Bankruptcy as Bailout: Coal Company Insolvency and the Erosion of Federal Law

Joshua C. Macey is a Postdoctoral Associate at Cornell Law School and Jackson Salovaara works in the renewable energy industry. This post is based on their recent article, forthcoming in the Stanford Law Review.

Almost half of all the coal produced in the United States is mined by companies that have recently gone bankrupt. As we explain in a recent article in the Stanford Law Review, those bankruptcy proceedings have undermined federal environmental and labor laws. In particular, coal companies have used the Bankruptcy Code to evade congressionally imposed liabilities requiring that they pay lifetime health benefits to coal miners and restore land degraded by surface mining. Using financial information reported in filings to the Securities and Exchange Commission and in the companies’ reorganization agreements, we show that between 2012 and 2017, four of the largest coal companies in the United States succeeded in shedding almost $5.2 billion of environmental and retiree liabilities. These regulatory debts constituted 22% of the total debt discharged.

Coal companies disposed of these regulatory obligations by placing them in underfunded subsidiaries that they later spun off. When the underfunded successor companies liquidated, the coal companies that originally incurred the obligations managed to get rid of their regulatory obligations without defaulting on the pecuniary debts they owed to their creditors. Peabody Energy pioneered this strategy in 2007, when it spun off a subsidiary called Patriot Coal. Patriot received 13% of Peabody’s coal reserves, 40% of its healthcare obligations, and $233 million in environmental clean-up costs. A year later, Arch Coal divested itself of 12% of its assets and 97% of its retiree and healthcare liabilities by giving those assets and liabilities to Patriot. At that point, Patriot held more than $2 billion in environmental and healthcare liabilities that had originally been incurred by Peabody and Arch. When Patriot filed for bankruptcy, first in 2012 and again in 2015, it wiped out legacy Arch and Peabody environmental and retiree obligations. Similarly, when Peabody itself filed for bankruptcy in 2016, it shifted hundreds of millions of dollars in environmental obligations onto a subsidiary called Gold Fields, which was spun off as a liquidating trust. Gold Fields had assets of roughly $6 million against claims of almost $13 billion, including at least $745 million in environmental claims.

Our analysis of the coal industry also has implications for bankruptcy theory. First, we question the view that bankruptcy proceedings should prioritize Chapter 11 reorganization over Chapter 7 liquidation. Recent coal bankruptcies show that corporate reorganization can be used to externalize costs onto third parties, despite statutes designed to force coal companies to internalize those costs. We argue that reorganization should not undermine Congress’s efforts to force firms to internalize the costs they impose on others. When a reorganization threatens to do so, liquidation is the better method for resolving bankruptcies. Second, our account poses challenges for scholars who argue that parties in bankruptcy proceedings should be able to contract around Chapter 11. While there are compelling reasons to allow parties to do this with respect to contractual debts, some mandatory federal rules are necessary to prevent creditors and debtors from negotiating around federal regulatory programs. And third, the use of Chapter 11 to discharge regulatory obligations whose purpose is to further congressional policy impedes the government’s ability to adopt certain efficient regulatory designs. This bias occurs because in a reorganization, injunctions enjoy what amounts to an effective priority claim while pecuniary liabilities are generally treated no differently than are ordinary contracts—even when such liabilities are designed to further regulatory goals.

A commonly held view about corporate bankruptcy—known as the Creditors’ Bargain Theory—is that bankruptcy proceedings should (1) not disturb nonbankruptcy entitlements and (2) maximize the value of the insolvent firm’s estate. The role of bankruptcy law, on this view, is primarily to solve the coordination problem caused by having multiple creditors who all want to seize an insolvent debtor’s assets before other creditors. Adherents of the Creditors’ Bargain Theory generally concede that bankruptcy law should respect nonbankruptcy entitlements. This article shows that strategic reorganizations that occur before and during a bankruptcy proceeding can be used to rearrange nonbankruptcy entitlements to the detriment of regulatory obligations. Many of the substantive rules embraced by the Creditors’ Bargain Theory as maximizing asset values and preserving nonbankruptcy entitlements have been weaponized by corporations to evade their regulatory obligations. The implication is that the Bankruptcy Code allows corporations and their creditors to make ex post readjustments to nonbankruptcy entitlements, and they do so at the expense of the government’s ability to effectively regulate.

There is a tension between bankruptcy law’s goal of maximizing the value of an estate and regulatory programs that operate by forcing regulated parties to internalize the social costs of their behavior. Maximizing the value of an estate is obviously in the interest of both debtors and creditors, because a corporation’s ability to extricate itself from its regulatory obligations will increase the pool of assets available to the other creditors. Unfortunately, maximizing asset valuations can conflict with—and even undermine—regulatory schemes that operate by forcing regulated parties to internalize the social costs of their activities. The central claim of this article is that regulatory obligations need to be understood as fundamentally different from debts incurred in capital markets, and that a company should not be able to use bankruptcy to dispose of obligations whose purpose is to force corporations, shareholders, and creditors to bear the social costs of corporate activities.

To be sure, strategic prebankruptcy conduct has played a critical role in allowing coal companies to evade their regulatory obligations. By spinning off underfunded subsidiaries and giving those subsidiaries legal responsibility for the parent’s regulatory obligations, coal companies have been able to separate productive assets from onerous regulatory debts. When the underfunded successor entity liquidates, it is difficult to hold that original company responsible for honoring those regulatory debts. In this way, the ability to siphon off regulatory obligations through spin-offs and divestitures has allowed companies to pay unsecured pecuniary creditors a relatively high percentage of what they are owed while paying regulatory creditors virtually nothing.

Finally, this article acknowledges how difficult it is to prevent parties from manipulating bankruptcy law in this way. While scholars who have considered the treatment of environmental claims in bankruptcy have generally argued that the solution to the problem of environmental discharges is to give such debts priority in bankruptcy, our analysis has shown that a simple priority claim is meaningless if prior corporate restructurings have drained the company of valuable assets. A priority claim will not guarantee payment on regulatory obligations if spin-offs and divestitures leave the company an empty shell with insufficient assets left to pay even its senior creditors. To properly police bankruptcy proceedings, it is necessary to allow robust enforcement of fraudulent conveyance law (with an expanded lookback period), encourage accurate accounting and valuation techniques during bankruptcy, ensure that successor entities are financially feasible, and give regulatory claims a priority claim or security interests. Thus this is a difficult challenge, as each of the solutions we propose is insufficient by itself. Each of the solutions we propose is insufficient by itself.

The complete article is available here.

Both comments and trackbacks are currently closed.