In light of recent examples of corporate mismanagement, whether a bankruptcy court can or should effectively discharge claims against third-party non-debtor entities through a permanent post-confirmation injunction continues to be a debated "on-the-edge" topic in the world of chapter 11 bankruptcies.

Upon confirmation of a reorganization plan in a chapter 11 case, the debts of the bankrupt entity are discharged pursuant to §1141(d) of the Bankruptcy Code. 11 U.S.C. §1141(d) (2003). While this discharge does not apply to non-debtor entities, debtors have sought to expand the scope of the discharge to include the release of claims against third-party non-debtor entities including insiders and affiliates of the debtor. "Reorganization plans now contain release provisions that purport to permanently discharge the liability of other parties, such as the bankrupt entity's insiders, partners, affiliates, plan funders or other individuals or entities that contribute to the reorganization process." In re Transit Group Inc., 286 B.R. 811, 815 (Bankr. M.D. Fla. 2002).

Currently, the circuits are split on the question of whether a bankruptcy court can, under any circumstances, issue a permanent injunction that protects third-party non-debtors from liability post-confirmation. The grounds for this disagreement among the circuits primarily centers around conflicting applications of the broad equitable powers found in Code §105(a) and the discharge provisions of §524(e).

The Second, Third, Fourth, Sixth and Seventh Circuits are considered "pro-release" courts, holding that bankruptcy courts have the power under §105(a) to issue permanent injunctions or third-party releases when appropriate and depending on what factual circumstances exist. See In re Drexel Burnham Lambert Group Inc., 960 F.2d 285, 292 (2d Cir. 1992); In re Continental Airlines, 203 F.3d 203, 214 (3d Cir. 2000); In re A.H. Robins Co. Inc., 880 F.2d 694, 700-02 (4th Cir. 1989); In re Dow Corning Corp., 280 F.3d 648, 658 (6th Cir. 2002); In re Specialty Equipment Cos., 3 F.3d 1043, 1047 (7th Cir. 1993) (The Seventh Circuit has approved permanent post-confirmation injunctions enjoining actions against third parties, but only with respect to those creditors who consent to the relief). These circuits do not find any conflict between §§105(a) and 524(e).

For example, the Sixth Circuit in the Dow Corning decision recognized that a bankruptcy court, acting consistent with the Bankruptcy Code, functions as a forum for resolving large and complex mass litigations and has substantial power to reorder creditor-debtor relations needed to achieve a successful reorganization. See Dow Corning Corp., 280 F.3d at 656; see, also, 11 U.S.C. §§105(a) and 1123(b)(6) (Section 1123 (b)(6) permits a reorganization plan to "include any...appropriate provision not inconsistent with the applicable provisions of this title").

The First, Eleventh and D.C. Circuits align themselves with the "pro-release" circuits. Although not considering in a direct fashion the issue of whether a bankruptcy court has authority to approve third-party non-debtor releases, the courts recognize the ability to approve third-party non-debtor releases in the context of settlement agreements. See In re Munford Inc., 97 F.3d 449 (11th Cir. 1996); In re Monarch Life Insurance Co., 65 F.3d 973, 984-85 (recognizing that the court had the power to approve releases and issue third-party non-debtor releases). In In re AOV Industries, 792 F.2d 1140 (D.C. Cir. 1986), the court affirmed confirmation of a reorganization plan and noted that the district court's approval of the plan containing third-party non-debtor releases did not constitute an impermissible discharge. See AOV Industries, 792 F.2d at 1152.

In contrast to the "pro-release" position, the Ninth and Tenth Circuits prohibit third-party non-debtor releases altogether and find a direct conflict between the preclusive effect of §524(e) and the application of the broad equitable powers found in §105(a). See In re Lowenschuss, 67 F.3d 1394, 1401-02 (9th Cir. 1995) cert. denied, 517 U.S. 1243 (1996); In re Western Real Estate Fund Inc., 922 F.2d 592, 601 (10th Cir. 1990); In re American Hardwoods Inc., 885 F.2d 621, 625-26 (9th Cir. 1989). However, this conclusion is flawed because nothing in §524(e) prevents the application of §105(a). The two provisions are not mutually exclusive. Although §524(e) explains the effect of a debtor's discharge, it does not prohibit the release of a non-debtor. See Dow Corning Corp., 280 F.3d at 657; Specialty Equipment Corp., 3 F.3d at 1047 (The language of §524(e) does not purport to limit or restrict the power of the bankruptcy court to otherwise grant a release to a third party).

Without resolving the dispute between the circuits, this article will outline the factors that courts consider in determining whether the inclusion of a third-party non-debtor release is an appropriate provision of a reorganization plan pursuant to §1123 (b)(6). At a minimum, "pro-release" courts require that the third-party non-debtor releases be fair and necessary. In addition, the use of such releases is justified only in unusual circumstances. "Routine inclusion is not appropriate." See Transit Group, 286 B.R. at 817.

One example of unusual circumstances is debtors engaged in extensive, nationwide product-liability litigation, like in the Dow Corning and A.H. Robins bankruptcy cases. See, e.g., Dow Corning, 280 F.3d 648; A.H. Robins Co. Inc., 880 F.2d 694. Additional examples include the unusual circumstances existing in the Drexel Burnham bankruptcy case. In Drexel Burnham, non-debtor parties, specifically the debtor's management, paid a large settlement to the Securities and Exchange Commission for the benefit of the corporation that they would not have paid but for a release from further claims. See Drexel Burnham, 960 F.2d 285. In addition to the general requirements set forth above, over time seven specific factors have evolved for courts to consider. These factors include:

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;
2. Whether the non-debtor has contributed substantial assets to the reorganization;
3. Whether the injunction is essential to reorganization—namely, whether 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;
6. Whether the plan provides an opportunity for those claimants who choose not to settle to recover in full, and;
7. Whether the bankruptcy court made a record of specific factual findings that support its conclusions.

See Dow Corning, 280 F.3d at 658; Transit Group, 286 B.R. at 817.

Applicable case law dictates that, in order for a debtor to confirm a reorganization plan containing a non-debtor release, the debtor must demonstrate that (1) unusual circumstances exist and (2) the non-debtor release is fair and necessary, utilizing the seven factors. See Transit Group, 286 B.R. at 817. Therefore, case-by-case analysis is required. See Id.; Dow Corning, 280 F.3d at 658. "Allowing non-debtor releases is the exception, not the norm. Debtors should not automatically expect to release officers, directors, insurers or creditors from future liability, unless some extraordinary reason is proven." Transit Group, 286 B.R. at 818.

Not only should courts apply the above analysis on a case-by-case basis, but if a number of releases are requested in the reorganization plan, the court should examine the basis for each release individually.

For example, under Dow Corning's reorganization plan, a $2.35 billion fund was established for the payment of claims asserted by various groups of creditors. Dow Corning, 280 F.3d at 654-55. The $2.35 billion fund was established with funds contributed by the debtor's products liability insurers, shareholders and operating cash reserves. Dow Corning, 280 F.3d at 654-55. As a quid pro quo for making proceeds available for the fund, a section of the reorganization plan released the company's insurers and shareholders from all further liability related to a number of different claims. The Sixth Circuit confirmed that third-party non-debtor releases are permissible under appropriate circumstances, but remanded the case to the district court for a determination that the releases were warranted as to each non-debtor entity. See Id. at 653.

Further, the bankruptcy court in the recent Transit Group decision also evaluated each third-party non-debtor release sought by the debtor through the reorganization plan on an individual basis. See Transit Group, 286 B.R. 817-20. The court held that the third party non-debtor releases and related injunctions for the company's current officers and a number of the members of the unsecured creditors' committee were not fair, necessary or supported by any factual findings. See Id. at 820-21. However, the court did uphold one release to the creditor that extended substantial post-petition debtor-in-possession financing to the company. See Id. As the debtor continued to need funds during the course of the bankruptcy, this creditor supplied additional financing and agreed to provide exit financing under the reorganization plan. The debtor needed every bit of this funding to have a chance of reorganization. See Id.

As reflected in the Transit Group and Dow Corning decisions discussed above, in a "pro-release" circuit, a debtor can expect a detailed examination by the court in determining whether a requested third-party non-debtor release is appropriate. Accordingly, third-party non-debtor releases should be saved for unusual circumstances and in cases where such releases are essential to a debtor's successful reorganization.

Footnotes

¹ Board-certified in business bankruptcy by the American Board of Certification. Return to article