By: Bruce R. Zirinsky, Esq., Rebecca D. Rosenthal, Esq. and Paul T. Martin, Esq., Greenberg Traurig, LLP
Releases granted under a Chapter 11 plan are controversial and have been the subject of divergent opinions among the federal courts. The scope of the release and the identity of the parties involved are heavily negotiated aspects of the plan confirmation process, especially where it involves the release of claims by or against third parties. While releases have become common in connection with a plan, a national uniform standard does not exist with respect to third party releases and majority and minority views have emerged among the federal circuit courts.
Releases can be split into the following categories: i) claims held by a debtor against a non-debtor third party frequently called “estate releases”; ii) claims held by a non-debtor third party against another non-debtor third party typically called “third party releases”; and iii) claims held by the debtor or non-debtor third parties against professionals and other fiduciaries of the bankruptcy estate, such as directors and officers of the debtor, often called “exculpations.”
An estate release extinguishes claims held by the debtor against specified non-debtor third parties as part of a plan. This category of releases is not the subject of great controversy as Bankruptcy Code Section 1123(b)(3)(a) specifically states that a Chapter 11 plan may “provide for the settlement or adjustment of any claim or interest belonging to the debtor or to the estate.”1 Courts typically apply the standard for approving settlements pursuant to Bankruptcy Rule 9019 when analyzing whether to approve a release of claim held by the debtor's estate.2 As a general rule, a plan's attempted release of claims held by the debtor's estate will be approved unless the decision to settle the estate claim falls below the lowest point in the range of reasonableness.3
It is important to note, however, that an estate release is only effective to the extent it seeks to release an interest in a claim held by the debtor's estate. For example, the debtor's estate may release shareholder derivative claims as part of an estate release because shareholder derivative claims are considered property of the estate.4 However, a federal securities action arising under section 16(b) of the Securities Exchange Act of 1934 (as amended), is a personal claim and not property of the estate, thereby rendering a debtor's attempted release of the action ineffective.5
As mentioned above, third party releases are the release of claims held by a non-debtor third party against another non-debtor third party. Whether a court will approve a third party release is partially determined by how the court interprets an apparent statutory conflict between Bankruptcy Code Sections 105(a) and 524(e). Bankruptcy Code Section 105(a) grants a court broad equitable power “to issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”6 However, Bankruptcy Code Section524(e) arguably restricts the broad power in Bankruptcy Code Section 105(a) because Bankruptcy Code Section 524(e) provides that “except as provided in subsection (a)(3) of this section, discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of another entity for, such debt.”7
The Circuits have split regarding this statutory conflict. The Fifth, Ninth, and Tenth Circuits – the minority – refuse to allow non-debtor releases due to a narrow interpretation of Bankruptcy Code Section 524(e).8 Under the reasoning of the minority position, a bankruptcy court has no power to effect the liability of third parties with respect to an obligation of the debtor.9 The majority position, expressed by the Second, Third, Fourth, Sixth and Seventh Circuits, is that a Chapter 11 plan can release non-debtors, but only in limited circumstances.10 While the First, Eleventh and DC Circuits have not directly addressed the issue they have issued decisions more in accord with the majority position.11
Prior to determining whether a court may confirm a Chapter 11 plan containing a third party release, the bankruptcy court must first determine whether the court has jurisdiction over the attempt to enjoin the party's unasserted claims against another third party.12 As stated by the Southern District of New York in In re Dreier:
“Related to” jurisdiction to enjoin a third party dispute exists where the subject of the third party dispute is property of the estate, or the dispute would have an effect on the estate … . As a result, before the Bankruptcy Court decides whether the proponent of a plan settlement injunction has demonstrated the “unusual circumstances” mandated by Metromedia, it must first decide whether it has subject matter jurisdiction under Manville II. The inquiries may nevertheless overlap. A third party action that will directly and adversely impact the reorganization is more likely to present the “unusual circumstances” required under Metromedia.13
Determining when a bankruptcy court may confirm a Chapter 11 plan containing third party releases is another conundrum as no uniform standard exists regarding appropriate timing. The only clear agreement is that whether such relief is appropriate must be determined on a case-by-case basis following a fact intensive inquiry.14 As discussed in greater detail below, courts approving third party releases require at a minimum that they are “fair”, “necessary”, “reasonable”, “equitable”, or “appropriate.”15 Many courts further require the presence of “unusual circumstances” in order to approve non-debtor releases.16 The Third Circuit has suggested it would also adopt a requirement akin to “unusual circumstances.”17 However, the Second Circuit has recently reiterated its view that third party releases are appropriate “only in rare cases.”18
Third party releases can be further broken into two additional groups – consensual and nonconsensual. Courts have found that third party releases that are consensual and non-coercive are in accord with the strictures of the Bankruptcy Code and that creditors voting in favor of the plan are bound by the release as a vote in favor of a plan constitutes consent.19 In addition, a plan may provide for a release of third party claims against a non-debtor upon consent of the party affected.20 Accordingly, creditors and equity holders who accept the terms of the plan are bound by the release of pre- and post-petition claims.21
The circuits that allow nonconsensual third party releases under Bankruptcy Code Section 105(a), also have diverged in their reasoning. Some courts have adopted a five-factor test, referred to as the Master Mortgage five-factor test, to determine if an involuntary release by a non-debtor of another non-debtor's claims is appropriate. However, even the Master Mortgage court has stated that the test is not exclusive. The Master Mortgage five-factor test looks at the following: i) the identity of interest between the debtor and non-debtor such that a suit against the non-debtor would deplete the debtor's resources; ii) a substantial contribution to the plan by the non-debtor; iii) the necessity of the release to the reorganization; iv) the overwhelming acceptance of the plan and release by creditors and interest holders; and v) the payment of all or substantially all of the claims of the creditors and interest holders under the plan.22 The Master Mortgage five-factor test was adopted by the Delaware bankruptcy court in In re Exide Technologies23 and later applied in In re Washington Mutual, Inc.,24among others.
The Third Circuit has stated that it is inappropriate to enjoin claims against third party non-debtors solely on the basis of that third party's financial contribution to a debtor's estate.25 The Second Circuit has been more resistant and has stated that i) the only explicit statutory authority for such releases, i.e., Bankruptcy Code Section 524(g), is limited to asbestos cases and requires the creation of a trust to satisfy future claims and ii) releases are subject to abuse because they confer the benefits of bankruptcy without a filing and the concomitant “safeguards” of the Bankruptcy Code.26 Other courts have also expressed the concern that third party releases may circumvent the Bankruptcy Code and should not be lightly approved.27 While “not a matter of factors and prongs”, the Second Circuit has indicated that the following considerations should be analyzed: i) whether the estate received substantial consideration; ii) the enjoined claims were “channeled” to a settlement fund, rather than extinguished; iii) enjoined claims would indirectly impact the debtor's reorganization “by way of indemnity or contribution”; and iv) the plan otherwise provided for the full payment of enjoined claims.28
Recently, in Washington Mutual, the Delaware Bankruptcy Court discussed the topic of third party releases in detail. Washington Mutual has become a seminal case on the topic of nonconsensual releases for directors, officers, committee members and estate professionals, and provides an applicable framework for non-debtor releases in Chapter 11 plans. The Washington Mutual court relied on the Master Mortgage five-factor test, discussed above. However, the court stated that the factors “form the foundation for such an analysis, with due consideration of other factors that may be relevant.”29 Of great interest, the court offered a robust discussion on the importance of the contribution to the estate made by the parties receiving the release under the proposed plan. As an initial matter, the court approved the release of certain lenders under the plan and placed a heavy emphasis on the fact that the lenders were making a substantial contribution under the plan by waiving significant claims.30 The court found that without resolving these claims, a successful plan could not be achieved.31 Furthermore, the court found that i) an overwhelming number of creditors accepted the plan and ii) their recovery was significantly dependent on the value conveyed by the settling lenders under the global settlement.32 However, the court did find that the plan's release of the creditors' committee and its members, the indenture trustees, the liquidating trust, the trustee, and certain settling noteholders was not reasonable, as it stated:
The Liquidating Trust and its Trustee have not done anything yet for which they need a release. They will not even come into existence until the Plan is confirmed. Further, it is impossible to determine how the Liquidating Trust and its Trustee will prospectively make a substantial contribution to the Plan or that their actions will result in a substantial recovery for creditors or the equity security holders.33
Regarding the Creditors' Committee and its members, the court found that there was:
nothing unusual about this case that demonstrates that the Committee or its members have done anything other than fulfill their fiduciary duties. Under the Master Mortgage factors, they do not qualify for a release from the Debtors. There is no identity of interest between them and the Debtors. They have not contributed cash or anything else of a tangible value to the Plan or to creditors nor provided an extraordinary service that would constitute a substantial contribution to the Plan or case. While creditors are receiving a substantial recovery in the case, it is not coming from the Committee or its members. The same analysis applies to the Indenture Trustees.34
Moreover, the court found additional reasons not to approve the release of certain settling noteholders as the only alleged contribution made by them was their participation in the settlement negotiations.35 They did not act in the case in any fiduciary capacity as their actions were taken solely on their own behalf.36 Also, the settling noteholders held interests in various levels of debt and the result of the negotiations was to get them a full recovery in all but the lowest level of debt, an insufficient reason, as stated by the court, to warrant a release.37Lastly, the court stated that it was further reluctant to grant releases to certain noteholders in light of allegations that these noteholders had engaged in improper trading.38
There is no reported decision in which a court has held that a third party release that requires creditors to “opt-out” rather than “opt-in” is improper. In fact, several courts within the Second and Third Circuits have approved releases containing opt-out provisions. For example, in In re Calpine Corp., the court determined that holders of claims and interests who voted in favor of the plan, or abstained from voting, received adequate notice of the third party releases in the plan and therefore were bound by such releases, absent an affirmative election to opt out of such releases.39 Also, in In re DBSD N. Am. Inc., the court held that i) members of voting classes received adequate notice of the third party release provision, making those releases voluntary and ii) except for those who voted against the plan or who abstained and then opted out, the third party release provision was consensual and within the scope of releases permitted in the Second Circuit.40 Additionally, the court in In re U.S. Energy Sys. Inc., held that each class member who voted to accept the plan or abstained from voting and had not opted out from the release provided therein was bound by the release. 41
Very recently, the topic of opt-in releases, where an interest holder failed to vote on a plan, was discussed by the Delaware bankruptcy court.42 The plan, in Indianapolis Downs, provided that those who failed to opt-out, or to vote, were “deemed” to consent to the third party release.43 The United States Trustee argued in opposition that without affirmative consent, the third party release should be unenforceable.44 The Indianapolis Downs court stated that “case law teaches that no such hard and fast rule applies” and held that “returning a ballot is not essential to demonstrating consent to a release.”45 The Indianapolis Downs court also noted that in Spansion, no creditor or interest holder whose rights were affected by the “deemed” acceptance language objected to the plan, and that “the silence of the unimpaired classes on this issue is persuasive.”46 Citing to other jurisdictions for a likewise flexible approach in evaluating whether a third party release was consensual, the Indianapolis Downs court looked to the Southern District of New York and the Northern District of Illinois to find “that even impaired creditors who abstained from voting on a plan and did not otherwise opt out were nevertheless bound.”47 The Indianapolis Downs court concluded:
In this case, the third party releases in question bind certain unimpaired creditors who are deemed to accept the Plan: these creditors are being paid in full and have therefore received consideration for the releases. As for those impaired creditors who abstained from voting on the Plan, or who voted to reject the Plan and did not otherwise opt out of the releases, the record reflects these parties were provided detailed instructions on how to opt out, and had the opportunity to do so by marking their ballots. Under these circumstances, the Third Party Releases may be properly characterized as consensual and will be approved.48
Exculpation differs from both estate releases and third party releases because an exculpation provides qualified immunity to estate professionals, the committees and their members, and the debtors' directors and officers for actions taken within the Chapter 11 proceeding. Such immunity, however, excludes claims based on gross negligence or willful misconduct.49 Exculpation clauses that exclude gross negligence and willful misconduct do not implicate Bankruptcy Code Section 524(e), as any exculpation clause drafted to meet this standard reflects the same standard to which fiduciaries are generally held in a Chapter 11 case.50 It is important to note that even the Fifth Circuit, which normally prohibits non-debtor releases (see discussion above), will permit an exculpation for estate professionals in the context of their post-petition duties pursuant to that standard.51
Generally, releasing the debtor's management for pre-petition conduct is not approved.52 As the Southern District of New York has stated:
Exculpation provisions (and their first cousins, so-called “third party releases”) are permissible under some circumstances but not as a routine matter. They may be used in some cases, including those where the provisions are important to a debtor's plan; where the claims are “channeled” to a settlement fund rather than extinguished; where the enjoined claims would indirectly impact the debtor's reorganization by way of indemnity or contribution; where the released party provides substantial consideration; where the plan otherwise provides for the full payment of the enjoined claims; or where creditors consent.53
Furthermore, Section 1103(c) of the Bankruptcy Code, which grants a creditors' committee broad authority to formulate a plan and perform “such other services as are in the interest of those represented,” has been interpreted to imply both a fiduciary duty to committee constituents and a limited grant of immunity to creditors' committee members.54 A practical view has also been acknowledged by the Third Circuit as it has stated that “[a]ctions against committee members in their capacity as such should be discouraged. If members of the committee can be sued by persons unhappy with the committee's performance during the case or unhappy with the outcome of the case, it will be extremely difficult to find members to serve on an official committee.”55
A court's approval of releases, especially third party releases, is largely dependent upon the venue of the Chapter 11 case. Practitioners should be mindful of the limits of third party releases and exculpation clauses set forth in their jurisdiction in order to ensure a smooth plan confirmation process.
Bruce R. Zirinsky is Co-Chair of Greenberg Traurig's Business Reorganization & Financial Restructuring Practice and is based in the firm's New York office.
Rebecca D. Rosenthal is an Associate in Greenberg Traurig's Business Reorganization & Financial Restructuring Practice and is based in the firm's Chicago office.
Paul T. Martin is an Associate in Greenberg Traurig's Business Reorganization & Financial Restructuring Practice and is based in the firm's New York office.
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