure and is limited to any account: (i) held in the name of that person or (ii) held for the benefit of that person.”^[34]

Anti-Evasion

Rather than adopt the “control” or “parallel account structure” concepts, the Final Rules adopted an “anti-evasion” provision. This provision prohibits evading the Final Rules’ registration requirements by either: (i) engaging in activities indirectly that would satisfy the Expressing Trading Interest or Primary Revenue Factors or (ii) disaggregating accounts.^[35]

The Commission makes it clear that anti-evasion provision is intended to capture persons dividing or structuring their activity to evade the application of the Final Rules and notes that potentially evasive activity includes, but is not limited to:^[36]

• Coordinating and integrating trading across commonly controlled legal entities such that no entity meets the qualitative standards;
• Using two legal entities to separately purchase and sell securities; and
• Using several legal entities to purchase and sell securities but rotating the activity across the entity in a way that none of the entities trades frequently enough to satisfy the “regular” test under either factor.

In determining whether or not a person is evading the dealer registration requirements, the Commission may consider whether:^[37]

• There are information barriers to prevent sharing of information or sufficiently segregated trading,
• There are overlapping personnel across accounts or entities,
• There are separate account statements for each account, or
• There is a business purposes that demonstrates that there is no coordinated buying and selling between accounts or entities.

Notably, the Commission provided that it would generally consider management by an adviser of managed accounts that are separately owned, but follow substantially the same investment objectives and strategies, to be ordinary course business activities and thus the Commission would not impute the trading in the clients’ accounts to the adviser’s own account, absent an intent to evade the dealer registration requirements.^[38] Notwithstanding this exclusion, it is important to recognize that whether a person has violated the anti-evasion provision will depend on an evaluation of the totality of the facts and circumstances.

No Presumption

The Final Rules include a “no presumption” provision, stating that no presumption shall arise that a person is not a Dealer solely because such person’s activities are not captured by the adopted tests. Accordingly, the SEC could still determine that a market participant that does not trigger either of the qualitative standards is still a Dealer under applicable precedent.

Exclusions

The Proposal included an exclusion for registered investment companies and persons with less than $50 million of total assets.

A number of commenters requested additional exclusions, including exclusions for registered investment advisers and private funds. While the Commission declined to exclude investment advisers and private funds, the Final Rules expand the scope of excluded entities to add certain “Official Sector” entities^[39] to the types of entities excluded from the Proposal (i.e., a person with less than $50 million of total assets and registered investment companies).^[40]

The Commission also declined to exclude crypto asset securities from the Final Rules, noting that whether or not an entity is a Dealer depends on the securities trading activities undertaken by a firm, not the type of securities being traded.^[41]

Potential Impact

As part of its economic analysis, the SEC identified certain market participants that it determined might be captured by the Final Rules. In determining who would be impacted, the Commission looked at data from FINRA’s Trade Reporting and Compliance Engine (TRACE) and Form PF.

Using TRACE data for US Treasury securities, the SEC identified firms that appeared to meet the Primary Revenue Factor by earning revenue from capturing bid-ask spreads in the market for US Treasury securities. As part of this exercise, the SEC noted that unregistered “principal trading firms” (or PTFs) were most likely to be impacted, noting their de facto role as market makers in the US Treasuries markets. Based on its analysis of TRACE data, the SEC approximated that 13-22 PTFs and four (4) private funds may be within scope of the rule.^[42] The SEC was unable to estimate the number of entities that appear to meet the Expressing Trading Interest Factor because the Commission does not have sufficient data on quoting activities.

Outside of the market for Treasury securities, the SEC’s economic analysis relied on Form PF disclosures regarding private funds’ use of high frequency trading strategies. While the SEC acknowledged that it was unable to determine whether the self-reported HFT activities would satisfy the Expressing Trading Interest or Primary Revenue tests, it concluded that the funds most likely to be within the scope of the Final Rules were those funds with a higher percentage of their net asset value (“NAV”) dedicated to HFT strategies. Accordingly, the SEC identified as likely to meet the definition of Dealer under the Final Rules twelve (12) private funds that reported at least 10 percent of their NAV as associated with HFT strategies. For clarity, this is in addition to the four (4) private funds identified through TRACE data for US Treasury securities.

Enforcement Implications for Unregistered Dealer Activity

Notably, the SEC recognized that its approach in estimating the number of potentially impacted PTFs and private funds is imperfect as the estimate is based largely on what data was available to the SEC rather than clear indicators of potential dealer activity. While the Commission’s estimates are imperfect, its approach may help identify firms that are likely to be targeted in future exams.

Notably, all firms should perform a self-assessment of their trading strategies in light of the Final Rules. While firms that meet the criteria used by the SEC may want to engage in more comprehensive self-assessments, the deficiencies in the SEC’s estimates mean that other firms should not assume they are outside the scope of the Final Rules.

Issues for Advisers and Funds That Register

Dealers are subject to a number of rules and requirements to which registered investment advisers, private funds and principal trading firms are not currently subject. While the scope of the Final Rules have generally been narrowed, given the ambiguity in the Final Rules, we highlight certain considerations relating to dealer registration.

SRO Membership

A dealer must register with one or more self-regulatory organizations (“SROs”), and most dealers are required to become members of FINRA.^[43] SRO members are subject to the relevant SRO’s rules, including a number of technical rule requirements that are not applicable to other market participants (e.g., consolidated audit trail and trade reporting obligations), and periodic examinations by the SRO.

New Issues (IPO) Restrictions

FINRA Rules 5130 and 5131 (commonly known as the FINRA “new issues” rules) restrict certain market participants from receiving shares in initial public offerings (“IPOs”), including broker-dealers, associated persons of a broker-dealer and certain persons owning a broker-dealer. If a private fund is registered as a dealer, the fund would be restricted from receiving shares in an IPO and, relatedly, certain of its owners (e.g., its limited partners) could similarly become restricted from participating.^[44]

Capital Withdrawals

Dealers are subject to the net capital requirements of Exchange Act Rule 15c3-1 (the “Net Capital Rule”). Generally, the Net Capital Rule requires that dealers maintain more than a dollar of highly liquid assets for each dollar of liabilities. The Net Capital Rule highly discourages withdrawals of capital within one year of contribution, providing, generally, that any capital withdrawn within one year of contribution was never eligible to be treated as “good” capital for purposes of the Net Capital Rule. If a private fund (or its subsidiary) registers as a dealer, the private fund’s existing liquidity terms may need to be amended in order to include all of the investors’ capital as “good” capital and any such amendment is likely to require investor consent.

Change in Control Filings

FINRA rule 1017 requires that broker-dealers file an application for any change in ownership that results in one person or entity directly or indirectly owning or controlling 25 percent or more of the equity or partnership capital. While, in certain cases, closing may occur thirty (30) days after filing of such application, FINRA may impose interim restrictions that delay closing until 180 days (or longer) after filing. This could delay a private fund’s ability to accept new subscriptions or process redemptions to the extent such subscriptions or redemptions require a filing of a “change in ownership” application by such private fund or its subsidiary.

Other Considerations

• Certain investors may not be permitted to invest (directly or indirectly) in the equity of a broker-dealer and may need to be redeemed from the private fund before the private fund or its subsidiary becomes a registered dealer.
• Modifying a fund’s investment strategy (e.g., by moving the dealer activity out of the private fund to a new entity that is not owned by the private fund to avoid dealer registration at (or below) the private fund level) may require investor consent and also trigger investor redemption rights.

Compliance Deadline

The final rules will become effective 60 days following the date of publication of the Adopting Release in the Federal Register. The compliance date will be one year after the effective date of the Final Rules (“Compliance Period”) and, in a departure from the Proposal, the Compliance Period applies to both market participants engaged in activity that meets one or both adopted tests prior to the effective date and new entrants.

Impacted persons will need to have their dealer registrations approved by the end of the Compliance Period (absent an extension). This represents a very short window as impacted firms will need to identify, among other things, the anticipated ownership structure, personnel and procedures. Further, while FINRA indicated it would attempt to expedite the registration process for entities impacted by the Final Rules, in our experience FINRA approval of a new membership application can easily take over six (6) months from the date of submission.

Authored by William J. Barbera, Jennifer M. Dunn, Marc E. Elovitz, Kelly Koscuiszka, Julian Rainero, Derek N. Lacarrubba, and Kristopher J. Kendall.

If you have any questions concerning this Client Alert, please contact your attorney or one of the authors.

Introduction

On Dec. 4, 2023, the US Supreme Court heard oral arguments in Harrington v. Purdue Pharma L.P., No. 23-124 (US argued Dec. 4, 2023), on whether a bankruptcy court may approve a Chapter 11 reorganization plan that non-consensually releases direct claims against non-debtor third parties. The Court’s decision may dictate whether a third-party non-debtor will be able to discharge civil litigation claims without having to file for bankruptcy or follow Bankruptcy Code requirements. The Court considered extensively whether the Bankruptcy Code permits third-party releases under § 1123(b)(6) and looked at the impact of a ruling here on accepting and hold out creditors. The Court appeared divided (and not on typical ideological lines) making prediction of an outcome particularly difficult here. We expect a ruling before the end of the term in June 2024.

Background

Purdue Pharma, a manufacturer of branded opioid medications, including OxyContin, filed for bankruptcy on Sept. 15, 2019. The Company faced significant threats to its continued viability stemming from mass tort litigation over its marketing and sale of prescription opioid medications, including OxyContin.

The proposed chapter 11 plan sought to resolve the opioid litigation by incorporating a settlement framework that included a release of the family that owned the equity in Purdue, the Sackler family, in exchange for a lump-sum settlement payment of $4.325 billion at the time of confirmation. The Bankruptcy Court approved this Plan and entered a confirmation order on Sept. 17, 2021. Certain parties, including the US Trustee appealed the confirmation order. On appeal (from the District Court), the Second Circuit affirmed the bankruptcy court’s confirmation of a chapter 11 reorganization plan containing nonconsensual releases of direct claims against third-party non-debtors, including the debtor’s controlling owners, the Sacklers. After a subsequent appeal by the office of the United States Trustee, the US Supreme Court granted certiorari and teed up the hearing.

Analysis

In a “dramatic” argument, the court questioned the parties on four main issues: the interpretation of § 1123(b)(6) in the Bankruptcy Code; the legacy a ruling may leave for future liable companies and those impacted by mass tort; the difference between direct and derivative claims; and recoveries for the mass tort plaintiffs.

Statutory Interpretation. First, the justices tackled statutory interpretation. Justices Jackson, Kavanaugh and Gorsuch questioned the parties on the interpretation of the term “appropriate” in § 1123(b)(6) of the Bankruptcy Code. Section 1123(b)(6) states that a plan may “include any other appropriate provision not inconsistent with the applicable provisions of this title.” Arguing on behalf of the US Trustee, the Deputy Solicitor General asserted that nonconsensual third-party releases are outside the scope of the term “appropriate.” Counsel for the US Trustee argued that Congress did not intend for Bankruptcy Code § 1123(b)(6) to go beyond general principles of the Bankruptcy Code and allow bankruptcy courts to “simply redistribute others’ private property rights” without consent.

Justice Kavanaugh asked counsel for the US Trustee to explain his position in light of decades of cases where claims against directors were indemnified by the debtor and therefore properly incorporated into the plan of reorganization. Counsel for the US Trustee argued that “[t]his [Plan] really sweeps much more broadly than that. It isn’t just people who are directors and officers.”

In contrast, counsel to Purdue emphasized flexibility, arguing that “‘[a]ppropriate’ is a term of classic breadth. It essentially gives the courts a common law role that while broad is part and parcel of what bankruptcy courts and equity courts have been doing for centuries in this context.”

Justice Jackson, however, questioned counsel to Purdue on how the statutory context informs his interpretation of § 1123(b)(6), asking why in this case should the Court depart from its standard interpretation of statutory lists. Counsel to Purdue argued that §§ 1123(b)(1)-(5) work directly with § 1123(b)(6) in that each provision grants the authority needed by the bankruptcy court for a plan to be effective. Section 1123(b)(6) is the catch-all provision that encapsulates what is not specifically mentioned in §§ 1123(b)(1)-(5). Justice Gorsuch observed that counsel to Purdue’s position lacked the support of a strong historical analogue. Not only was this issue the most significant point of questioning from the Court but also will likely be a deciding factor in the Court’s opinion.

Impact on Future Mass Torts. Second, the Justices focused on how this case might impact future mass tort bankruptcies, with Justice Barrett inquiring into potential ramifications for victims in cases such as LTL Management.^[1] To resolve issues related to mass torts, counsel for the US Trustee suggested that Congress could step in “as it did with § 524(g) of the Bankruptcy Code which permits the resolution of mass torts related to asbestos litigation, and create a customized framework for some of these individual case[s].” Counsel to Purdue countered that should the Debtors’ position not be validated, the Court would have to find § 524(g) unconstitutional, taking a “wrecking ball” to the asbestos bankruptcy carve-out and the rest of the Code.

Direct and Derivative Claims. Third, the justices spent considerable time questioning the parties about direct versus derivative claims. Both parties agreed that similar to direct claims, derivative claims belong to individual creditors under state law. However, upon filing for bankruptcy, the estate secures the exclusive right to litigate or settle such claims for the benefit of all creditors. Justice Sotomayor questioned counsel to Purdue on this distinction, noting that she did not understand why the personal injury claims were not derivative claims given that the defective product was sold by the corporation not the Sackler parties. Counsel to Purdue responded that, in this case, the direct claims were “functionally indistinguishable from the derivative claims,” thereby making them dischargeable without consent under § 1123(b)(6), On rebuttal, counsel for the US Trustee argued that the derivative claims are ones that can be recovered from “… the corporation as a whole,” and that, in this case, the mass tort plaintiffs’ claims were direct, not derivative. Specifically with respect to the state government claims against the estate, counsel to the UCC explained the importance of the release, stating that if the release is eliminated each of the states’ claims will be resurrected because they are direct claims.

Making Creditors Whole. Lastly, Justices Kavanaugh and Barrett asked the parties the best way to make mass tort victims whole once more. According to Justice Kagan, the trustee’s position, and the position of the hold out creditors could be “standing in the way of [recovery] as against the huge, huge, huge majority of claimants who have decided that, if this provision goes under, they’re going to end up with nothing.” Counsel to Purdue suggested this as well, pointing out repeatedly that the Plan has the support of 97 percent of the voting plaintiffs. Counsel for the US Trustee responded that even in a situation where there was the hypothetical “nut-case holdout” who did not consent to the Plan, that holdout creditor should still have its day in court and should not be forced to relinquish its property rights in its claim as a non-debtor third party. Justice Jackson also pointed out that even if there are holdouts, the Sackler parties could still fund victims who do consent and litigate with any holdouts. Counsel to the UCC argued that the US Government’s $2 billion super-priority claim against the Sacklers, if not discharged through the Plan, would flatten the estate, leaving little to nothing for the plaintiffs to collect.

Conclusion

As detailed above, the Court focused foremost on § 1123(b)(6) of the Bankruptcy Code and whether third-party releases are “appropriate” provisions to include in a plan. This, as well as the ideologically mixed nature of the arguments, suggests that any ruling here will focus narrowly on the propriety of the releases of direct claims at issue in this case – rather than a broader ruling on whether and when third-party releases are permitted broadly. The Plan proponents here faced heavy questioning on the propriety of these releases from the Court. However, the Court also placed some emphasis on the practical impact of this ruling. And the Court may be reluctant to undermine a plan with widespread consent and recovery for creditors.

Authored by Douglas S. Mintz, Reuben E. Dizengoff, and Christiana Johnson.

If you have any questions concerning this Alert, please contact your attorney or one of the authors.