Rochelle's Daily Wire

The Sixth Circuit banned district courts from granting nondebtor releases in equity receiverships. More precisely, the Cincinnati-based appeals court ruled that an equity receivership cannot stop creditors from pursing their direct claims (as opposed to derivative claims) against nondebtors.

The rationale was simple: Nondebtor releases were previously unknown to equity jurisprudence. As a result, the circuit said that an equity receivership cannot protect the non-receivership assets of non-receivership parties.

Most insolvencies end up in chapter 11, so the February 7 opinion may have limited practical application. Still, the February 7 opinion is food for thought: Is the Sixth Circuit an example of growing antipathy by Article III judges toward nondebtor releases, even in chapter 11 cases? Does the opinion suggest that the Sixth Circuit may revisit or limit its own decision that allowed nondebtor releases in In re Dow Corning Corp., 280 F.3d 648 (6th Cir. 2002)?

The Bankruptcy that Wasn’t in Bankruptcy

The nonprofit debtor purchased and for a short time operated three “university” systems with dozens of campuses. The venture soon became insolvent. The debtor contended that the for-profit seller had misrepresented revenues and expenses.

Students filed a class action against the debtor and its officers and directors, alleging that the debtor represented that it was accredited when the accreditation had been lifted. The suit alleged fraud.

A creditor owed $250,000 filed a diversity action in federal district court in Ohio, seeking appointment of a receiver. The debtor “quickly consented” to the receivership, Circuit Judge Eric E. Murphy said.

Why not chapter 11 instead of a receivership? Judge Murphy explained how the debtor believed that bankruptcy would cut off its income because students would be unable to take down federal loans to pay tuition.

The debtor’s assets included directors’ and officers’ liability insurance policies. The receiver negotiated a settlement for the insurer to pay $8.5 million, the unused portion of coverage provided by a D&O policy. The receiver justified the settlement by saying that the receivership estate had claims against the policy.

There was a hitch, though: The insurance company wanted a so-called bar order preventing creditors from suing based on the policy. The receiver agreed. As consolation for the class plaintiffs, the settlement allowed the class claimants to file claims in the receivership.

As ultimately drafted, the bar order enjoined creditors, including the class plaintiffs, from suing not only the debtor but also the nondebtor parent, officers and directors and the insurance company. The class plaintiffs objected, but the district court approved the settlement and the bar order. The class plaintiffs appealed to the circuit and won.

The History of Equity Receivers

Judge Murphy said that the case presented a legal question: Did the district court have “power to enter the Bar Order that enjoined the [class plaintiffs’] claims not just against the receivership entities . . . but also against third parties outside the receivership”? [Emphasis in original.]

To answer the question, Judge Murphy traced the history of equity receiverships going back 500 years in England and the refinements in the U.S. in later decades. The opinion is worth reading as a refresher course on the jurisdiction and powers underlying equity receiverships.

Judge Murphy said that equity receiverships “remain a reorganization option” for companies that otherwise could file bankruptcy petitions.

Today, Judge Murphy said, equity receiverships are governed by Federal Rule 66, which says that “the practice in administering an estate by a receiver or similar court-appointed officer must accord with the historical practice in federal courts or with a local rule.”

Citing the Supreme Court’s decision in Grupo Mexicano de Desarrollo S.A. v. Alliance Bond Fund, Inc., 527 U.S. 308, 318-319, 322 (1999), Judge Murphy said that “a federal court’s exercise of its equitable powers must fall within the traditional principles of equity exercised by the High Court of Chancery in England at the founding.”

Judge Murphy explained that the court in an equity receivership has quasi in rem jurisdiction over the corporate debtor and its property. Over the res, the jurisdiction is exclusive, he said. The court therefore “could issue a variety of injunctions to protect its exclusive jurisdiction over the debtor’s property.” In addition, the receiver has power to bring claims held by the debtor.

Judge Murphy turned to the limitations on a receiver’s power. If there could be no effect on receivership property, there could be no injunction. Indeed, the receivership court could not enjoin suit against a debtor if it sought only an in personam judgment and did not threaten receivership property.

The Principles Applied to the Case on Appeal

The class plaintiffs had fraud claims against non-receivership entities and individuals. In fact, the claims were not covered by the insurance policy because the policy excluded claims for fraud. Consequently, the class claims did not threaten to diminish the policy proceeds. Judge Murphy had no reason to decide whether insurance proceeds were estate property, because the class claims would not become a charge against the policy.

Judge Murphy concluded that the class fraud claims were not derivative of the claims that the receiver would have against the directors and officers. The claims did not represent “injuries that [the class] incurred indirectly as a result of a harm that the directors and officers caused [the debtor].” Thus, the class claims were “direct” claims belonging to the class members.

In sum, the class claims belonged to the class alone and did not threaten to invade insurance proceeds. Judge Murphy said that the court might have issued a narrow injunction preventing the insurance company from paying defense costs in the class suit, but the “Bar Order, in enjoining all personal-liability claims against [the debtor’s] directors and officers, went far beyond this narrow property-protective injunction.”

The Analogy to Chapter 11 Nondebtor Injunctions

Judge Murphy said that “[o]ur bankruptcy precedent confirms that the Bar Order cannot stand on traditional equity principles.” He cited the Fifth and Tenth Circuits for prohibiting injunctions to protect nondebtors.

Citing Dow Corning, Judge Murphy said that his circuit was among those protecting nondebtors. Those injunctions, he said, “have obtained a judicial foothold only in the last several decades.”

“The relative recency of this innovation provides strong evidence that it lacks roots in ‘the principles applied by the English Court of Chancery before 1789, as they have been developed in the federal courts,’” he said, citing Grupo Mexicano.

Judge Murphy justified Dow Corning’s injunction prohibiting suit against nondebtors as having been based on Section 105 of the Bankruptcy Code. For equity receiverships, on the other hand, he implied that there is no Section 105 counterpart.

Having distinguished Dow Corning, Judge Murphy reversed the order approving the settlement and the bar order because a court of equity could not have granted that type of relief.