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.