Can a Federal Court Tell A Tobacco Company Not to Spin Off Its Subsidiary, In Order to Protect Smokers' Ability to Successfully Sue the Company for Damages?

Tobacco litigation has produced some of the most difficult problems in tort law that the nation has seen in the past twenty years. This may be partly a result of the incredible amounts of money at stake in the litigation: When enough money is at stake, lawyers tend to pursue every possible avenue in an effort to gain an advantage.

Today, I want to discuss a novel problem that may soon be facing the tobacco industry and the judges of the U.S. Court of Appeals for the Second Circuit. The problem is this: Can a federal judge temporarily prevent a multi-billion-dollar tobacco corporation from "spinning off" one of its massive subsidiaries, in order to protect the interest of smokers suing the corporation?

The Huge Schwab Case, Challenging Big Tobacco on Ads for "Light" Cigarettes

In a column I wrote a few months ago, I described a gigantic and highly speculative racketeering class action against Big Tobacco. The gist of the suit's allegations is that all the companies that sold "light cigarettes" were engaged in a massive conspiracy to defraud smokers, because light cigarettes have never been safer than regular cigarettes, and the tobacco companies always knew this.

Known as the Schwab case (after the name of one of its lead plaintiffs), the lawsuit is huge in every respect--it covers a period of possibly 30 years, and possibly millions of plaintiffs, and represents potentially hundreds of billions of dollars in liability. The class action was recently certified by U.S. District Judge Jack Weinstein of the Eastern District of New York, and that decision was instantly appealed to the Second Circuit.

While we are waiting for the appellate court to render its judgment about whether a class action was properly certified by Judge Weinstein, another issue has emerged.

Can Altria Go Through with Its Planned Sale of Kraft Foods Stock?

Altria, one of the defendant tobacco companies, has been waiting for years--perhaps a decade--to sell its share of Kraft Foods. Altria currently owns 88% of Kraft, and this close connection between the tobacco company and the food group has suppressed the price of Kraft's shares. Investors have been concerned that if Altria were someday to be found liable for billions of dollars in a tobacco case, then Kraft, too would end up being responsible for some of the judgments.

Recently, the CEO of Altria announced that his company would set out the schedule for a planned spin-off of Kraft in January 2007. The oddity of this little corporate "save the date" announcement was soon dwarfed by the realization that, if Altria was truly serious about finally spinning off Kraft, there was a good chance that the class action attorney who brought the Schwab case might try to stop the spin-off.

The effect of an injunction against the spin-off of Kraft--a company with a market capitalization of $58 billion--would be to annoy and frustrate Altria very much. In fact, it was this precise fear that led Altria to postpone the spin-off for years. An injunction would be costly on a number of levels. Altria' own share price would probably fall, since it had been slowly increasing in value because of shareholders' expectation that the spin-off would occur. Moreover, the court's interference with the internal financial dealings of both Altria and Kraft would have a negative effect on the companies' standing in the financial markets.

In sum, the rewards of a spin-off (and the consequences of delay) are large, as are the risks of an injunction.

The Possible Injunction: Why Judge Weinstein Might Stop the Spin-Off

Readers may wonder: Why would Judge Weinstein grant an injunction to stop the spin-off? What does Altria's role as a defendant in a class action have to do with its corporate strategy?

Michael Hausfeld, the plaintiffs' attorney managing the Schwab case, might make the following argument: Suppose the damages from the class action turn out to be so great (for example, in the hundreds of billions of dollars) that Altria needs Kraft to fund the plaintiffs' damages. If so, he might argue, any attempt to separate the two companies could be construed as an attempt to deprive the plaintiffs of their rightful compensation for the injuries Altria caused them.

This argument is not fanciful--it has been tossed about in the financial press for years. Moreover, there are reports that Hausfeld has suggested that if Altria is really serious about spinning off Kraft, he will not hesitate to sue for an injunction.

The Legal Question: Does Judge Weinstein Have the Power to Issue the Order?

At first blush, the idea that a plaintiffs' attorney can block a multibillion dollar transaction in order to protect his clients' compensation, when he hasn't even won their lawsuit yet, seems a little odd. If it were possible, it would give Hausfeld tremendous leverage in settlement negotiations. Even if Altria's attorneys were confident that they would prevail in their attempt to get Judge Weinstein's class certification reversed on an interlocutory appeal, they might still feel pressured to settle with Hausfeld simply because the spin-off might not be able to wait for the appeal to be decided.

Does a federal judge have the power to enjoin a company from engaging in corporate restructuring just because a lawsuit has been filed against the company? And if so, what protection exists for corporations who are planning major restructuring, and whose CEOs fear that lawsuits will be filed against them during or before the restructuring process merely to extort settlements? The answer, it turns out, is complex.

The place to begin is with the law of preliminary injunctions. The power of a federal court to enjoin a corporate spin-off is rooted in the inherent power of all common law courts to exercise their powers in equity. Moreover, federal courts, like state courts, can issue preliminary injunctions - that is, injunctions that precede, and possibly long precede, the ultimate adjudication of the merits of a case -- if certain conditions are satisfied. Those conditions vary in their precise formulation, but in general, the idea is that a court may issue a preliminary injunction if it is convinced that the defendant's actions will cause irreparable harm to the plaintiff before a final judgment on the merits of a case is issued, and that there is a likelihood that the plaintiff will ultimately succeed in proving his case.

So, for example, consider a dispute over the ownership of an irreplaceable work of art. The plaintiff suing to recover the artwork can get a temporary injunction to prevent the defendant from destroying or selling the object, because the temporary interference with the defendant's liberty to dispose of his property (assuming it is his, and her suit is based on a fallacy) as he sees fit is minor, in comparison with plaintiff's loss were she to win the suit, only to receive money damages, rather than the unique object to which she had a right.

The plaintiffs in the Schwab case would argue in the same vein. While it is true that "all" they want is damages, it is also true that a defendant who takes steps to render itself incapable of satisfying a tort judgment risks imposing an irreparable harm on the plaintiffs -- who will end up with no compensation at all, and no prospect of compensation.

Compare this 'irreparable' injury to the interference with Altria's liberty to dispose of what is currently its own property, as it sees fit. The plaintiffs in the class action would argue that forcing a company to wait on a spin-off until there is a final disposition of a lawsuit, is a minor inconvenience compared with what they would suffer were they to win the lawsuit and discover that Altria had no money.

A Key Precedent: The Grupo Mexicano Case

There is one problem with this argument, however: the Supreme Court said in 1999 that the equitable power of federal courts does not extend to freezing the assets of companies in anticipation of a successful claim against the company by a party who merely has filed a lawsuit, but has not yet won it.

In Grupo Mexicano De Desarrollo, S. A. v. Alliance Bond Fund, Inc., the Court was asked whether an unsecured creditor who had loaned money to a Mexican holding company in the United States could prevent it from transferring $17 million in bonds to creditors in Mexico. The creditor argued that the transfer would leave it with no practical way to collect its judgment, once it had completed its suit against the holding company.

Justice Scalia reviewed the history of English and American equity, and concluded that, at the time the federal courts were created, equity did not allow judges to "attach" or seize property for a temporary period of time, just to insure that plaintiffs did not suffer the irreparable harm of being left unable to collect a possible judgment. This precedent would suggest that Judge Weinstein should refuse any attempt by the plaintiffs in Schwab to block the spin-off.

But there are some interesting subsequent interpretations of Grupo Mexicano that suggest that an injunction might be permitted. For example, in 1999, in Walczak v. EPL Prolong, Inc., the U.S. Court of Appeals for the Ninth Circuit permitted a preliminary injunction against the sale of a company to stand, in order to protect certain unsecured creditors against dissipation of the defendant corporation's assets. Walczak involved a dispute between shareholders of a company over its sale. The minority shareholders filed a derivative suit (that is, a suit by shareholders on behalf the corporation itself) against the corporation, and then asked a federal judge to enjoin the sale until the underlying derivative suit could be heard.

When the Ninth Circuit upheld the preliminary injunction, it distinguished Walczak from Grupo Mexicano on the grounds that in the latter case, the unsecured creditor was asking the court to prevent the defendant from disposing of its property as it saw fit, while in the former case, the defendant was free to do what it wanted with assets--it just could not sell the company to another company. The Ninth Circuit held that enjoining changes in corporate form is far less intrusive and offensive than "completely prohibit[ing] a party from taking any action with regard to their assets."

One might quibble with the Ninth Circuit's judgment as to what is more offensive, and object to the Ninth Circuit's splitting hairs in distinguishing the sale of a company itself from the sale of the company's assets. I am sure that Altria would take the position that an injunction prohibiting it from selling a $50 billion interest in a subsidiary to another company, is far more intrusive than an injunction requiring that it simply not transfer assets out of the company to another creditor, given that the plaintiffs in the lawsuit will become the company's creditors, too, if they win their case.

The Bottom Line: An Open Question the Supreme Court May Ultimately Resolve

The bottom line is, however, that it is currently an open question whether the plaintiffs in the Schwab case can hold up the spin-off of Kraft. If they try to do so--and if Judge Weinstein grants their motion--then the Second Circuit will have judge for itself what Justice Scalia really meant in Grupo Mexicano.

If the case gets that far, then there is a good chance that the Supreme Court will have a spectacular opportunity to revisit the question of whether federal courts have the power to enjoin major corporate decisions, even before blockbuster tort cases go to trial.