Chapter 11 Non-Debtor Release Provisions: The High Burden Officers and Directors Must Meet
By: Ashraf Mokbel
St. John’s Law Student
American Bankruptcy Institute Law Review Staff
Recently, in National Heritage Foundation Inc. v. Highbourne Foundation,[i] the Fourth Circuit held that a non-debtor release provision in a chapter 11 reorganization plan was not warranted by the circumstances of the case because the court found that the bankruptcy case would not be adversely affected if the provision was not included in the plan.[ii]
In National Heritage Foundation, a non-profit public charity that administered and maintained donor-advised funds voluntarily filed for bankruptcy under chapter 11 of the Bankruptcy Code after a state court entered a multi-million dollar judgment against the charity.[iii] As part of its chapter 11 case, the charity proposed a plan that contained a broad non-debtor release provision that would have shielded all of the charity’s officers, directors, and employees from any lawsuit stemming from the bankruptcy or the actions the charity or its officers, directors, and employees took prior to the bankruptcy.[iv] After several revisions, the bankruptcy court initially confirmed a reorganization plan that contained the proposed non-debtor release provision.[v]
The impacted parties appealed the non-debtor release provision ruling to the district court, which affirmed the confirmation order.[vi] The impacted parties then appealed to the Fourth Circuit, which remanded the case after finding that the bankruptcy court’s record contained insufficient factual findings to support the alleged necessity of the provision.[vii] On remand, the bankruptcy court refused to confirm the plan because the court found the non-debtor release provision was not warranted by the circumstances of the case.[viii] The charity appealed to the district court, which affirmed the bankruptcy court. The charity then appealed to the Fourth Circuit, which also affirmed.[ix]
The circuits have split as to whether non-debtor release provisions are permissible under the Bankruptcy Code. On one hand, the Fifth, Ninth, and Tenth Circuits have refused to confirm plans with non-debtor releases because these courts have narrowly interpreted section 524(e) of the Bankruptcy Code.[x] Under these circuits’ reasoning, a bankruptcy court cannot confirm a plan that contains a non-debtor release provision because the court lacks the power to affect the liabilities of third parties.[xi] On the other hand, the Second, Fourth, Sixth, and Seventh Circuits have held that, in limited circumstances, a bankruptcy court overseeing a chapter 11 plan can release non-debtors if such a release is in the best interest of the reorganization.[xii] Moreover, while these circuits do not apply the same test, they all agree that a non-debtor release should only be permitted in the rare circumstance that the release is vital to the debtor’s successful reorganization.[xiii]
Consistent with its previous decisions, the National Heritage Foundation, the Fourth Circuit adopted the majority rule and applied the six factors articulated by the Sixth Circuit in Class Five Nevada Claimants v. Dow Corning Corp. (In re Dow Corning Corp.) to determine whether the non-debtor release provision was permissible.[xiv] The only Dow factor that weighed in the charity’s favor was the presence of an identity of interests between the charity and the third parties that would be released under the plan.[xv] Indeed, almost all of the Dow factors weighed against allowing the non-debtor release provision.[xvi] In particular, the Fourth Circuit expressed concern that the charity’s non-debtor provision did not take into account the desires, needs, or concerns of the impacted parties.[xvii] Moreover, the provision did not provide a mechanism to pay the impacted parties’ claims affected by the non-debtor release.[xviii] Nor did the plan provide an opportunity for claimants who chose not to settle to recover in full.[xix] Finally, the charity did not put forth any convincing evidence or facts that showed the non-debtor release provision was necessary to successful reorganization.[xx] On the contrary, the Fourth Circuit concluded that the charity would be able to reorganize successfully without the provision[xxi] because the court found that the directors and officers failed to show that they provided any sort of cognizable contribution to the charity’s reorganization.[xxii]
National Heritage Foundation is an important decision because the Fourth Circuit demonstrate that while non-debtor releases are permissible in theory under the majority view, in practice, such provisions are often not permissible. As the Fourth Circuit emphasized, a debtor’s directors and officers cannot shield themselves from liability by using a non-debtor release provision unless such a provision would provide a benefit to creditors and other parties impacted by the reorganization.[xxiii] Indeed, in National Heritage Foundation, the Fourth Circuit refused to confirm the charity’s proposed plan because the non-debtor release did not benefit, and in fact harmed, creditors.[xxiv] Thus, at the end of the day, the real lesson from National Heritage Foundation and the other decisions adopting the majority view for the permissibility of non-debtor release provisions appears to be that under majority view is very difficult for a debtor’s directors and officers shield themselves from liability under the debtor’s plan of reorganization. Further, it is important to remember that under the minority view, it is impossible to confirm a plan with a non-debtor release provision.
[i] 760 F.3d 344 (4th Cir. 2014)
[ii] Id. at 347.
[iii] Id. at 346.
[vi] Nat’l Heritage Found. Inc., 760 F.3d at 346–7.
[ix] Id. at 347.
[x] See In re Zale Corp., 62 F.3d 746 (5th Cir. 1995) (finding that because a permanent injunction improperly discharged a potential debt of a non-debtor the bankruptcy court exceeded its powers under Section 105); In re Lowenschuss, 67 F.3d 1394 (9th Cir. 1995) (affirming the district court’s decision to vacate a release provision because the bankruptcy court lacked the power to approve a provision); In re W. Real Estate Fund, 922 F.2d 592 (10th Cir. 1990) (holding that a permanent injunction relieving a non-debtor from its liability to a creditor is inappropriate).
[xi] See generally In re Zale Corp., 62 F.3d 745; In re Lowenschuss, 67 F.3d 1394; In re W. Real Estate Fund, 922 F.2d 592.
[xii] See In re Metromedia Fiber Network, 416 F.3d 136, 141 (2d Cir. 2005) (“[I]t is clear that such a release is proper only in rare cases.”); In re AH Robins, Inc., 880 F.2d 694 (4th Cir. 1989); In re Dow Corning Corp., 280 F.3d 648 (6th Cir. 2002); In re Specialty Equip. Co., 3 F.3d 1043, 1047 (7th Cir. 1993) (“[The language of Section 524(e)] does not purport to limit or restrict the power of the bankruptcy court to otherwise grant a release to a third party.”). As mentioned in the text above, the Fourth Circuit has adopted the Sixth Circuit’s test for determining whether a non-debtor release provision is permissible. However, the Second Circuit uses a different approach. It does not put forth a specific test with prongs and factors. Instead, the Second Circuit reluctantly allows non-debtor releases only if the release plays a crucial role in the debtor’s reorganization plan. To aid courts in determine whether the non-debtor release is crucial, the Second Circuit articulates two questions that the lower courts must raise and answer. First, whether the non-debtor release is essential to the success of the reorganization. Second, whether the breath of the non-debtor release is necessary.
[xiii] In re Metromedia Fiber Network, 416 F.3d at 141; In re Specialty Equip. Co., 3 F.3d at 1047; In re Dow Corning Corp., 280 F.3d at 346–7.
[xiv] Id. at 347–8.; The six Dow factors are as follow: (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 for 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.
[xv] Nat’l Heritage Found. Inc, 760 F.3d at 347.
[xvi] Id. at 348–9.
[xix] Nat’l Heritage Found. Inc, 760 F.3d at 348–9.
[xxii] Id. at 349.
[xxiii] Id. at 349–351.