Frenville – Gone But Not Forgotten: Third Circuit Prohibits Retroactive Application of Grossman’s

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On June 2, 2010, in Jeld-Wen, Inc. v. Van Brunt (In re Grossman’s Inc.), 607 F.3d 114 (3d Cir. 2010), the Third Circuit reversed course on the highly criticized accrual test, overruling Frenville and adopting an amalgam of the “conduct” test and “prepetition relationship” test used by other courts to determine when a claim arises for purposes of the Bankruptcy Code.  Under the Third Circuit’s new test, a claim arises when an individual is exposed prepetition to a product or other conduct giving rise to an injury, which underlies a right to payment under the Bankruptcy Code.  Grossman’s expanded the range of debts that could be discharged in bankruptcy, and arguably signaled a new, more debtor-friendly era in the Third Circuit.

However, on May 18, 2010, the Third Circuit issued a decision in Wright v. Owens Corning, Case No. 11-2026 (3d Cir. May 18, 2012) holding that due process concerns may preclude retroactive application of Grossman’s to certain unknown future claims and, accordingly, the debts on account of such claims may survive a chapter 11 discharge.  Thus, Owens Corning indicates that the fresh starts received by some reorganized debtors may not be quite as fresh as originally anticipated.

Background

Owens Corning and certain of its subsidiaries, manufacturers of fiberglass and related products, commenced chapter 11 cases in October 2000.  The Bankruptcy Court established April 15, 2002 as the bar date, and Owens Corning published notice of the bar date in several national publications, among other media outlets.  In June 2006, Owens Corning filed a proposed plan of reorganization, and similarly published notices of the plan and corresponding disclosure statement, and subsequently, the September 2006 confirmation date of the plan.  In accordance with section 1141 of the Bankruptcy Code, which provides that “confirmation of a plan . . . discharges the debtor from any debt that arose prior to the date of such confirmation”, Owens Cornings’ plan provided for the discharge all claims relating to Owens Corning arising before the confirmation date.

Nearly seven years prior, in late 1998 or early 1999, Patricia Wright hired a contractor who installed Owens Corning shingles on her roof.  In 2005, Kevin West hired a contractor who likewise installed Owens Corning shingles on his roof.  In 2009 – after confirmation of the plan – both customers discovered leaks in their roofs and determined that the shingles had cracked.  Each submitted warranty claims to Owens Corning, which rejected Wright’s claim in part and West’s claim in full.  Wright subsequently commenced a class action against Owens Corning alleging fraud, negligence, strict liability, and breach of warranty.  West was added later as a named plaintiff.

At the time Wright commenced the class action, Frenville was still controlling law in the Third Circuit.  Under Frenville, Wright and West did not have claims against Owens Corning until the shingle defect manifested – years after Owens Cornings confirmed its plan.  However, approximately one year after commencement of the class action, the Third Circuit overruled Frenville and announced the new conduct / prepetition relationship test in Grossman’s.  Citing Grossman’s new debtor-friendly standard, Owens Corning moved for summary judgment on the basis that Wright’s and West’s claims arose when they purchased the shingles and, thus, both claims were discharged under the plan.  Wright and West countered, asserting that Grossman’s should not apply retroactively.  The District Court sided with Owens Corning, and held that Wright’s and West’s claims were discharged under Owens Cornings’ plan.  We have previously discussed the District Court’s decision  here.

On appeal, Wright and West advanced two new arguments.  First, they argued that the District Court applied Grossman’s too rigidly, creating an unworkable result that requires both debtor and claimant to anticipate an unknowable, future injury / tort action at the time of bankruptcy proceedings for a claim to exist.  Second, they asserted that the District Court’s due process analysis was flawed because it based its ruling on Third Circuit precedent holding that unknown claimants generally are entitled to notification by publication.

Analysis

Before turning to the merits, the Court first addressed whether Wright and West had waived their arguments on appeal regarding Grossman’s by failing to advance the arguments before the District Court.  While noting the general rule that it is inappropriate for an appellate court to consider new arguments not raised below, the Court acknowledged that the principle is premised on discretion rather than jurisdiction.  Accordingly, courts may consider an argument raised for the first time on appeal in “exceptional circumstances”, such as when warranted by the public interest.  The Court concluded that these exceptional circumstances were present, as the question of what constitutes a claim had the potential to affect a wide range of proceedings.

Existence of “Claims”

The Court framed its substantive analysis by highlighting the competing policy interests at stake in any discussion regarding unknown future claims:  the Bankruptcy Code’s goal of providing debtors with a fresh start by resolving all claims arising from the debtor’s pre-emergence conduct, versus the rights of individuals who may be damaged by that conduct but are unaware of the potential harm at the time of the debtor’s bankruptcy.  In striking the appropriate balance, the Court recognized that Grossman’s conduct / prepetition relationship test may disadvantage potential claimants, whose injuries have yet to manifest and therefore have no reason to file a claim in the bankruptcy.  Grossman’s requires individuals to recognize that, by being exposed to a debtor’s product or conduct, they might hold a claim even if no damage is then evident.  However, the Court observed that the Grossman’s test better reflects the Bankruptcy Code’s expansive treatment of claims, and comports with the growing consensus among courts in other jurisdictions that a prerequisite for recognizing a claim is some form of prepetition exposure to the debtor.

Applying Grossman’s, the Court easily concluded that Wright had a claim because she purchased shingles manufactured by Owens Corning prior to its bankruptcy.  With respect to West, however, the answer was less obvious.  West purchased Owens Corning shingles in 2005, after commencement of the bankruptcy but before plan confirmation.  In Grossman’s, the Court was not confronted with postpetition, preconfirmation exposure and, thus, based its test solely on prepetition exposure.

In evaluating whether to expand Grossman’s test, the Court noted that the Eleventh Circuit had extended the prepetition relationship test to postpetition, preconfirmation relationships.  Agreeing with the Eleventh Circuit’s reasoning, the Court found that other Bankruptcy Code sections also support expansion of the test beyond just prepetition exposure.  E.g., section 1141(d)(1)(A) (provides that confirmation of a plan “discharges the debtor from any debt that arose before the date of such confirmation”) (emphasis added), section 348(d) (provides that, in the context of conversion from a chapter 11 or a chapter 13 proceeding to a chapter 7 proceeding, claims other than priority claims arising postpetition, preconversion are treated as prepetition claims in the chapter 7 proceeding), and section 502(e) (provides that a claim for reimbursement or contribution that becomes fixed after the commencement of a case is a prepetition claim for purposes of allowance).

Additionally, the Court determined that, absent this expansion, the current Grossman’s rule would artificially separate individuals who are affected by a debtor’s products prepetition from those who are affected after the debtor commences bankruptcy but before confirmation of a plan.  Accordingly, the Court restated Grossman’s test, and held that a claim arises when an individual is exposed preconfirmation to a product or other conduct giving rise to an injury that underlies a right to payment under the Bankruptcy Code.

Applying the restated Grossman’s test,  the Court concluded that West held a claim, as his exposure to Owens Corning’s shingles occurred prior to confirmation.

Due Process

Similar to the two-part analysis employed in Grossman’s, the Court went on to consider whether due process deficiencies precluded the discharge of Wright’s and West’s claims under Owens Cornings’ confirmed plan of reorganization.  The Court began by noting that notice is a fundamental requirement of due process, and for unknown claimants, like Wright and West, notice by publication in national newspapers, particularly if supplemented by notice in local newspapers, is sufficient to satisfy the requirements of due process.  Whether adequate notice has been provided in any given case, however, depends on the particular facts and circumstances of the case.

Although the Court found that Owens Corning’s notices were sufficient as to most unknown claimants, Wright’s and West’s situation differed considerably from that of the typical unknown claimant.  Specifically, at the time Wright and West received notice, Frenville was still the law in the Third Circuit and, under Frenville, neither held a claim against Owens Corning.  Thus, the Court concluded that, on reading the notices, Wright and West could only understand that their rights would not be affected in any way by the bankruptcy, and – correctly – would not have taken any action to ensure representation of their interests.  The first date on which Wright and West held claims that arguably could be discharged in Owens’ Corning’s bankruptcy was not until June 2, 2010 when Grossman’s overturned Frenville.  By that time, however, the bar date had passed and the plan had been confirmed – without an opportunity for Wright or West to be heard.  In special situations such as these, the Court determined that due process afforded a “re-do” to ensure all claimants have equal rights.  Therefore, the Court held that for persons who have claims under the Bankruptcy Code based solely on the retroactive effect of the rule announced in Grossman’s, those claims are not discharged when the notice given to those persons was with the understanding that they did not hold claims.

The Court found that there are two groups of persons holding claims who, at the time they received notice of a bankruptcy proceeding, would not have known that they held claims.  The first group is comprised of persons like Wright – persons with prepetition exposure to a debtor’s conduct or product who hold claims based on Grossman’s rejection of Frenville.  As to persons in this group, the Court held that due process requires application of Frenville to bankruptcy cases in which reorganization plans were confirmed prior to June 2, 2010, when Grossman’s was decided.  But – after that date, persons exposed to a debtor’s conduct or product prepetition are deemed to understand that they held claims.

The second group was necessary to avoid any injustices resulting from the Court’s restatement of the Grossman’s test.  Because Grossman’s test was limited to only prepetition exposure, persons exposed to a debtor’s product or conduct postpetition, but preconfirmation would continue to conclude that they did not hold claims.   Therefore, the second group is comprised of persons, like West, who hold claims based on the Owens Corning Court’s decision to extend the Grossman’s test to postpetition, preconfirmation exposure.  For persons in this group, the Court held that due process mandates application of Frenville to bankruptcy cases in which reorganization plans were confirmed prior to the date of its decision.

Significantly, the Court cautioned that its holding was not “a bright-line rule that all persons with unknown future claims once governed by Frenville could not have been provided due process regardless of the adequacy of notice to those future claimants.”  This limitation was consistent with the Court’s prior observation that whether due process had been provided depends on the circumstances of a particular case.  By way of example, the Court noted that, in some cases, due process concerns have been addressed through the appointment of a future claims representative who advocates on behalf of persons with unknown future claims.  However, no such representative was appointed in Owens Cornings’ bankruptcy cases.  Accordingly, the Court left open whether, “when such a representative provides persons with unknown future claims an opportunity to participate in the bankruptcy case through that representation, they are afforded due process through otherwise adequate notice to the future claims representative.”

Conclusion

Owens Corning represents both a step forward and a step backward for debtors and creditors alike in the Third Circuit.  On the one hand, Owens Corning expands the Grossman’s test to include claims arising from postpetition, preconfirmation exposure, thereby increasing the universe of debts that may be discharged under a plan of reorganization.  On the other hand, the decision limits the retroactive application of the restated Grossman’s test when doing so would result in a discharge of claims held by persons who had no basis to know that they held claims at the time notice of the bankruptcy was given.  Accordingly, reorganized debtors should be aware that they may continue to be subject to a certain subset of preconfirmation claims, notwithstanding any discharge provided by a plan or confirmation order.  Importantly, for bankruptcy cases in which a future claims representative was appointed, Owens Corning acknowledges the possibility that unknown future claimants may have been afforded due process through the representative.  Thus, at least with respect to reorganized debtors whose bankruptcy cases involved the appointment a future claims representative, the real impact of Owens Corning remains to be seen.