Continuing the battle: quantity of claims, not underlying merit, has become a driving force in asbestos bankruptcies.

Bankruptcy is intended to prevent a feeding frenzy by creditors, maximize value of bankrupt debtors' limited assets and ensure that creditors' claims are paid in an orderly and fair manner.

But recent asbestos bankruptcies reveal different interests at work. An asbestos bankruptcy typically spawns a feeding frenzy of new claims because of the collision of two laws, Section 524(g) of the Bankruptcy Code and the law of unintended consequences, often felt acutely by insurers.

Section 524(g) allows asbestos-tainted debtors to obtain discharges from present and future asbestos claims, which are channeled to trusts for evaluation and payment. The goal is to permit debtors' going-concern value to be preserved and shared equitably among both existing creditors and future claimants, instead of being dismembered in a Chapter 7 "fire sale" liquidation with current creditors receiving far less and future claimants receiving nothing.

Unfortunately; that didn't work out. The structure of 524(g) significantly tilted the playing field to benefit current asbestos claimants because they must approve a 524(g) plan by a 75% supermajority. However, other creditors are subject to the Bankruptcy Code's "cram down" provisions, forcing them to accept a reorganization plan.

The result: a small group of plaintiffs' attorneys--controlling vast claimant inventories--wields veto power over a debtor's ability to cleanse itself of its asbestos liabilities through 524(g). Now, at the first hint an insured may the for bankruptcy, claims against it skyrocket as attorneys jockey for maximum leverage in negotiations. Thus, quantity of claims, not their underlying merit, has become a driver in asbestos bankruptcies. This has spawned abuses.

Plaintiff-attorney-controlled asbestos creditors committees seek to impose lenient distribution procedures, setting standards for who gets paid what by the trust and helping to ensure claimants will be paid with minimal scrutiny of individual injuries or the asbestos defendant's tort liability.

There is a burgeoning effort by asbestos plaintiffs' counsel to induce companies to create prepackaged bankruptcies, often extracting extra fees for facilitating a settlement. No commercial creditors object because they are promised payment in full. Under 524(g), the trust is supposed to be funded "in whole or in part by the securities of [one] or more debtors." Nevertheless, these prepacks typically let the shareholders retain their stock. In exchange, the company assigns its insurance policies to a trust, controlled by personal-injury attorneys and designed to approve claims with little or no proof of harm--typically in amounts far exceeding historical recoveries against that company.

The recent, landmark 3rd U.S. Circuit Court of Appeals decision in In Re: Combustion Engineering Inc. vacating confirmation of CE's prepack plan, presages the rejection of many of these abuses. The court:

* Wrote disapprovingly of efforts to permit preferred treatment for clients of favored attorneys or allow hordes of unimpaired claimants to overwhelm votes of the truly sick.

* Further suggested that 524(g) protection will not be available where the future claimants" legal representative is not involved from the early stages of negotiations, and implied that any 524(g) plan must envision the trust's obtaining majority control of an ongoing business to provide "evergreen" funding for the trust.

* Reiterated the broad right of "parties in interest" to be heard in bankruptcy court and expressly recognized insurers' appellate standing to raise issues impacting their financial interests--implicitly rejecting efforts to exclude insurers from participation in bankruptcy court proceedings because they are not creditors.

* Endorsed using "super-preemptory" language to ensure that a reorganization plan did not affect insurers' rights.

However, it is unclear whether the language approved by the 3rd Circuit will be sufficient to avoid another situation like Fuller-Austin Insulation Co. vs. Fireman's Fund Insurance Co. In this case a California court found a bankruptcy court's estimation of future asbestos liabilities immediately accelerated the insurers' duty to pay full policy limits into a 524(g) trust, although such claims would not be asserted for years. This acceleration of liability to pay for claimants who are not yet sick presents a frightening specter for insurers.

Combustion Engineering is a welcome first step, but there's no sign plaintiffs' counsel will abandon efforts to use prepacks as "insurance plays." Until Congress enacts legislation to deal with the "elephantine mass" of asbestos claims, or at least ameliorates the more egregious litigation abuses, insurers, policyholders and claimants will continue to battle these issues in court.

William P. Shelley chairs the insurance coverage practice at law firm Cozen O'Connor and serves as national counsel for insurers in asbestos bankruptcy matters. He may be reached at [e-mail].