Texas State Court Strikes Down Ch. 11 Litigation Trust Agreement As Void Against Public Policy

A Texas Court of Appeals has ruled that a litigation trust created under a chapter 11 plan of reorganization was void as against public policy as a “Mary Carter Agreement.” Turoff v. McCaslin, 2007 Tex. App. LEXIS 2343 (Tex. App.—Waco, 3/21/07). As a result, the court sustained a take-nothing summary judgment rendered against the plan trustee and in favor of the corporate officers and directors (D & O Defendants) and the corporate auditor who had been sued.

The Litigation Trust Agreement

ProMedCo Management Company (PMC) and its affiliates filed bankruptcy in 2000 amidst allegations that they had operated as a Ponzi scheme. On April 30, 2002, the Bankruptcy Court confirmed a plan of reorganization which provided for a Litigation Trust Agreement . The Litigation Trust Agreement was intended to provide a vehicle for pursuing claims against the D & O Defendants and the corporate auditor Arthur Andersen, as well as to allocate any proceeds recovered between the beneficiaries of the trust.

The beneficiaries of the trust were the Bank Group, the Preferred Shareholders and the unsecured creditors. The Bank Group agreed to advance $400,000 to fund the trust and would receive the first $800,000 in proceeds. The Bank Group and the Preferred Shareholders were to divide 95% of any proceeds over $800,000, while the unsecured creditors would receive 5%. Each of the parties which contributed claims to the trust released each of the other parties contributing claims.

Thus, the essence of the trust was an agreement by the Debtors, the Bank Group and the Preferred Shareholders to pool their claims for the benefit of the Bank Group and Preferred Shareholders (and to a de minimus extent the unsecured creditors) and not to sue each other. The covenant not to sue apparently protected the Bank Group from being sued by the Preferred Shareholders based on allegations that it had withheld critical information from the Preferred Shareholders at the time of their investment. Thus, rather than suing each other, the Bank Group and Preferred Shareholders agreed to combine forces and jointly pursue the D & O Defendants and Arthur Anderson under the framework of the Litigation Trust Agreement.

The D & O Defendants cried foul and filed a Motion for Summary Judgment seeking to characterize the Litigation Trust Agreement as a “Mary Carter Agreement.” Because a Mary Carter Agreement is void under Texas law, invalidating the trust would deprive the trustee of standing to pursue the claims.

Who Was Mary Carter Anyway?

The seminal Texas case on Mary Carter Agreements is Elbaor v. Smith, 845 S.W.2d 240 (Tex. 1992). In that case, the plaintiff sued three doctors and a hospital. The plaintiff then settled with two of the doctors and the hospital. Instead of dismissing out the settling defendants, these parties continued to participate in the trial where they could point the blame at the non-settling defendant. In return for this collaboration, they could be reimbursed for the amount of their settlement out of amounts recovered from the non-settling defendant. Needless to say, this was a problem, because the jury was given the impression that the case involved one plaintiff against four defendants, when in fact the real alignment was that one plaintiff and three defendants were all out to get the remaining defendant.

The Court of Appeals explained the problem with Mary Carter Agreements as follows:

“The classic Mary Carter Agreement exists when the settling defendant retains a financial stake in the plaintiff’s recovery and remains a party at the trial of the case. (citation omitted). It presents to the jury a sham of adversity between the plaintiff and a settling defendant, while these parties are actually allied for the purpose of securing a substantial judgment for the plaintiff and, in some cases, exoneration for the settling defendant. (citation omitted). These types of agreement tend to promote litigation rather than settle it and distort the trial against the nonsettling defendants. (citation omitted). And Texas does not favor settlement arrangements that tend to skew the trial process, mislead the jury, promote unethical collusion among nominal adversaries, and create the likelihood that a less culpable defendant will be hit with the full judgment. (citation omitted).”

Slip Op. at p. 4.

The Litigation Trustee pointed out that the Litigation Trust Agreement did not meet the literal definition of a Mary Carter Agreement. Critically, there was not a settling defendant who concealed the fact of settlement in return for a share of the proceeds. Instead, the potential adversaries settled out their claims well before any litigation was ever brought so that there were no sham defendants in the suit.

The Court of Appeals did not allow such a literal reading of the Texas case law to restrict it. It stated:

“(T)he law on Mary Carter Agreements in Texas has evolved to include agreements that violate the principles laid out in Elbaor even if the precise structure of the agreement does not fit the precise pattern of an agreement previously determined to be in violation of public policy. (citation omitted). A strict application of Elbaor is not necessary to find a Mary Carter Agreement.”

Id.

The Court of Appeals found that the Litigation Trust Agreement was a Mary Carter Agreement based upon the following factors:

1. The beneficiaries in the trust had a financial interest in the outcome of the litigation;
2. The beneficiaries were required to cooperate and assist with the suit;
3. The beneficiaries mutually released each other as well as four individuals employed by Goldman Sachs (one of the preferred shareholders);
4. The beneficiaries “skewed” the trial process by settling their claims between themselves and contributing their other claims to the trust; and
5. It appeared likely that less culpable defendants would be hit with the full judgment.

Thus, it seems that the Court of Appeals was offended by the fact that the Litigation Trust Agreement was essentially a joint venture between the Bank Group and the Preferred Shareholders to settle the claims between them and present a united front against the other potential defendants.

Bankruptcy Order Not So Supreme

The Court of Appeals also rejected an argument that the Supremacy Clause precluded the court from invalidating the Litigation Trust Agreement. The Court of Appeals was careful to note that the Litigation Trustee had not argued for the application of collateral estoppel or res judicata so that the court did not consider these doctrines.

The Court of Appeals stated that there were three types of pre-emption arguments: (1) where Congress has expressly pre-empted all state laws in a field; (2) where Congress has inferentially pre-empted all state laws in a field; and (3) where state law actually conflicts with federal law. The Court of Appeals analyzed the Supremacy Clause argument under the third type of pre-emption and found that it did not. According to the Court of Appeals, the issue as framed by the Litigation Trustee was whether the trial court’s summary judgment order stood as an obstacle to the execution of the Confirmation Order.

The Court of Appeals noted that the Litigation Trustee “provides no case law to support the concept that a Confirmation Order, itself, preempts a state trial court’s decision in litigation that does not relate to the bankruptcy proceeding.” The Court rejected an argument that the Bankruptcy Court’s finding that the plan was proposed in good faith and not by any means forbidden by law would prevent another court from determining that implementation of the Litigation Trust Agreement was forbidden by state law. Finally, the court noted that the purpose of the Litigation Trust Agreement, as stated in the Confirmation Order, was to “liquidate the Contributed Causes of Action.” The Court noted that one definition of “liquidate” was to determine the amount of a claim or damages. Because the Confirmation Order could not guaranty the success of the claims in state court, the state court’s order granting summary judgment liquidated the claims within the meaning of the Confirmation Order and thus implemented rather than conflicted with the Confirmation Order.

What Does It All Mean?

From the perspective of the Litigation Trust, this decision was a disaster. A structure commonly used in chapter 11 plans and specifically approved by order of the Bankruptcy Court was struck down as invalid by a state court with the result that parties who had allegedly contributed to the downfall of the debtors were able to escape liability. The result is particularly galling because the Court of Appeals really had to reach to apply the Mary Carter doctrine. Unlike a “traditional” Mary Carter Agreement, there was no sham defendant participating in the litigation and the terms of the agreement were disclosed to the world before the litigation was ever filed.

However, it may be that the problem lay with this particular litigation trust agreement and not with litigation trusts in general. Specifically, the Court of Appeals may have done rough justice by stretching state law (and this ruling does appear to be a stretch) to strike down an agreement that served only a dubious bankruptcy policy. The Litigation Trust Agreement served three constituencies:

(a) the Bank Group;
(b) the Preferred Shareholders; and
(c) the Unsecured Creditors.

Taking these in reverse order, the unsecured creditors had very little interest in the litigation. They would receive 5% of proceeds in excess of $800,000. It appears likely that the unsecured creditors were thrown into the trust as window dressing to make it appear that the trust served a valid bankruptcy purpose.

On the other hand, the Preferred Shareholders received a significant share of the trust despite the fact that they likely did not have a cognizable bankruptcy interest. Under the absolute priority rule, the interest of the preferred shareholders should have been canceled out unless the unsecured creditors received payment in full. Thus, their participation in the Litigation Trust Agreement was clearly based on their contribution of causes of action to the trust and their release of claims against the Bank Group. It can be argued that this was “new value” which would allow them to participate under the plan. However, the fact remains that they were using the bankruptcy case as a vehicle to make a deal with the Bank Group which could have been done outside of bankruptcy.

The Bank Group has the strongest claim to a share of the pie. As secured creditors of the debtors, they had the right to be paid out of causes of action asserted by the estate. However, they also had an independent interest in not getting sued. The Litigation Trust Agreement can be viewed as an agreement by the Bank Group to pay $400,000 to settle claims which could have been asserted by the Preferred Shareholders. Rather than having the money go directly to the Preferred Shareholders, the parties agreed that the money would be used to fund a joint venture between them. The complicating factor here is that it is impossible to unscramble whether the Bank Group received more value from being able to recover a share of the proceeds from the estate’s causes of action (a proper bankruptcy interest) or from not being sued by the Preferred Shareholders (a private interest). No doubt, it was the mixed nature of these interests which made the Litigation Trust Agreement appear to be beneficial, since it resolved both interests in one package.

In a perverse way, it can be argued that no substantial bankruptcy purpose was maligned by the Court’s ruling. The Bank Group paid $400,000 and received a release of claims. While they did not receive anything more, this was a risk that they took. The Preferred Shareholders were entitled to nothing under the absolute priority rule and that is exactly what they received. The unsecured creditors stood to gain very little, so that they lost very little as well.

Having said all this, it is still a bit unseemly that the D & O Defendants apparently sat back and did not challenge the plan in bankruptcy court and then attacked the validity of the structure created by the plan in state court. It could be that they didn’t know enough to raise the objection at the time or it could be that they waited to press the argument in a local state court which would be less receptive to the subtleties of federal bankruptcy law.

It is also confusing why the Litigation Trustee relied upon the Supremacy Clause, which is basically a pre-emption doctrine, when there were other arguments which could have been made. Section 1141(a) provides that the plan is binding upon the debtor, creditors, equity security holders, persons acquiring property from the debtor and persons issuing securities under the plan. It seems highly likely that the D & O defendants were either creditors or equity security holders. The Court of Appeals does not mention this section at all. As a result, it is unclear whether it glossed over the issue to get to the result it wanted or whether this argument was not made. It is also perplexing why the Litigation Trustee did not argue that the Confirmation Order had res judicata or collateral estoppel effect upon the D & O Defendants or why judicial estoppel was not urged.

Regardless of what could have or should have been argued or how the Court of Appeals should have applied the law, this case should be required reading for chapter 11 lawyers drafting litigation trust agreements in the future.