Chapter 11 Working Group Proposal #6: Release of Claims Against Non-Debtor Parties

The successful rehabilitation of a business involves the discharge of the debtor’s liability for certain prepetition claims. A debtor or plan proponent also might seek to release non-debtor parties from liability, either through the plan of reorganization or using the bankruptcy court’s equitable powers in a settlement. A third party release may be necessary to solicit new capital, to attract and retain key managers or directors, or to settle expensive lawsuits against third parties in which the debtor company would remain entwined. Although many would agree that the release of third parties through the bankruptcy process is entirely appropriate in some circumstances, and can be gauged on a case-by-case basis, courts are split over whether the Bankruptcy Code authorizes such releases at all.

The Recommendation

Congress should amend sections 1123 and 524(e) to clarify that within the discretion of the court, a plan proponent may solicit releases of non-debtor liabilities. Creditors that agree to release non-debtor parties will be bound by such releases, whereas creditors that decline to release their claims against non-debtor parties will not be bound to release their claims.

Reasons for the Change

This issue can arise either in a plan of reorganization or in a settlement that may require injunctive enforcement. Practitioners, judges, and scholars have agreed that the case law on the permissibility of third party releases is in disarray and requires statutory clarification. The Bankruptcy Code provides in section 524(e) that the "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." Yet, section 105 authorizes the court to "issue any order, process or judgment that is necessary or appropriate to carry out the provisions of this title." A third party release may provide a necessary benefit to the estate that may be integral to the success of the reorganization, but courts disagree about whether such provision may be included in a plan of reorganization and subsequently enforced by a bankruptcy court injunction.

Based in part on the language of section 524(e), some circuit courts of appeal have held that bankruptcy courts lack the power to prevent a creditor from enforcing a judgment against a nondebtor party. [ FN: Resorts Internat ’l v. Lowenschuss , 67 F.3d 1394 (9th Cir. 1995), citing American Hardwoods Inc. v. Deutsche Credit Corp. , 885 F.2d 621, 625 (9th Cir. 1989) (section 524(e) precludes bankruptcy courts from discharging liabilities of non-debtors, and "the specific provisions of section 524 displace the court's equitable powers under section 105 to order the permanent relief "); Landsing Diversified Properties-II v. First Nat ’l Bank and Trust Co. of Tulsa , 922 F.2d 592, 600 (10th Cir. 1990)( "Congress did not intend to extend such benefits to third - party bystanders "), modified sub nom. , Abel v. West , 932 F.2d 898 (10th Cir. 1991). .] Conversely, according to other circuit courts, the statute does not impose aper se rule against permitting and enforcing third party releases. [ FN: In re A.H. Robins Inc. , 880 F.2d 694, 702 (4th Cir. 1989); Shearson Lehman Bros. Inc. v. Munford Inc. , 97 F.3d 449, 454 (11th Cir. 1996) (using section 105(a) and Fed. R. Civ. P. 16(9) to enjoin actions by nonsettling defendants against non-debtor consulting firm); In re Specialty Equipment Cos. Inc. , 3 F.3d 1043, 1046 (7th Cir. 1993) (statute does not preclude all releases that are accepted and confirmed as integral part of reorganization); See also In re AOV Indus. Inc. , 792 F.2d 1140 (D.C. Cir. 1986) (recognizing viability of third party release when addressing equality of treatment of creditors), vacated on other grounds , 797 F.2d 1004 (D.C. Cir. 1986). See also Feld v. Zale Corp. , 62 F.3d 746 (5th Cir. 1995) (when courts find "related to " jurisdiction over third party actions, it is because subject of dispute is property of estate or because dispute over asset would have effect on estate), citing Pacor Inc. v. Higgins , 743 F.2d 984, 994 (3d Cir. 1984) (action is related to bankruptcy if outcome could alter debtor ’s rights, liabilities, options, or freedom of action).]

The chapter 11 Working Group devoted its full session in January to this topic. At that session, the discussants generally agreed that the use of third party releases in bankruptcy is entirely appropriate in some circumstances and the Code should make clear that third party releases are not prohibited wholesale. Many circumstances give rise to requests for third party releases, such as guaranties, new contributions by large shareholders who in return seek release from potential liabilities, sales free and clear, lender liability claims, ERISA claims, director and officer shareholder litigation, and insurance and co-liability in both tort and contract. In many instances, the debtor and its creditors will benefit from the release of claims against third parties. The discussants contemplated that bankruptcy court discretion may be necessary to assess the propriety of a third party release in a given instance. The court might consider whether a third party suit would deplete assets necessary for the reorganization, whether enjoining actions against certain third parties will significantly aid the reorganization, or whether the non-debtor will contribute substantial assets or otherwise add value to the reorganized enterprise. [ FN: See , e.g. , In re Master Mortgage Investment Fund Inc. , 168 B.R. 930, 935 (Bankr. W.D. Mo. 1994) (providing overview of factors that courts have considered in permitting third party releases).] Some injunctive power would be necessary to enforce third party releases, although it already is the case that plan provisions may be res judicata in a subsequent action. [ FN: Stoll v. Gottlieb , 305 U.S. 165, reh ’g denied , 305 U.S. 675 (1938), cited in Republic Supply Co. v. Shoaf , 815 F.2d 1046, 1050 (5th Cir. 1987) (final and unappealed confirmation order may discharge non-debtor guarantor by virtue of res judicata); Monarch Life Insurance Co. Ropes & Gray , 65 F.2d 973, 983 (1st Cir. 1995).]

At the same time, there has been recognition that a third party release may be inappropriate in some instances, again requiring the sound discretion of a bankruptcy judge. As an additional safeguard, the proposal would permit only voluntary releases; the majority of a class could not bind a dissenting creditor and force it to release its claim.

This proposal does not address channeling injunctions authorized by section 524(g) of the Bankruptcy Code, nor is it intended to address issues unique to partnership cases, all of which theCommission will assess separately.

Competing Considerations

Some might argue that the proposal is too narrow. Per this view, the majority of a class should be able to bind the minority on all issues, including whether class claimants will release non-debtor parties from certain liabilities. Otherwise, the minority might be able to exercise undue leverage and derail a plan of reorganization even though the majority has found it acceptable to release claims against third parties. For example, one may find it appropriate for the majority to bind the minority if the majority agreed that releasing directors and officers from a particular liability would be essential to the success of the reorganization. However, it also has been suggested that this more permissive approach would impose only nominal checks on self-dealing and would afford too little protection to creditors who would not be able to opt out of the release.

Others have argued that a bankruptcy discharge is a creature of federal bankruptcy law, not of contractual consent. Permitting any third party releases in bankruptcy would extend bankruptcy court intervention well beyond the confines of a bankruptcy case.