For 30 years I have studied the American chapter 11 bankruptcy system, first as a practicing lawyer and subsequently as a law professor. In that period, the American bankruptcy system has withstood myriad economic challenges—the dot.com bust of the 2000s, the fallout from the 9/11 attacks, the financial crisis, the auto company bankruptcies (and the city of Detroit itself), and most recently, the economic destruction caused by the pandemic and government responses to it. But despite its resiliency, the bankruptcy system is facing a threat that is more damaging, as it strikes at the heart of the system itself—the abuse of the system by predatory class action lawyers who are exploiting the system for their own selfish interests and harming their own clients in the process.
The American bankruptcy process works because it provides a swift, efficient, and equitable mechanism for distributing the assets of a company that doesn’t have enough to go around. To work effectively, Chapter 11 requires all the parties to cooperate, in order to reduce the costs and delay of the process. Every dollar spent on legal fees is one less dollar available out of this limited pool of resources to pay creditors and other claimants. While many areas of law are marked by high degrees of friction and protracted conflict, bankruptcy provides a relatively informal and speedy process that depends on the good faith of the participants.
But a pending mega-bankruptcy in Delaware involving the Boy Scouts of America shows how ill-suited our bankruptcy system is for the arrival of the trial lawyers who often exhibit little in the way of good faith or cooperative instincts. To be sure, the facts of the Boy Scouts bankruptcy arose out of terrible allegations of sexual abuse against the Boy Scouts and was intended to produce an orderly handling of the sexual abuse claims alongside the usual corporate liabilities. At the time of the initial Boy Scouts bankruptcy filings, the Scouts acknowledged 275 abuse lawsuits, plus another 1,400 potential claims. Back in 2020, when the case started, there seemed to be little question that these lawsuits and potential claims included very serious allegations of abuse and victims who deserved to be at the forefront of the bankruptcy process. As with many organizations and companies driven into bankruptcy by mass litigation actions, the claims of these victims substantially exceeds the funds available to compensate not only them, but all other claimants, including landlords, small businesses, and other innocent creditors who provided valuable goods and services to the Scouts.
Still, aside from the terrible nature of the alleged behavior, the Boy Scouts case is the type of case for which the bankruptcy process is designed to maximize the amount paid out to each of the claimants.
Then the trial lawyers showed up.
Using their road-tested client-generation machine from earlier actions such as asbestos, silicosis, and medical products, and reportedly funded by deep-pocketed hedge funds, the initial 275 cases soon ballooned to some 95,000 claims. Over 10,000 of those claims appear to be duplicates and tens of thousands are either of dubious factual veracity or legal validity (largely due to being barred by the statute of limitations). Mainly of the claims that can be identified as coming from real people look to have no relationship to scouting but are various shades of tax evaders and other criminals looking for a quick payout.
Because of its relative informality and emphasis on speed, the bankruptcy system is ill-equipped to deal with fraud and abuse on this scale. While this approach is effective most of the time, it leaves the system open to exploitation by characters intent on abusing it. Unfortunately, the real losers from this multiplication of fake claims are the truly injured victims themselves, who will have less money available to pay them after distributions are made to all the crooks—in some cases as little as a few thousand dollars.
But while victims lose, trial lawyers win big—one report estimates attorneys could walk away with as much as $1 billion. While legal fees on this scale are not unprecedented for a bankruptcy case, in the past they have been relegated to massive, complicated cases, such as the bankruptcies of Enron and Lehman Brothers that required thousands of hours of sophisticated lawyering to unravel. In this case, they appear to be a shake down racket and little else.
Moreover, piling up claims aids the trial lawyers in a second way—in voting on approval of a plan of reorganization, Chapter 11 essentially awards one dollar per vote. Thus, by multiplying legitimate claims with a pile of bogus ones, the trial lawyers can exercise command over the case, thereby orchestrating the case to divert assets from other claimants to themselves.
Fortunately, the brazen greediness of the trial lawyers has caught the attention of both the bankruptcy judge and the Department of Justice’s Executive Office of United States Trustee, the public official charged with preserving the integrity of the system against fraudulent and abusive behavior. This vigilance is necessary and timely—if the trial lawyers are able to get away with diluting legitimate claims with bogus claims, not only will true victims be harmed, so will the American people.
Warts and all, the bankruptcy process has proven an effective and efficient way of resolving financial distress for decades. If the trial lawyers are allowed to break that system, the real losers will be the thousands of small businesses who will die rather than be reorganized in bankruptcy and the employees, suppliers, and public authorities that count on the bankruptcy system for an inexpensive mechanism to collect on what they are owed.
