312-263-2200

Courts that permit third-party releases often rely on Sections 1129(a)(1), 1123(b)(6) and 105 of the Bankruptcy Code.  In re Millennium Lab Holdings II, LLC, 2018 WL 4521941, at *20 (D.Del. Sept. 21, 2018).  However, the issue of whether bankruptcy courts have the power to issue injunctions or grant third-party releases discharging the liability of non-debtors has centered primarily around 28 U.S.C. § 1334 as well as the conflicting interpretations of Sections 105(a) and 524(e) of the Bankruptcy Code.  The analysis begins with Section 1334, due to the fact that while Section 105(a) allows a bankruptcy court to issue any order necessary to carry out the provisions of the Code (arguably, including third-party injunctions), it “does not provide an independent source of federal subject matter jurisdiction.”  See, In re W.R. Grace & Co., 591 F.3d 164, 170 (3rd Cir. 2010).  Thus, before a court can consider the merits of any injunction, the court must first establish that it has subject matter jurisdiction to enter the injunction.

Once the jurisdictional predicate is resolved, the analysis proceeds with Section 105(a) which 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.”  As noted, however, the equitable powers of bankruptcy courts must be exercised within the confines of the Bankruptcy Code, and therefore, Section 105(a) cannot be used to authorize relief that is prohibited by other provisions of the Code.  Section 524(e) arguably restricts the broad equitable authority that Section 105(a) confers on the courts.  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 any other entity for, such debt.” 

Courts that refuse to allow non-debtor releases narrowly interpret the language of Section 524(e) to mean that a bankruptcy court has no power to affect the liability of third parties on an obligation of the debtor.  See e.g., In re Western Real Estate Fund, Inc., 922 F.2d 592, 600 (10th Cir. 1990); In re Zale Corp., 62 F.3d 746, 756 (5th Cir. 1995); and In re Lowenschuss, 67 F.3d 1394, 1401 (9th Cir. 1995).  Conversely, courts that allow non-debtor releases find no conflict between Sections 105(a) and 524(e).  Those courts argue that the plain language of Section 524(e) provides only that a discharge does not affect the liability of third parties and does not restrain the power of the bankruptcy court to otherwise grant a release to a third party.  See, In re Mahoney Hawkes, LLP, 289 B.R. 285, 299 (Bankr. D.Mass. 2002) (Section 524(e) does not specifically prohibit the injunctions which the Debtor is seeking in this case because that section only describes the parameters of a discharge order.); Matter of Specialty Equipment Company, Inc., 3 F.3d 1043, 1047 (7th Cir. 1993) (bankruptcy courts may release non-debtors from their debts if effected creditors consent).  This memorandum breaks down this issue circuit by circuit.

First Circuit Decisions:

In In re Mahoney Hawkes, LLP, 289 B.R. 285 (Bankr. D.Mass. 2002), the court held that injunctive relief protecting non-debtor third-parties may be appropriate depending upon the circumstances of the case.  In this case, the plan provided for the creation of a creditor’s trust to be funded by a payment of $6.5 million from Continental Casualty Company (“CNA”).  Pursuant to the plan, the debtor sought to separately classify its legal malpractice claimants from other unsecured creditors and obtain a permanent injunction and releases for CNA and the debtor’s partners.  In analyzing the issue of whether an injunction involving CNA was achievable, the court adopted the multi-factored test summarized above.  The first factor it considered was whether there was an identity of interest between the debtor and CNA, so that a suit against CNA was essentially a suit against the debtor and would deplete assets of the estate.  The court concluded that the debtor’s right to have CNA pay money to satisfy debts accrued as a result of alleged legal malpractice was property of the estate and subject to automatic stay.  Moreover, to the extent that CNA paid over the limits of the policy to the creditor’s trust, its obligations under the contract were terminated.  Therefore, a suit against CNA was neither a suit against the debtor nor would such a suit deplete assets of the estate.  Id. at 300.

The second factor was whether CNA was contributing substantial assets to the plan.  While arguably this was the case, the court noted that this fact was not particularly persuasive because CNA was only fulfilling its contractual obligations to the debtor.  Id.  The third factor was whether the injunction was essential to the reorganization, and in this regard the court noted that CNA contended that it would only fund the reorganization so long as it received the injunction.   However, given the court’s conclusion regarding the proceeds of the policy, it determined that CNA could no longer take this posture.  “CNA must turn over the estate assets notwithstanding its perceived need for an injunction.” Id.

With respect to the fourth factor, because the dispute had arisen at the disclosure statement stage, the court obviously could not determine whether the affected classes have voted in favor of the plan.  With respect to the fifth factor, whether the plan provided a mechanism for the payment of all or substantially all of the claims of the class or classes affected by the injunction, the court noted that the range of payments for the affected class was only 3% to 17%.  As a result, this factor was not satisfied.  Id. at 301.  Because a release or injunction involving CNA did not meet any of the above-mentioned factors a permanent injunction was not possible.

Second Circuit Decisions:

In In re Johns-Manville Corp., 517 F.3d 52 (2nd Cir. 2008), the court reviewed an order entered by the bankruptcy court approving a postconfirmation settlement with Travelers Casualty and Surety Company and, in conjunction with the settlements, issued an order clarifying that all direct action claims against Travelers were barred by the original 1986 injunction issued as part of Manville’s reorganization plan.  The Appellants, who were not party to the settlements, argued that the bankruptcy court erred by interpreting its prior order to enjoin suits brought against Travelers that allege independent misconduct by Travelers during its tenure as Manville’s primary insurer.  The court held that its ability to provide finality to a third-party is defined by its jurisdiction, not its good intention.  The court noted that it previously recognized that “a non-debtor release is a device that lends itself to abuse if a non-debtor can shield itself from liability to third parties.  In form, it is a release; in effect, it may operate as a bankruptcy discharge, arranged without a filing and without safeguards of the Code,” citing to In re Metromedia Fiber Network, Inc., 416 F.3d 136, 142 (2d Cir. 2005).

The Second Circuit noted that it was inappropriate for a bankruptcy court to enjoin claims brought against third-party non-debtors solely on the basis of that third-party’s financial contribution to a debtor’s estate.  Citing to In re Combustion Eng’g, Inc., 391 F.3d 190, 228 (3d Cir. 2004), the court noted that if such an action were possible then,

[A] debtor could create subject matter jurisdiction over any non-debtor third party by structuring a plan in such a way that it depended upon third-party contributions.  As we have made clear, subject matter jurisdiction cannot be conferred by consent of the parties where court lacked subject matter jurisdiction over a dispute, the parties cannot create it by agreement even in a plan of reorganization.

A bankruptcy court only has jurisdiction to enjoin third-party non-debtor claims that directly affect the res of the bankruptcy estate.  Id. at 66.  Thus, in MacArthur Co. v. Johns-Manville Corp., 837 F.2d 89, 92-93 (2d Cir. 1988), the court noted that the third party sought to collect out of proceeds of Manville’s insurance policies on the basis of Manville’s conduct.  The plaintiff’s claims were, therefore, inseparable from Manville’s own insurance coverage and consequently well within the bankruptcy court’s jurisdiction over Manville’s assets.  In this case, the court stated that what remained was a legal determination: did Travelers owe a duty to the Direct Action Plaintiffs independent of its contractual obligation to indemnify those injured  by the tortious conduct of Manville?  “If such a duty exists, then the fact that it arises from a common nucleus of operative facts involving Travelers and Manville (e.g., Manville/Travelers insurance relationship) is of little significance from a jurisdictional standpoint.  Id. at 67.

In In re Saint Vincents Catholic Medical Centers, 417 B.R. 688 (S.D.N.Y. 2009), the issue existed whether a plan released “covered persons” from medical malpractice claims.  The plan defined “covered person” as “any physician or employee of [St. Vincents] to the extent that such physician or employee has a right of indemnification against or from [St. Vincents] with respect to claims of alleged medical malpractice.”  The court held that a non-debtor release in a plan of reorganization should not be approved absent the finding that “truly unusual circumstances render the release terms important to the success of the plan.” Id. at 696.  Here, the court found that there were no findings that (i) discharging the liability of “covered persons” would be important to the plan; (ii) the covered persons had given substantial consideration to the estate; (iii) enjoined claims against covered persons would be channeled to a settlement fund and not just extinguished; or (iv) the plan provided for payment of such claims in any way. Id.

In In re Charter Communications, 419 B.R. 221 (Bankr. S.D.N.Y. 2009), the court stated that non-debtor releases were permissible where “truly unusual circumstances render the release terms important to success of the plan.”  Id. at 258 (citing to Deutsche Bank AG v. Metromedia Fiber Network, Inc. (In re Metromedia Fiber Network, Inc.), 416 F.3d 136, 142-43 (2d Cir. 2005)).  The court further noted that the mere fact of a financial contribution by the non-debtor could not be enough to trigger the right to a release.  Id. at 258.  Given the above, the court found that under the unusual features of the plan, the releases were appropriate. 

First, the court noted that the debtors’ estates would be receiving substantial consideration in exchange for the third-party releases.  The parties agreed to undertake actions to permit the reinstatement of the senior secured debt at favorable interest rates and to refrain from taking action that would degrade the value of the debtors’ potentially valuable NOLs.  The court stated that “[d]ue to these uniquely personal structuring benefits, no other party could stand in their shoes and achieve the same results.  The Third-Party Releases, therefore, are being granted in exchange for very substantial consideration in a rare restructuring context.” Id. at 259.  Second, the indemnification obligations between the debtors and their officers, directors and professionals produced an identity of interest between the debtors and the released parties.  Third, unusual circumstances existed to support the releases.  In this regard, the court noted that the released parties were “uniquely able to support the structure of the Plan.” Id.  Additionally, the debtors’ structure was complex, its debt load was enormous, and its bankruptcy was one of the largest prearranged cases ever filed.  Additionally, by means of this rights offering the debtor succeeded in raising substantial capital during an exceptionally difficult and uncertain time in the credit market.  Finally, the plan was only possible if the senior secured debt was reinstated and the company’s NOL’s were preserved, and both of these goals required voluntary participation in the plan by the released parties.  Id.  Fourth, the court noted that the releases were integral to the plan.

In In re Ion Media Networks, Inc., 419 B.R. 585 (Bankr. S.D.N.Y. 2009), the court allowed the non-debtor releases.  In doing so, the court noted that the releases arose in the unusual setting of a transaction that was conditioned upon FCC approval.  Specifically, the debtors’ plan was unusual because the debtors needed FCC authorization to transfer control of their most valuable assets, their FCC licenses, and while awaiting this authorization they needed the continued cooperation of the parties being released in order to achieve the objectives. Id. at 601.

The debtors proposed a two-step process for compliance with the FCC requirements.  The debtors had sought FCC short form approval to be followed by FCC long form approval.  Short form approval permitted the debtors to assign the FCC licenses to a trust and exit bankruptcy but required a continuity of control over the FCC licenses.  The long form approval allowed the reorganized debtors to transfer control of the FCC licenses to the new equity owners.  To satisfy the FCC’s short form requirements, the debtors board of directors would be staying on control of the trust and the FCC licenses.

In return for retaining control over the FCC Licenses during this interim period between the effectiveness of the Plan and the long form approval by the FCC, the directors of the Debtors’ board of directors are receiving the releases described under the Plan.  Likewise, the DIP Lenders, Avenue Capital, Black Diamond and Trilogy have made substantial contributions to the success of the Plan including DIP financing, exit financing, and funding of the Global Settlement with the Committee.  Without these releases, these critical aspects of the Plan would not have been achieved.  Additionally, in the context of these consensual cases (with Cyrus as the only objecting party), the Non-Debtor Releases have been consented to by a vast majority of the affected creditors.  They also are subject to a carve-out for governmental claims.

Id. at 602.

In In re Stearns Holdings, LLC, 607 B.R. 781 (Bankr. S.D.N.Y. 2019), the court noted that it had jurisdiction to enjoin third-party, non-debtor claims that directly affect the res of the estate. Id. at 787.  The court applied Deutsche Bank AG v. Metromedia Fiber Network, Inc. (In re Metromedia Fiber Network, Inc.), 416 F.3d 136 (2d Cir. 2005) in holding that that a non-debtor release may be justified in cases where (i) the released parties provide a substantial contribution to the debtor’s estate, (ii) where the claims are “channeled” to a settlement fund rather than extinguished, (iii) where the enjoined claims would indirectly impact the debtor’s reorganization by way of indemnity or contribution, (iv) where the released party provides substantial consideration, (v) where the plan otherwise provides for the full payment of the enjoined claims, or (vi) where the creditors consent. Id. at 787-88. 

The court noted that other courts have also found that a non-consensual third-party release can be appropriate where the release plays an important part in the debtor’s plan of reorganization. Id. at 788.  Here, it found the releases enforceable for two reasons.  First, the releases were consensual, notwithstanding the fact that the third-party releases were deemed effective against creditors who rejected the plan or who abstained from voting unless they affirmatively “opt out” from granting the third-party releases, i.e., a creditor’s inaction in failing to opt out constituted consent to the release.

The Court finds that the Third-Party Releases here are consensual with respect to the Releasing Parties, each of whom was given an opportunity to affirmatively reflect its consent or not to the Third-Party Releases.  The ballots distributed to holders of Claims entitled to vote on the Amended Plan clearly informed holders of Claims entitled to vote of the steps required to take if they disagreed with the scope or the grant of the releases.  Thus, affected parties were on clear notice of the Third-Party Releases, including the option to opt out of the Third-Party Releases, rendering such releases consensual, as this Court has held in prior cases involving similar facts and circumstances.

Id. at 788.  Even assuming the releases were not consensual, however, the court noted that the releases played an important part in the debtor’s plan, where the released party had made a substantial financial contribution to the debtor’s chapter 11 case.  “Here, the Debtors assert persuasively that the substantial consideration provided by the Released Parties is entirely consistent with the types of contributions courts have identified as a basis for approving a non-debtor, non-consensual release under Metromedia.  In addition, the Global Settlement is an essential element of the Amended Plan and the Third-Party Releases are a crucial component of the Global Settlement; thus, the Third-Party Releases are integral to the Debtors’ reorganization efforts.” Id. at 789.

The court found that the released parties contributed substantial consideration to the Debtors’ reorganization by, inter alia, negotiating an improved New Money Investment from Blackstone, agreeing to support the Amended Plan and forebear from further contentious and expensive litigation which may have been value-destructive to the Debtors’ reorganization and their businesses, and waiving their right to make an election under Section 1111(b) with respect to any portion of a claim arising from the Notes that is unsecured. Id.

Accordingly, the contributions of the Released Parties in negotiating and agreeing to the Global Settlement have resulted in improved recoveries to the Debtors’ creditors and will enable the Debtors to maximize the value of their estates and maintain their businesses as a going concern after emergence.  Such contributions have also enabled the Debtors to propose a plan that has the support of all classes of creditors and to emerge from chapter 11 expeditiously, which is critical to the Debtors’ businesses.

Id. at 789.

In In re Purdue Pharma, L.P., 635 B.R. 26 (S.D.N.Y. 2021), the debtors were privately held pharmaceutical companies involved in the manufacture and promotion of a proprietary prescription opioid pain reliever.  In their Chapter 11 plan, they sought broad releases of civil claims against non-debtor family members who owned the debtors and against their related entities.  However, the court concluded:

[T]hat the Bankruptcy Code does not authorize such non-consensual non-debtor releases: not in its express text (which is conceded); not in its silence (which is disputed); and not in any section or sections of the Bankruptcy Code that, read singly or together, purport to confer generalized or “residual” powers on a court sitting in bankruptcy.

Id. at 37-8.  However, before resolving this dispute the court needed to determine whether the bankruptcy court, in fact, had the necessary subject matter jurisdiction over the third-party claims against non-debtors.  In concluded that it did, stating that for purposes of subject matter jurisdiction, “it is well settled that the only question a court need ask is whether ‘the action’s outcome might have any conceivable effect on the bankrupt estate.”  If the answer to that question is yes, then related to jurisdiction exists – no matter how implausible it is that the action’s outcome actually will have an effect on the estate.” Id. at 85.  It noted that the non-derivative third-party claims that were being asserted against the Sacklers were the type of claims that bring into question the very distribution of the estate’s property.  Pursuit of the third-party claims threatened to “unravel[ ] the plan’s intricate settlements” and “recoveries on * * * judgments” against the Sacklers would have a “catastrophic effect” on all parties’ possible recovery under the Plan.” Id.

Further, the claims raised against the Sacklers could conceivably impact on the estate, in that they threaten to alter “the liabilities of the estate” and “change” “the amount available for distribution to other creditors.” Id.  Additionally, the claims had a high degree of interconnectedness with the lawsuits against the debtors and against the Sacklers – especially those members of the family who could be sued derivatively as well as directly. Id. at 86.  Finally, it was more than conceivable that the debtor’s litigation of the question of its indemnification, contribution, or insurance obligations to the director/officer/manager Sacklers could burden the assets of the estate. Id. at 87.

Notwithstanding that subject matter jurisdiction existed over these third-party claims, the court ruled that it did not have the statutory authority “to release, on a non-consensual basis, direct/particularized claims asserted by third parties against non-debtors.” Id. at 90.  The court noted that only one section of the Bankruptcy Code expressly authorizes a bankruptcy court to enjoin third party claims against non-debtors without the consent of those third parties.  That section is Section 524(g).  This section provides for such an injunction solely and exclusively in cases involving injuries arising from the manufacture and sale of asbestos. Id. at 91.  It concluded that this reflected that fact that Congress “believed that Section 524(g) created an exception to what would otherwise be the applicable rule of law.” Id. at 92.  The court explained that “[t]he word ‘notwithstanding,’ suggests that the type of injunction Congress was authorizing in §524(g) would be barred by §524(e) in the absence of the statute.” Id.

The court went on to ask whether any of the sections other than Section 105(a) conferred a substantive right to allow for third party releases.  It concluded that no such sections exist.  With respect to Section 1123(b)(6) of the Bankruptcy Code, which provides that a plan may “include any other appropriate provision not inconsistent with the applicable provisions of this title,” the court stated that it is “substantively analogous to Section 105(a)’s authorization of ‘any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.’” Id. at 106.  “If the latter does not confer any substantive authority on the bankruptcy court * * * then the former can in no way be read to do so.” Id.

Further, the Purdue Pharma release did not carve out or exempt claims for fraud or willful and malicious conduct, liabilities from which Purdue cannot be discharged in its own bankruptcy.  “Reading the Bankruptcy Code as authorizing a bankruptcy court to discharge a non-debtor from fraud liability – something it is strictly forbidden from doing for a debtor – cannot be squared with the fact that Congress intended that the Bankruptcy Code ‘ensure that all debts arising out of fraud are excepted from discharge no matter what their form.’” Id.

With respect to Section 1123(a)(5) of the Bankruptcy Code, which provides that a plan of reorganization must “provide adequate means for [its] implementation” and contains a laundry list of things that a plan can include in order to make sure that resources are available to implement the plan – any of which can be ordered by a bankruptcy court.

Injunctions against the prosecution of third-party claims against non-debtors, and the release of such claims, are nowhere to be found on that list.  Every single example listed in Subsections 5(A) through (J) authorizes the court to do something with the debtor’s assets (retaining estate property; transfer of property; sale of property; satisfaction or modification of a lien; cancellation or modification of an indenture or similar instrument; curing or waiving defaults; extension of maturity dates; issuing securities; even amending the debtor’s charter).  Since the bankruptcy court has in rem jurisdiction over the res of the debtor’s estate, none of that should be surprising.  It is equally unsurprising that none of the types of relief listed in Section 1123(a)(5) involves disposing of property belonging to someone other than the debtor or a creditor of the debtor. That is because it is the debtor’s resources – not the resources of some third party – that are supposed to be used to implement a plan that will adjust the debtor’s relations with its creditors.

Id. at 108.

Finally, the court noted that following:

The “special remedial scheme” contemplated by the Bankruptcy Code addresses the rights of persons who have claims against a debtor in bankruptcy – not claims against other non-debtors.  The Code lays out a claims allowance process so that creditors can file their claims against someone who has invoked the protection of the Bankruptcy Code; it provides a mechanism for those parties to litigate those claims against the debtor and to determine their value.  In order to take advantage of this “special remedial scheme,” debtors have to declare bankruptcy, disclose their assets, and apply them – all of them, with de minimis exceptions – to the resolution of the claims of their creditors.

Non-debtors have no such obligations, and so do not have any rights at all under the “special remedial scheme” that is bankruptcy – certainly not the “right” to have claims that are being asserted against them outside the bankruptcy process released.

Id. at 114.

Third Circuit Decisions:

In In re Continental Airlines, 203 F.3d 203 (3rd Cir. 2000), shareholders filed objections to confirmation of a reorganization plan that released and permanently enjoined shareholder lawsuits against the debtor-airline’s non-debtor officers and directors.  The circuit court reversed the district courts order affirming the bankruptcy court’s decision to confirm the plan, finding that the plan’s release of shareholder claims was not supported by a sufficient evidentiary or legal basis.  The court first noted that the shareholders who were forced to release their claims “received no consideration in exchange for having their lawsuits permanently enjoined.”  Id. at 215.  Further, the court found no evidence that the non-debtor officers and directors provided a critical financial contribution to the debtors’ plan that was necessary to make the plan feasible in exchange for receiving a release of liability.  Nor did the lawsuits themselves propel the debtors in bankruptcy.

Additionally, the court found no evidence in the record supporting the possibility or probability of officer and director indemnification as a factual or legal matter.  “Even if the D&O defendants’ obligations culminating from Plaintiffs’ class actions were indemnifiable, the fact that the reorganized Continental Airlines might face an indemnity claim sometime in the future, in some unspecified amount, does not make the release and permanent injunction of Plaintiffs’ claims ‘necessary’ to ensure the success of the Continental Debtors’ reorganization.” Id. at 216.  Similarly, it was unsupported that the non-debtor release and permanent injunction were warranted because Plaintiff’s’ lawsuits ultimately might implicate the D&O liability insurance policy, which was property of the debtors’ estate.  “[T]he proceeds form a [sic] insurance policy should be evaluated separately from the debtor’s interest in the policy itself.” Id.

In In re Genesis Health Ventures, Inc., 266 B.R. 591 (Bankr. D.Del. 2001), the debtor attempted to release, among others, Senior Lenders from any act or omission in connection with the Chapter 11 cases and the reorganization process.  Citing In re Continental Airlines, the court notes that third-parties releases are possible if “there are circumstances under which [the court] might validate a non-consensual release that is both necessary and given in exchange for fair consideration.” Id. at 214, n.11.  However, the court went further and noted that even if the “threshold Continental criteria of fairness and necessity” are satisfied, the releases will only be approved “in the context of extraordinary cases” like Robins, Manville and Drexel Burnham.  In re Genesis Health Ventures, Inc., 266 B.R. 591, 608 (Bankr. D.Del. 2001).  The court then concluded that “the message of Continental appears to be that the type of financial restructuring plan under consideration here would not present the extraordinary circumstances required to meet even the most flexible test for third party releases.” Id.

In In re W.R. Grace & Co., 591 F.3d 164 (3d Cir. 2009), the injunction involved claimants who, prior to the petition date, brought lawsuits against the State of Montana alleging that Montana was liable to them because it was negligent in failing to warn them of the risks of asbestos from mines run by W.R. Grace.  After the debtor filed for bankruptcy it asked the bankruptcy court to expand an existing preliminary injunction to include the actions brought against Montana.  The debtor argued that its motion should be granted because the debtor and Montana shared an identity of interests such that the Montana actions were essentially suits against the debtor, which would be harmful to the debtor’s efforts to reorganize. 

The Third Circuit disagreed with this conclusion and held that the bankruptcy court did not have the jurisdiction to issue the requested preliminary injunction.  In doing so, the court held that W.R. Grace would not be bound by any judgment against the third-party in question.  Rather, an entirely separate action would be necessary for the liability incurred by Montana to have an impact on the debtor’s estate. 

Specifically, Montana would first have to be found liable by its state courts and would then have to successfully bring an indemnification or contribution claim against Grace in the Bankruptcy Court.  This is precisely the situation in which we have found that related-to jurisdiction does not exist.  Indeed, we have stated and restated that, in order for a bankruptcy court to have related-to jurisdiction to enjoin a lawsuit, that lawsuit must “affect the bankruptcy [ ] with out the intervention of yet another lawsuit.”

Id. at 172-73 (citing to Federal-Mogul, 300 F.3d at 382 and Combustion Eng’g, 391 F.3d at 232).

The court went on to note that the “unity of interest” argument did not further their cause.  Citing to Combustion Eng’g, the court stated that a non-debtor’s potential right of contribution was not enough to establish related-to jurisdiction. Id. at 173.

In short, our recently reaffirmed precedent dictates that a bankruptcy court lacks subject matter jurisdiction over a third-party action if the only way in which that third-party action could have an impact on the debtor’s estate is through the intervention of yet another lawsuit.  Here we are presented with state court actions that have only the potential to give rise to a separate lawsuit seeking indemnification from the debtor.  Accordingly, we must affirm the Bankruptcy and District Courts conclusion that subject matter jurisdiction does not exist for the purpose of expanding the §105(a) injunction to preclude the Montana Actions.

Id. at 173.  The court finally noted that its conclusion might have been different had a clear contractual right to indemnity existed, which may have presented a more direct threat to the debtor’s reorganization.  But even on that point, the court cautioned that it did not mean to imply that contractual indemnity rights are in themselves sufficient to bring a dispute over that indemnity within the ambit of related-to jurisdiction.  “What will or will not be sufficient related to a bankruptcy to warrant the exercise of subject matter jurisdiction is a matter that must be developed on a fact-specific, case-by-case basis.” Id. at 174 n.9.

In re Millennium Lab Holdings II, LLC, 2018 WL 4521941 (D.Del. Sept. 21, 2018), involved a debtors’ proposed Chapter 11 plan, which provided for the release of claims that nondebtor third parties might have against equity holders that had made a $325 million contribution to debtors’ reorganization.  The proposed plan provided no ability for parties to “opt-out” of the third-party releases, meaning the releases would be granted upon confirmation of the plan regardless of whether a creditor consented.  The proposed plan also permanently enjoined the appellants from commencing or prosecuting claims released pursuant to the plan.

Here, the court noted that in In re Master Mortgage Inv. Fund, Inc., 168 B.R. 930, 935 (Bankr. W.D.Mo. 1994), the factors that needed to be considered for third-party releases were:

(1) an identity of interest between the debtor and the third party, such that a suit against the non-debtor is, in essence, a suit against the debtor or will deplete assets of the estate; (2) substantial contribution by the non-debtor of assets to the reorganization; (3) the essential nature of the injunction to the reorganization to the extent that, without the injunction, there is little likelihood of success; (4) an agreement by a substantial majority of creditors to support the injunction, specifically if the impacted class or classes “overwhelmingly” votes to accept the plan; and (5) provision in the plan for payment of all or substantially all of the claims of the class or classes affected by the injunction.

Yet, it noted that the so-called Master Mortgage factors, while helpful guideposts, were not controlling and were are not an exclusive list of considerations, nor are they a list of conjunctive requirements.  Citing to In re 710 Long Ridge Road Operating Co., II, LLC, 2014 WL 886433, *14 (Bankr. D.N.J. March 5, 2014), the court stated that the Master Mortgage “guideposts are not considered requirements for the approval of third-party releases but may be instructive to the court.  Rather, citing to Continental, it ultimately came down to “fairness, necessity to the reorganization.” Id. at 21. 

Notwithstanding, this analysis, the court found the Master Mortgage factors were satisfied.  Of most interest, was its discussion of the “identity of interest” factor, and “payment for all or substantially all of the claims” factor.  With respect to the “identity of interest” factor, the court stated that like the other released parties under the plan, the equity holders were covered by the debtors’ indemnification, advancement, and defense obligations.  Thus, claims brought against the released parties could be viewed as suits against the debtors, or at minimum as suits that threaten to deplete the debtors’ assets, which is sufficient here to establish identity of interest. Significantly, the court cited to In re Seaside Engineering & Surveying, Inc., 780 F.3d 1070, 1079-80 (11th Cir. 2015), for the proposition that an identity of interest between the debtor and released parties, who were debtor’s key employees, existed simply where debtor would deplete its assets defending released parties against litigation.  In other words, the court found that the debtors were obligated to advance defense costs without regard to the type or substance of claims, which was enough. Id.

With respect to the payment, the court noted that the debtors contended that the plan provided for “all or substantially all” affected claims to be paid as it “provides for payments to all classes of claims in excess of the liquidation value of those claims.”  Again, this was enough.  Citing to In re Condustrial, Inc., 2011 WL 3290389, *5-6 (Bankr. D.S.C. Aug. 1, 2011), the court explained that the impacted class would receive payment of “all or substantially all” as “the [p]lan provide[d] for the releasing parties to receive payment in an amount in excess of any funds they would receive from an orderly liquidation of the [d]ebtor”. Id. at 22.  Quoting the bankruptcy court in Millennium, it noted:

[T]here is an enormous disparity between the reorganization value and the liquidation value of this company …. Without this settlement, this case turns into litigation. Inherent in that litigation is the uncertainty of success, expenses and delay in obtaining recoveries.

Id.

In re Mallinckrodt PLC, 2022 WL 404323 (Bankr. D.Del. Feb. 8, 2002), dealt with both consensual and non-consensual third-party releases.  With respect to non-consensual releases, the court stated that they must be both necessary and fair. Id. at *15.  The non-consensual releases here involved opioid cases.  Specifically, the debtors were named in more than 3,000 opioid related lawsuits alleging potentially trillions of dollars in damages.  While they believed they had meritorious defenses to those claims, the debtors claimed that there were simply too many to litigate.  The company was spending approximately $1 million a week on legal expenses, and the amount of time required of management on the litigation was distracting from business operations.  Additionally, the possibility of large judgments was impacting the company’s ability to obtain sufficient credit and the reputational harm of the mass litigation also led to difficulties in attracting and keeping the necessary employees.

In arguing that the releases were necessary, the debtors offered evidence that without the releases, the settlements with various creditor groupings could not have been achieved and that without the Settlements, the Plan would fall apart, and the debtors would be forced to sell off the company in pieces.  In other words, the debtors argued that the releases, the settlements, and the plan are all inextricably intertwined such that the releases are essential to plan confirmation.  The court found these non-consensual releases appropriate, stating:

The decision to approve the Opioid Releases here is not one that I make lightly, and it is informed by several considerations.  First and foremost is the extraordinary nature of this case.  As previously noted, Debtors were sued in over 3000 cases around the country by both governmental entities seeking to abate the opioid crisis they allege Debtors contributed to, as well as private organizations and individuals who were affected by Debtors’ opioid products.  The settlement of those claims, of which the releases are a necessary and integral part, will remove an existential threat to Debtors’ business while at the same time ensuring that Opioid Claimants receive recoveries far in excess of what they could obtain through continued litigation.  This is particularly true given that the opioid claims are only one of several potentially massive litigation liabilities faced by Debtors.

This is also a notorious and sensitive case because it involves opioids at the height of a national opioid epidemic.  The nature of the claims at issue here – personal injury claims arising out of the use of opioid medications – makes time of the essence.  While the parties here could spend decades litigating who is right and who is liable for what, the need for funds to manage and abate this crisis is real and immediate.

The confluence of these factors here makes this case exactly the type of extraordinary case the Third Circuit alluded to in Continental, where nonconsensual releases might be appropriate.

Id. at *19.

Further, the court noted that the settlement related to the releases was negotiated at arm’s length with a large group of sophisticated parties representing diverse interests.  It found that substantial consideration was being given in exchange for the releases in the form of “a well-funded trust to which opioid claimants can turn for potential compensation.” Id.  Additionally, with respect to the non-debtors being released, the evidence showed that the releases were necessary because the entities and individuals were involved to such a degree with debtors’ business that a suit against them was likely to be a drain on debtors.  They were fair both because debtors provided additional compensation in exchange for the releases of these non-debtors and because the record suggests it was unlikely that there were any material claims for liability against these non-debtors that were being waived.  Id.

The non-opioid releases, on the other hand, were allegedly consensual.  Here, the plan included releases by certain non-debtors other than opioid claimants, including: “(a) Holders of all Claims who vote to accept the Plan, (b) the Holders of all Claims that are Unimpaired under the Plan, (c) the Holders of all Claims whose vote to accept or reject the Plan is solicited but who (i) abstain from voting on the Plan and (ii) do not opt out of granting the releases * * *, (d) the Holders of all Claims or Equity Interests who vote, or are deemed to reject the Plan but do not opt out of granting the releases * * *, (e) all Holders of Claims or Equity Interests to the maximum extent permitted by law, and (f) the Released Co-Defendants and each of their Co-Defendant Related Parties * * * *”

The court stated that the use of the opt out mechanism can be a valid means of obtaining consent, but its validity was fact specific, and they were not appropriate in every case.  Here, the court found it was appropriate.  Id. at *23.  First, the court noted that “there can be no debate over the proposition that a bankruptcy court can approve a plan that includes third-party releases.”  Rather, the question was, what constitutes consent and can consent be inferred from failure to respond to a notice including an opt out?  In other words, can consent be inferred from silence or more accurately, the failure to act?  The court concluded that it can.

The notion that an individual or entity is in some instances deemed to consent to something by their failure to act is one that is utilized throughout the judicial system.  When a party to a lawsuit is served with a complaint or a motion, they need to file an answer or otherwise respond, or a judgment is automatically entered against them.  Within the bankruptcy system, Debtors send out bar date notices and if claimants fail to file a proof of claim by a certain time, they lose the right to assert a claim.  Additionally, if a claim objection is filed and the claimant fails to respond, the claim is disallowed.  There is no reason why this principle should not be applied in the same manner to properly noticed releases within a plan of reorganization.

Id. at *24.  The court went on to state the following:

I am aware, of course, that this ruling conflicts with those of some of my colleagues who have suggested that consensual releases obtained through an opt out process may never be appropriate.  However, neither of those cases involve mass tort bankruptcies like this one.  Although the Third Circuit has not explicitly commented on the propriety of non-debtor releases in these circumstances, it has suggested that if they are appropriate anywhere, it would be in a mass tort case like this one.  This makes sense because the sheer volume and complexity of the issues presented in cases like these require creative solutions which often build upon each other or depend on the success of each other in a way that unraveling one will cause all to fall apart.  Bankruptcy policy often requires flexibility rather than adherence to a strict inflexible model because the goal is to get the debtors through to the other side.  Here, I have a plan before me that is supported by every estate fiduciary, almost every organized creditor group, and 88% of voting creditors. The settlements of which these releases are a part reflect the consensus of many and that too, is persuasive.

Fourth Circuit Decisions:

In Nat’l Heritage Foundation v. Highbourne Foundation, 760 F.3d 344 (4th Cir. 2014), the Chapter 11 debtor, a non-profit charitable organization, sought to confirm a plan that contained non-debtor release, injunction, and exculpation provisions.  Focusing on the releases, the court noted that the following six substantive factors enumerated in Class Five Nevada Claimants v. Dow Corning Corp. (In re Dow Corning Corp.), 280 F.3d 648, 658 (6th Cir. 2002), should be considered:

(1) There is an identity of interests between the debtor and the third party . . .; (2) The non-debtor has contributed substantial assets to the reorganization; (3) The injunction is essential to reorganization . . . ; (4) The impacted class, or classes, has overwhelmingly voted to accept the plan; (5) The plan provides a mechanism to pay all, or substantially all, of the class or classes affected by the injunction; [and] (6) The plan provides an opportunity for those claimants who choose not to settle to recover in full.

The court then went through each of the factors.  The first factor required the court to consider whether there was an identity of interests – usually an indemnity obligation – between the debtor and the released parties.  A non-debtor release may be appropriate in such circumstances because a suit against the non-debtor may, in essence, be a suit against the debtor that risks depleting the assets of the estate. Here, the court concluded that the debtor had demonstrated an identity of interests between itself and the released parties.  Under the terms of its bylaws, the debtor must advance legal expenses and indemnity its officers and directors for “any action . . . in which such person may be involved by reason of his being or having been a director or officer of” the debtor.

The second factor required the debtor to demonstrate that the released parties made a substantial contribution of assets to its reorganization.  Here, none of the released parties in this case made any financial contribution to the reorganization.  Nonetheless, the debtor argued that its officers and directors satisfied this requirement by promising to continue serving the debtor.  The court held that this consideration would not constitute a substantial contribution of assets.  In doing so, it cited to In re SL Liquidating, Inc., 428 B.R. 799, 804 (Bankr. S.D.Ohio 2010), which concluded that directors and officers did not make a substantial contribution when their described efforts were consistent with their preexisting fiduciary duties and job responsibilities.

The third Dow Corning factor required the debtor to demonstrate that the non-debtor release was “essential” to its reorganization, such that the reorganization hinges on the debtor being free from indirect suits against parties who would have indemnity or contribution claims against the debtor.  Here, the debtor provided little to no evidence regarding the number of likely donor claims, the nature of such claims, or their potential merit.  The debtor’s vice-president stated that the debtor insiders were concerned about donors bringing suit, but that was simply too vague to substantiate the risk of litigation.  The court found no error in the lower court’s finding that the risk of officer-director flight in this case to be minimal.  Further, even if the debtor’s officers and directors did leave, the debtor did not suggest that it would face difficulty recruiting new personnel.  Further, the severability clause contained in the debtor’s plan cemented the court’s view that the release provision was not essential.  That clause provided that the plan would remain in effect “[s]hould any provision in [the] Plan be determined to be unenforceable.”  This language suggested that the plan would remain viable absent the release provision.

Under the fifth factor, the court considered whether the debtor’s reorganization plan provided a mechanism to consider and pay all or substantially all of the class or classes affected by the non-debtor release.  Here, the court noted that nondebtor releases were approved when the enjoined claims were channeled to a settlement fund rather than extinguished.  Id. (citing to In re Metromedia Fiber Network, Inc., 416 F.3d 136, 142 (2d Cir. 2005).  Here, although there was no per se requirement that a debtor “channel” claims, the absence of such a mechanism can weigh against the validity of a non-debtor release, especially when the result is that the impacted class’s claims are extinguished entirely.  The court stated that the absence of such a mechanism weighed against the release provision.  Any donor claims filed or allowed during the bankruptcy proceedings had simply been extinguished.  Thus, the debtor’s plan lacked an important element of the plan endorsed in A.H. Robins – a second chance for even late claimants to recover.”  As to the fourth factor, proof that the class or classes affected by the release provision overwhelmingly voted in favor of the plan, the court noted that the affected class was unimpaired because they were eligible for full payment with interest; however, the court also noted uncertainty regarding whether an unimpaired class’s presumed support for a reorganization plan is sufficient to satisfy this Dow Corning factor. Id. at 350.

In Patterson v. Mahwah Bergen Retail Group, Inc., 2022 WL 135398 (E.D.Va. Jan. 13, 2022), the district court found that the third-party releases at issue there implicated “the most fundamental right guaranteed by the due process clause in our judicial system: the right to be heard before the loss of one’s rights” and that the bankruptcy court improperly approved the releases.  It did so on subject matter jurisdiction grounds, citing to Stern v. Marshall for the proposition that bankruptcy courts only have the constitutional authority to adjudicate core claims.  It noted that a claim becomes core when it is integral to the restructuring of the debtor-creditor relationship.  This constitutional limitation applied to a bankruptcy court’s authority to grant releases. Id. at *13.  Quoting Purdue Pharma it stated that “[n]othing in Stern or any other case suggests that a party otherwise entitled to have a matter adjudicated by an Article III court forfeits that constitutional right if the matter is disposed of as part of a plan of reorganization in bankruptcy.  Were it otherwise, then parties could manufacture a bankruptcy court’s Stern authority simply by inserting the resolution of some otherwise non-core matter into a plan.”  More specifically, the bankruptcy court made a mistake in granting the third-party releases because:

Here, the Bankruptcy Court engaged in none of the content-based analysis demanded by Stern.  The Bankruptcy Court did not parse the content of the claims that it purported to release to determine if each claim constituted a core claim, a non-core claim or a claim unrelated to the bankruptcy case.  The sheer breadth of the Third-Party Releases renders this a herculean undertaking and underscores the constitutional questionability of the Bankruptcy Court’s actions.  However, the enormity of the task does not absolve the Bankruptcy Court of its responsibility to properly identify the content of the claims before it and ensure that it has jurisdiction to rule on each of them.  In fact, because of the constitutional implications of extinguishing these claims, this undertaking carries even greater import.  As an appellate court, this Court will not speculate as to the claims released and then parse each purportedly released claim to determine whether the Bankruptcy Court had the power to extinguish that claim – that was the responsibility of the Bankruptcy Court.

Id. at *14.

In the appeal, the debtors argued that the third-party releases did not implicate Stern’s constitutional limitations.  Essentially, debtors were asking the court not to parse the released claims in any way, and instead, find that the bankruptcy court had constitutional authority based on the inclusion of the releases in the plan.  The court, however, noted that this argument would require the court to improperly conclude that only the plan confirmation order constitutes a judgment and that jurisdiction over confirmation proceeding cures any jurisdictional defects within those proceedings.  Regardless, the bankruptcy court extinguished the “released claims,” which amounted to adjudication of the claims for Stern purposes.  The court stated that “[t]o claim that the Bankruptcy Court can fully extinguish these claims based solely on their inclusion in the Plan – without any hearing on them or any findings about them – amounts to arguing that courts need not have the authority to extinguish claims so long as they provide no procedural safeguards in extinguishing the claims. Obviously, this cannot be.” Id. at *16.  The court recognized that bankruptcy courts, as courts of equity, have broad authority to modify creditor-debtor relationships.  But “third-party claims belong to third parties, not the debtor’s estate.  As a general rule, a bankruptcy court has no power to say what happens to property that belongs to a third party, even if that third party is a creditor or otherwise is a party in interest.” Id.  Although a bankruptcy court’s in rem jurisdiction gives it authority over claims against the estate, it has no in rem jurisdiction over third-party claims not against the estate or property of the estate. Id.

Mahwah Bergen also found that the bankruptcy court erred as a matter of law in finding that failure to return the opt-out form constituted consent to Article I adjudication.  It stated that the Supreme Court had made it clear that implied consent to non-Article II adjudication can only be discerned from a party’s actions.  “However, they do not permit a finding of consent based on inaction.  Id. at *18.  In finding consent to Article I adjudication, the Supreme Court relied on the litigation conduct of the parties and the fact that they appeared before the magistrate judge to try their case after notification of the referral. 

Rather, the Bankruptcy Court merely relied on the fact that a document was mailed out with the goal of reaching thousands of individuals.  Then, without regard to whether those individuals received the document, and without regard as to whether those individuals took any overt actions in response to the document, the Bankruptcy Court determined that they had surrendered their constitutional right to an Article III court.

Id. at *19.  The court continued that:

hoping (without proving) that someone received a deficient document – without any further action from that person – does not meet the standard for knowing and voluntary consent to adjudication of a non-core claim by a bankruptcy court, as set forth by the Supreme Court in Wellness.

Additionally, the Supreme Court in both Wellness and Roell indicated that the implied consent standard that it set forth had its basis in the elimination of gamesmanship.  Yet, allowing inaction to imply consent encourages the very gamesmanship that the Supreme Court intended to check.  That is, non-debtors could tuck releases unrelated to a bankruptcy proceeding into bankruptcy plans, then secrete an opt-out opportunity into a convoluted legal document, send the document to non-parties previously unaware of the bankruptcy proceeding and use their non-response to extinguish all of their claims.  This type of gamesmanship, aimed at extinguishing claims of unwitting individuals and providing a golden parachute to the parties drafting the plan, cannot be tolerated.

The court also ruled that the plan did not satisfy the Fourth Circuit’s factors for non-consensual third-party releases detailed in Behrmann.  Under the first factor, “a court must consider whether there is an identity of interests – usually an indemnity obligation – between the debtor and the released parties,” such that the “suit against the non-debtor may, in essence, be a suit against the debtor that risks depleting the assets of the estate.”  But, in this case, the debtors had essentially liquidated and, therefore, it remained uncertain whether Debtors have a continuing indemnification obligation to the Individual Defendants.  Id. at *32.

The second factor requires debtors “to demonstrate that the Released Parties made a substantial contribution of assets to its reorganization.”  The court found that the record did not support that the Individual Defendants made any financial contribution to the reorganization or any other contribution.  Indeed, the court had already made a factual finding that the Individual Defendants played no role in the reorganization (they had already left debtors’ employment) and their releases were not integral to the reorganization.  The fact that they also provided releases to debtors did not amount to a “substantial contribution of assets,” especially given the illusory nature of the releases.  Id.

To satisfy the third factor, “a debtor must demonstrate that the non-debtor release is essential to its reorganization, such that the reorganization hinges on the debtor being free from indirect suits against parties who would have indemnity or contribution claims against the debtor.”  But again, in this case, the debtor had largely liquidated, rather than reorganize.  The court stated that this alone cut against the essential nature of the releases.  Id.

The fourth factor requires the debtor “to prove that the class or classes affected by the Release Provision overwhelmingly voted in favor of the Plan.”  Here, the Class Members, as a class received nothing under the Plan and were deemed to reject the Plan as a matter of law.  This factor was not satisfied.  Id. at *33.  Finally, under the fifth factor, the court considers “whether the debtor’s reorganization plan provides a mechanism to consider and pay all or substantially all of the class or classes affected by the non-debtor release.”  Here, the Plan did not create a separate fund to pay the claims released or provide any other mechanism to consider or pay the securities claims.  Id.

Fifth Circuit Decisions:

In In re Wool Growers Cent. Storage Co., 371 B.R. 768 (Bankr. N.D.Tex. 2007), the plan in question provided that, on its effective date, members of the debtor’s board of directors would pay to a disbursing agent the sum of $2,625,000.  This payment would be used in the form of loans made by the directors to the debtor.  The funds would be used to make a one-time distribution to the creditors in the case, First, funds were to be used to pay administrative claims, which were estimated to not exceed $150,000.  Second, the balance was to be used to pay unsecured creditors.  It was anticipated that there would be a distribution of 60% to 70% of outstanding unsecured creditor claims with the remaining balance discharged.

The plan and disclosure statement identified potential claims against the directors which were settled by mediation.  In exchange for the contribution of $2,625,000 and their agreement, via a subordination agreement, not to receive payment of any amount on their own claims from this sum, the directors would be released both individually and as board members from any claims and causes of action that might be brought against them by any creditor of the debtor.  In addition, to enforce the release, creditors were enjoined from pursing any such claims or causes of action against the directors.

The court stated that while a bankruptcy court may, through plan approval, modify the debtor-creditor relationship, an open issue existed as to whether such a court could modify the relationship between a creditor and a nondebtor third-party.  In this regard, two different types of releases were discussed: consensual nondebtor releases and non-consensual nondebtor releases.  With respect to the first type of release, the court noted that “[c]onsensual nondebtor releases that are specific in language, integral to the plan, a condition of the settlement, and given for consideration do not violate §524(e).” Id. at 776.  However, the court also noted that nondebtor release violates §524(e) when the affected creditor timely objects to the provision.  Id. (citing to Feld v. Zale Corp. (In re Zale Corp.), 62 F.3d 746, 761 (5th Cir. 1995).

Notwithstanding, the court also followed a factor driven approach for approving releases over creditor objections, utilizing the factors outlined in In re Master Mortgage Inv. Fund, Inc., 168 B.R. 930, 934 (Bankr. W.D.Mo. 1994).  Here, the court noted that the debtor satisfied the first four Master Mortgage factors, i.e., (1) identity of interest between the debtor and third-party; (2) substantial contribution of assets to reorganization; (3) release is necessary to the reorganization; and (4) majority of affect creditors have overwhelmingly accepted plan treatment.  However, the fifth factor, full or almost full payment of the affected claims, was not satisfied.  And the court was of the opinion that this fifth factors was critical for approval, at least under the facts and circumstances of its case. Wool Growers, 371 B.R. at 778.  As a result, the release was improper, and prevented the court from confirming the debtor’s plan.

In In re Patriot Place, Ltd., 486 B.R. 773 (Bankr. W.D.Tex. 2013), the court stated that “non-consensual, non-debtor releases in bankruptcy proceedings in this circuit have been ‘explicitly prohibited’, and citing to In re Vitro S.A.B. de CV, 701 F.3d 1031 (1051-53, 1054-55, 1058-59 (5th Cir. 2012), held that

Here, the non-debtor releases proposed in the PPL Plan are non-consensual – as 3LM (as well as Monaco) have affirmatively objected and not consented to such non-debtor releases.  Accordingly, because the releases are expressly not consensual, the non-debtor releases in ¶ 1 of the PPL Plan cannot be approved by the Court under binding Fifth Circuit precedent.

Id. at 822.

Sixth Circuit:

The Sixth Circuit in In re Dow Corning Corp., 280 F.3d 648 (6th Cir. 2002), dealt with releases involving mass tort claims.  It held that although under certain circumstances the bankruptcy court may enjoin a non-consenting creditor’s claim against a non-debtor to facilitate a Chapter 11 plan of reorganization, the record in that case did not support a finding of such unusual circumstances.  The court characterized third-party injunctions or releases as dramatic measures to be used cautiously only in unusual circumstances evidenced by the presence of each of seven factors.  Those factors were the following:

(1) There is an identity of interests between the debtor and the third party, usually an indemnity relationship, such that a suit against the non-debtor is, in essence, a suit against the debtor or will deplete the assets of the estate; (2) The non-debtor has contributed substantial assets to the reorganization; (3) The injunction is essential to reorganization, namely, the reorganization hinges on the debtor being free from indirect suits against parties who would have indemnity or contribution claims against the debtor; (4) The impacted class, or classes, has overwhelmingly voted to accept the plan; (5) The plan provides a mechanism to pay for all, or substantially all, of the class or classes affected by the injunction; (6) The plan provides an opportunity for those claimants who choose not to settle to recover in full and; (7) The bankruptcy court made a record of specific factual findings that support its conclusions.

Id. at 658.

Seventh Circuit Decisions:

In In re Conseco, Inc., 301 B.R. 525 (Bankr. N.D.Ill. 2003), the court considered the issue of whether a plan of reorganization may include the release of non-debtors by one group of creditors (the TOPrS Creditors).  The TOPrS release was part of a settlement reached between the TOPrS Committee and the debtors.  The court started its analysis by citing to the lead Seventh Circuit decision, In re Specialty Equip. Co., Inc., 3 F.3d 1043, 1047 (7th Cir.1993), which held that Section 524(e) provides only that the discharge of a debt of the debtor does not alter any other party’s liability on the debt.  In other words, the section does not prohibit the inclusion of consensual releases in a Chapter 11 plan.  The TOPrS release was, in fact, part of a voluntary settlement includable in a plan pursuant to Section 1123(b)(6).  The court noted that under previous plan provisions, all creditors who accepted a distribution under the plan would be required to release the non-debtors, regardless of whether they voted to accept the plan.  Stated another way, creditors who did not vote to accept the plan but were clearly entitled to a distribution in a Chapter 7 liquidation had to release non-debtors to receive a distribution.  The court concluded that these provisions violated the best interests of creditors test because they forced creditors to accept the release or to give up the distribution to which they were entitled under Section 1129(a)(7)(A)(ii).  Under these circumstances, a creditor’s mere acceptance of a distribution under the plan cannot be construed as a voluntary consent to the release.

Under the amended Conseco plan, each creditor receiving a distribution under the plan was given the opportunity to opt out of the release of non-debtors contained in the plan. 

The Article X release now binds only those creditors who agreed to be bound, either by voting for the Plan or by choosing not to opt out of the release.  Therefore, the Article X release is purely consensual and within the scope of releases that Specialty Equipment permits.

Id. at 528.

In In re Airadigm Communications, Inc., 519 F.3d 640 (7th Cir. 2008), the court held that Section 524(e) simply provides that a creditor can seek to collect a debt from a co-debtor who did not participate in the reorganization – even if the debt was discharged as to the debtor. 

In any event, §524(e) does not purport to limit the bankruptcy court’s power to release a non-debtor from a creditor’s claim.  If Congress meant to include such a limit, it would have used the mandatory terms “shall” or “will” rather than the definitional term “does.”  And it would have omitted the prepositional phrase “on, or . . . for, such debt,” ensuring that the “discharge of a debt of the debtor shall not affect the liability of another entity” – whether related to a debt or not.

Airadigm also ruled that the “residual authority” found in Sections 105(a) and 1123(b)(6) permits the court to release third parties from liability to participating creditors if the release is “appropriate” and not inconsistent with any provision of the Code.  Whether a release is “appropriate” for the reorganization is fact intensive and depends on the nature of the reorganization.  Under the facts of Airadigm it was appropriate.  The release in question related to liability for “any act or omission arising out of or in connection with . . . confirmation of this Plan . . . except for willful misconduct.”  First, the court noted that the release was narrow, as it applied only to claims arising out of or in connection with the reorganization itself and did not include “willful misconduct.”  In other words, it was not a “blanket immunity” for all times, all transgressions, and all omissions.  Second, the immunity did not affect matters beyond the jurisdiction of the bankruptcy court or unrelated to the reorganization itself.

Courts approving non-debtor releases when confirming a plan of reorganization consider various factors, including the following:

(1) Whether the debtor and the third party share an identity of interest, usually an indemnity relationship, such that a suit against the non-debtor is, in essence, a suit against the debtor or will deplete the assets of the estate;

(2) Whether the non-debtor has contributed substantial assets to the reorganization;

(3) Whether the injunction is essential to reorganization, namely, the reorganization hinges on the debtor being free from indirect suits against parties who would have indemnity or contribution claims against the debtor;

(4) Whether the impacted class, or classes, has overwhelmingly voted to accept the plan;

(5) Whether the plan provides a mechanism to pay for all, or substantially all, of the class, or classes, affected by the injunction; and

(6) Whether the plan provides an opportunity for those claimants who choose not to settle to recover in full.

See also, In re Mahoney Hawkes, LLP, 289 B.R. 285, 297-98 (Bankr. D.Mass. 2002); In re Exide Technologies, 303 B.R. 48, 72 (Bankr. D.Del. 2003) (noting that the above factors were neither exclusive  nor were they a list of conjunctive requirements and “Instead, they are helpful in weighing the equities of the particular case after a fact-specific review.”); In re Dow Corning Corp., 280 F.3d 648 (6th Cir. 2002).

In In re Berwick Black Cattle Co., 394 B.R. 448 (Bankr. C.D.Ill. 2008), the court refused to confirm a plan due to third-parties releases that went far beyond what was approved in Airadigm.  Here, the debtor attempted to release not just claims arising out of the bankruptcy cases, but pre-petition claims also, including claims based on nonbankruptcy law that had nothing to do with the bankruptcy proceedings.  The plan proposed to release claims held by all of the debtor’s creditors, without regard to actual notice of the plan or the bankruptcy cases, and whether scheduled or not.  In finding the releases problematic, the court stated that it was “aware of no authority, outside of the mass tort context, which supports the granting in the plan of a nonconsensual third-party release of claims other than for acts or omissions made in the bankruptcy proceeding, with gross negligence and willful misconduct excluded.” Id. at 460.

Among the problems with the releases, the court noted the releasors would not receive any compensation for losing their claims.  Additionally, although the plan was dressed up to look like a reorganization, it was in essence one of liquidation.  One of the debtors was being merged out of existence, after all of its assets had been liquidated.  “The rational for granting third-party releases is far less compelling, if it exists at all, in a liquidation than a reorganization.” Id. at 461.  The court went on to note that even if all of the problems with the releases were resolved, it should only be those making a substantial financial contribution who would be entitled to a release.  Granting releases to such parties would be “gratuitous, inequitable and inappropriate. Id. at 462.

Ninth Circuit Decisions:

In In re Excel Innovations, Inc., 502 F.3d 1086 (9th Cir. 2007), the debtor applied for a preliminary injunction staying arbitration proceedings between two non-bankrupt parties, one which was the debtor’s former CEO.  The court started its analysis by noting that Section 105(a) gives bankruptcy courts the power to stay actions that are not subject to the automatic stay but “threaten the integrity of a bankruptcy estate.” Id. at 1093.  Further, the court noted that the “usual preliminary injunction standard applied to stays of proceedings against non-debtors under §105(a).”  Id. at 1094.  

In sum, our usual preliminary injunction standard applies to applications to stay action against non-debtors under §105(a).  In granting or denying such an injunction, a bankruptcy court must consider whether the debtor has a reasonable likelihood of a successful reorganization, the relative hardship of the parties, and any public interest concerns if relevant.

Id. at 1096. 

The court held that this test was not satisfied.  With respect to the first prong, there was no indication in the record that the former CEOs would meaningfully contribute to the reorganization.  Further, the debtor had no income from business operations during the past twenty-four months, suggesting no reorganization was likely.  With respect to the second prong, i.e., the balance of the hardship, the credit argued that it would lose its bargained-for right to bring an arbitration claim against the CEO at a time of its choosing.  With respect to harm to the debtor, the court noted the following:

The bankruptcy court did consider the potential harm to Excel, and found that (1) Hoffman might raise a defense of indemnification by arguing to the arbitrator that he acted as Excel’s agent with a promise of indemnification from Excel; (2) denying the stay might lead to inconsistent results between the arbitration and the bankruptcy court; and (3) Hoffman might disclose privileged attorney-client communications, where Excel is the holder of the privilege, and Excel may have to participate in the arbitration to protect its privilege.  These finding are insufficient to support the conclusion that Excel stands to suffer irreparable harm if arbitration proceeds.

Id. at 1097.  Further, the court found that there was no evidence that the debtor has an insurance policy or other assets that would be immediately dissipated to cover a duty to defend and indemnify their former CEO.  Further, the court noted that “[the debtor] must show that the expenses will be substantial enough to interfere with its reorganization or harm creditors.” Id. at 1099.

In In re Regatta Bay, LLC, 406 B.R. 875 (Bankr. D.Az. 2009), the debtor’s plan provided the payment of a secured creditor’s claim in full, over time.  The plan also provided that the debtor’s owners would provide the debtor with a contribution of $400,000 for payment of operating expenses and professional fees.  The plan provided that the creditor was enjoined from attempting to collect its claim from the owners or any of their property until the earlier of (a) all required plan payments had been made, or (b) the bankruptcy case was dismissed or converted to Chapter 7; or (c) when there was a default under the plan that was not cured within ten days.  Finally, the order confirming the plan also provided that the owners were enjoined from transferring or encumbering any of their assets out of the ordinary course of business except as may be approved by the Bankruptcy Court after notice and opportunity for the creditor to object.

The court held that the plan provisions delaying enforcement of the creditor’s rights against the debtor’s owners was fair and equitable.  In doing so, it noted that while Ninth Circuit decisions did limit the authority of bankruptcy courts, under Section 105(a), to enjoin the collection of a debt from a non-debtor, those decisions did not hold that a bankruptcy court could not confirm a plan that “delays enforcement of creditor judgments.”  The court held that the injunctive effect of that type of plan provision comes not from a bankruptcy court injunction issued under Section 105(a), but rather from the statutory language of Section 1141(a) which states that the “provisions of a confirmed plan bind . . . any creditor.” Id. at 878.

Thus, if the plan was properly confirmed, there is no issue regarding the court’s ability to issue an injunction pursuant to Code §105(a). . . . Thus the only real issue here is whether a plan containing such a term is confirmable.

Id

Here, the court found the plan to be confirmable.  It noted that the plan term at issue merely delayed the creditor’s enforcement of its rights against the principals until the earlier of full consummation of the plan (including full payment of the creditor, with interest) or a default under the plan or dismissal or conversion of the case.  The court stated that the essential step in the creditor’s argument was to equate the temporary delay in enforcement to either a discharge or a release, i.e., to a complete denial of the creditor’s rights against the individuals.  “But it has long been fundamental, not only to bankruptcy law but also to constitutional law and even the structure of our judiciary, that a mere delay in enforceability of creditors’ remedies is not equivalent to a denial or a ‘taking’ of their rights. Id. at 879.  Therefore, the only question was whether the plan was fair and equitable.  In response to this question, the court stated the following:

The evidence established, and the Court found as a fact, both that Wright and Keesling would contribute $400,000.00 to the debtor in order to effectuate the plan, and that such a contribution was essential to the success of the plan.  The evidence also demonstrated, and the Court found as a fact, that the creditor’s enforcement of its judgment against Wright and Keesling would impair their ability to make those contributions to the debtor.  Finally, the facts also established that if the plan were not successful because Wright and Keesling could not make those contributions, there would likely be no return to the unsecured creditors in this case.  The secured creditors’ liens would exhaust all of the assets of the estate, so the unsecured creditors would receive nothing, instead of the full payment that is promised by the plan.

In effect, then, the plan term that delays the creditor’s enforcement of this rights against Wright and Keesling is akin to a marshalling order.

Id. at 881.  Moreover, as a court of equity, the bankruptcy court stated that it had the authority to issue a marshalling order when it permits a greater recovery for all creditors without causing harm to any creditor.  Id.

In In re Claar Cellars LLC, 623 B.R. 578 (Bankr.E.D.Wash.2021), the debtors’ plan provided that the reorganized debtor’s “obligations to [its lender] shall continue to be supported by the personal guaranties” of the Whitelatch family members [debtor’s principals] who guaranteed the debtors’ obligations.”  The court noted that the effect of this provision was to alter the terms on which these nondebtors were liable to the lender – the reorganized debtor’s obligations were extended and modified pursuant to the plan’s proposed treatment of the lender’s claims, notwithstanding the fact that the lender had accelerated the debtors’ obligations prepetition.  In this regard, the Commercial Guaranty signed by the debtor’s principals provided that they were absolute, unconditional, unlimited, and continuing obligations, and waived “any and all rights or defenses based on * * * any disability or other defense of Borrower * * * or by reason of the cessation of Borrower’s liability from any cause whatsoever, other than payment in full in legal tender, of the Indebtedness”

The court held that the debtors’ plan was an improper de facto restructuring of nondebtors’ liability to the lender and, thus, ran afoul of §524(e) and prevented confirmation absent the lender’s consent.  Id. at 594.  The court explained its reasoning as follows:

Bankruptcy Code section 524(e) provides that, subject to a narrow exception, “discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt.”  As the Ninth Circuit Court of Appeals recently reiterated, section 524(e) “prevents a reorganization plan from inappropriately circumscribing a creditor’s claims against a debtor’s co-debtor or guarantors over the discharged debt.”  Put differently, section 524(e) precludes a co-obligor of a bankrupt debtor from piggybacking on rights the debtor enjoys under the Bankruptcy Code, including the right to discharge or restructure indebtedness.  If a co-obligor seeks a discharge or to restructure its liability on a jointly liable claim, section 524(e) effectively requires the co-obligor to commence its own bankruptcy case.

Id.

Tenth Circuit Decisions:

In In re Digital Impact, Inc., 223 B.R. 1 (Bankr. N.D.Okla. 1998), held that Section 524(e) was not intended to prohibit third-party releases.  Rather, it was intended to ensure those co-debtors or guarantors and their property, are not automatically released from the debt or guaranty upon the discharge of a debtor, and that the rights of creditors are not impaired by the debtor’s discharge.  Id. at 10.

Notwithstanding this fact, Digital Impact concluded that it lacked have subject matter jurisdiction to release third-party claims.  It noted that the statutory authority for subject matter jurisdiction in bankruptcy cases is found in 28 U.S.C. §1334, which (i) confers exclusive jurisdiction of cases under Title 11, and (ii) non-exclusive jurisdiction of civil proceedings arising under Title 11, or arising in or related to cases under Title 11, and all property of the debtor and property of the estate.  The court noted that the cases or controversies a non-debtor seeks to be released from are disputes between the non-debtor, and claimants against the non-debtor who also happen to be creditors, interest-holders, or claimants of the debtor, or any other party that would be bound upon confirmation of the Plan.  These controversies are not “cases under” Title 11, because neither the non-debtor nor his claimants are debtors in bankruptcy.  Controversies between the non-debtor and his claimants do not “arise under” the Code because the controversies contemplated are not limited to causes of action under the Code, such as avoidance actions.

The court further found that the claims sought to be released are not proceedings “arising in” or “related to” a case under Title 11 simply because the non-debtor was a proponent of the Plan.  The court stated as follows:

If proceedings over which the Court has no independent jurisdiction could be metamorphisized into proceedings within the Court’s jurisdiction by simply including the release in a proposed plan, this Court could acquire infinite jurisdiction.  Dickerson could conceivably insert into the Plan a release of his personal tax liabilities, a release of his home mortgage, and claim that this Court has jurisdiction over disputes between himself and the taxing authorities or his mortgagee because disputes are “related to” a Chapter 11 case by virtue of the release appearing in a Chapter 11 Plan.

The court further noted that a permanent injunction prohibiting certain legal action against a non-debtor is a final adjudication of such anticipated legal action in favor of the nondebtor, and all jurisdictional and due process prerequisites for such a final adjudication must be satisfied.  However, persons and entities who have not subjected themselves and all their assets to the bankruptcy process have not earned the protection of the court’s power to determine any claims by permanent injunction.

Eleventh Circuit Decisions:

In re Deresinski, 216 B.R. 995 (Bankr. M.D.Fla. 1998), held that non-debtor releases were possible.  The court stated that under appropriate circumstances, it may use its powers under Section 105(a) to issue a third-party injunction and release in order to effectuate a reorganization plan.  However, in Deresinski, the court found that a third-party injunction was inappropriate.  Significantly, it noted that the Chapter 11 case before it was a liquidation case.  As a result, substantial assets would not be contributed to the reorganization because the debtor was not reorganizing.  Also, in a liquidation case, a third-party injunction is not essential to the continued operation of the debtor because the purpose of such an injunction is to aid in the rehabilitation of an ongoing business.  In addition, the plan in Deresinski did not provide for the payment of substantially all of the claims of the classes effected by the injunction.  Finally, the debtors had not sufficiently demonstrated that each third party which was to benefit from the injunction and release had a sufficient “identity of interest” with the debtors.

In In re Transit Group, Inc., 286 B.R. 811 (Bankr. N.D.Fla. 2002), the debtor, through their plan of reorganization, sought to release claims against insiders, including current officers and related affiliates.  The debtor also sought releases for certain non-insiders, including members of the unsecured creditors committee, and the Debtor’s lenders, i.e., GECC and Congress Financial Corporation. 

With respect to GECC, the court held that a release was appropriate.  In reaching this conclusion, the court noted that GECC had extended substantial post-petition, debtor-in-possession financing.  As the debtor needed additional funds to operate, GECC supplied the supplemental financing, all of which was necessary to give the debtor a chance to reorganize.  GECC also agreed to provide exit financing under the plan.  Further, GECC had agreed to refinance its pre-petition secured debt and to subordinate much of its substantial debt in exchange for a 70% equity interest in the reorganized debtor.  Based on these facts, the court found the release appropriate. 

As to Congress, the debtor sought similar non-debtor relief.  Congress was the senior, secured lender in the case and held a first-priority lien on virtually all of the debtor’s assets.  During the case, Congress had supplied no unusual financing or assistance of any type.  Indeed, Congress had aggressively exercised its dominance as the first priority secured lender, offering the debtor headaches but little help.  The court, therefore, concluded that Congress did not do anything that would even remotely justify the extraordinary grant of a non-debtor release requested in the plan. 

Similarly, the debtor was unable to articulate a basis why members of the unsecured creditors committee should receive the benefit of a non-debtor release.  While the court stated that it was understandable that creditors committee members would like to obtain such a broad release, nothing in the Bankruptcy Code supported this type of request.  As for the release of insiders, the court noted that while there was the possibility that indemnity claims may exist, the debtor failed to establish that any such claims were eminent or likely.  Because there was no eminent threat of indemnity claims, there was no real risk that the reorganized debtor would have to pay indemnity claims made by these officers .  Nor was there any evidence regarding the estimated amounts of any such claims that the debtor would be required to pay.  Rather, the request for a non-debtor release appears prophylactic in nature and designed to ensure no such indemnification claims are ever asserted, regardless of whether any exist or the amount of any potential liability to the reorganized debtor.  Under these facts, releases were not appropriate.

In In re Mercedes Homes, Inc., 431 B.R. 869 (Bankr. S.D.Fla. 2009), the court noted that language of Section 524(e) explains the effect of a debtor’s discharge but does not prohibit the release of nondebtors. Id. at 879.  Nevertheless, the court noted that “an injunction is a dramatic measure to be used cautiously in unusual circumstances.”  Id. (quoting In re Dow Corning Corp., 280 F.3d at 658).  In determining whether nondebtor releases are necessary and fair, the court adopted the seven-factor test enunciated by the Sixth Circuit in In re Dow Corning Corp, and the court’s analysis of the first five factors follows:

The first factor is whether there is an identity of interests between the debtor and the third party, usually an indemnity relationship, such that a suit against the nondebtor would be, in essence, a suit against the debtor or would deplete the assets of the debtor.  In this case, the court noted that the plan provided that the reorganized debtor would assume any pre-petition date indemnification obligation to any current or former directors and officers employed by the debtor as of the effective date.  In this regard, the articles of incorporation of the debtor required the debtor to indemnify officers and directors from any claims or causes of action brought against them. Id.  This indemnification obligation established an identity of interest between the debtors and the directors and officers such that a suit against the directors and officers was, in essence, a suit against the debtors.

The second factor is whether the nondebtor has contributed substantial assets to the reorganization.  Here, the court noted that the officers and directors were also shareholders of a creditor with a $40 million deficiency claim against the debtors.  Under the plan, the directors and officers agreed to have this creditor waive its deficiency claim in exchange of the release.  This waiver made possible a distribution in the amount of $6 million to unsecured creditors, which was estimated to provide a distribution of approximately 15% to unsecured creditors.  Without the waiver, the recovery to unsecured creditors would be substantially diluted. Id. at 880.  The court found this contribution both substantial and critical.  In addition, the court found that the officers and directors possessed specialized knowledge and expertise that was critical to the debtors’ ability to operate within the business plan that outlined in the Plan, which special knowledge and expertise the officers and directors could use to compete against the debtors. Id. at 881.

The third factor was whether the injunction was essential to reorganization, namely, the reorganization hinged on the debtor being free from indirect suits against the parties who would have indemnity or contribution claims against the debtors.  In this case, the court noted that the special knowledge and expertise of the officers and directors, and their continuing agreement to manage the reorganized company rather than to compete against it, was critical to the successful operation of the reorganized company.  In other words, the officers and directors were “essential to the feasibility of the Debtors’ Plan.”  Id.

The fourth factor was whether the impacted class, or classes had overwhelmingly voted to accept the plan.  Here, all impaired classes entitled to vote to accept or reject the plan voted to accept the plan.  The only opposition to confirmation of the plan and the release came from a subset of interest holders that were not to receive or retain any property in the debtors due to operation of the absolute priority rule.  Id. at 882.

The fifth factor was whether the plan provided a mechanism to pay all, or substantially all, of the class, or classes, affected by the injunction.  In this case, the court found that the objecting creditors lacked standing to bring the type of claims against the officers and directors that were the subject of the release, and so this factor favored the release.  Id. at 883.

IRS Claims:

In In re Prescription Home Health Care, Inc., 316 F.3d 542 (5th Cir.2002), the issue involved a debtor’s attempt to impose a temporary injunction against the IRS precluding it from imposing IRC Section 6672(a) liability on an alleged “responsible party” who was the plan sponsor, thereby allowing the debtor an opportunity to satisfy its tax claims through the plan.  Specifically, the plan provided that upon confirmation, all creditors would be enjoined from any act to collect from the debtor’s “management and employees” any portion of a claim against the debtor, as long as it complied with the plan.

The court held that it lacked the jurisdiction to issue such an injunction against the IRS.  It reached this conclusion first noting that “it is well established that a more specific statute controls over a more general one.” Id. at 548.  Thus, the general “related to” jurisdiction of Section 1334(b) did not circumvent the specific grant of jurisdiction to the bankruptcy court to determine tax liabilities.  In other words, the court did not have the jurisdiction to adjudicate all tax matters that could conceivably affect the debtor’s estate.  “Such a reading would render superfluous Section 505’s grant of jurisdiction to determine the tax liabilities of the debtor or the estate.”  Id.

Moreover, even if the §6672 assessment would jeopardize the success of the plan, this cannot be sufficient to confer “related to” jurisdiction.  As the IRS points out, the theory that a bankruptcy court has jurisdiction to enjoin any activity that threatens the debtor’s reorganization prospects would permit the bankruptcy court to intervene in a wide variety of third-party disputes.  For example, the bankruptcy court would have jurisdiction over any action (however personal) against key corporate employees, if they were willing to state that their morale, concentration, or personal credit would be adversely affected by the action.

Id.

 

Matthew T. Gensburg
mgensburg@gcklegal.com