The Permissibility of Exculpation Clauses Post-Purdue

By Michael Lathwell

Exculpation grants a party immunity from suit for their actions during the administration of a bankruptcy case.1 Parties typically shielded by exculpation clauses include debtors, creditors’ committees and professionals hired to help administer the estate.2

However, the U.S. Supreme Court’s ruling in Harrington v. Purdue Pharma has cast doubt on the permissibility of third-party exculpation.3 The Court held that the judiciary has no power to authorize nonconsensual third-party releases.4 Third-party releases and exculpation clauses are very similar, so by implication, the Court’s ruling may mean that the judiciary cannot authorize nonconsensual third-party exculpation clauses, either.5 Thus, the question presented is this: After Purdue, are nonconsensual third-party exculpation clauses permissible?

What Are Exculpation Clauses?

Exculpation clauses immunize those who administer the bankruptcy for their actions taken during the case.6 If a very litigious person is involved in the proceedings, others might not want to assist out of concern of being sued themselves.7 To quell these concerns, parties can offer to incorporate exculpation clauses into the reorganization plan.

Exculpation clauses are a common component of chapter 11 restructuring cases.8 To justify exculpation, courts have often pointed to two Bankruptcy Code provisions: 11 U.S.C. §§ 105(a) and 1123(b).9 Although neither provision explicitly allows exculpation, some courts have held that these provisions grant the court equitable powers to authorize exculpation.10

Third-Party Releases vs. Exculpation

Third-party releases are similar to exculpation clauses, leading some to say that exculpation clauses are a subspecies of third-party releases, but they differ in several respects.11 Exculpation clauses safeguard parties from liability for post-petition conduct tied to the bankruptcy administration,12 while third-party releases grant immunity primarily for conduct unrelated to the bankruptcy administration.13 In other words, third-party releases excuse conduct that could have caused the company’s financial woes, while exculpation excuses actions taken during the clean-up of the situation in bankruptcy. Historically, nonconsensual third-party releases were often used to help expedite cases,14 but the Supreme Court held in Purdue that they are impermissible.15

Gatekeeping Provisions vs. Exculpation

Another way to protect parties who are assisting in bankruptcy administration is to use gatekeeping provisions, which also differ from exculpation in several respects.16 Gatekeeping provisions provide that if a litigant wants to sue a trustee or court-appointed officer, the bankruptcy court must first determine whether the claim is “colorable.”17 Thus, the bankruptcy court acts as a gatekeeper to prevent frivolous claims from being brought.

The court’s authority to approve these provisions stems from a nineteenth-century Supreme Court case. In Barton v. Barbour,18 the Court held that “before a lawsuit is brought against a receiver, leave of the court by which he was appointed must be obtained.”19 Thus, gatekeeping provisions are different from exculpation because while they do not provide automatic immunity for individuals, they shield them from frivolous suits. Gatekeeping provisions also only cover trustees or court-appointed officers,20 while exculpation clauses protect a broader range of people.

Circuit Split

Prior to Purdue, the circuits were split over the permissibility of third-party releases and exculpation.21 The majority view was that releases and exculpation were allowable to varying degrees, even for third parties.22 A minority of circuits held that releases and exculpation were only allowable for first parties, such as the debtor and creditors’ committee, and not for third parties.23 The dispute largely centered around competing interpretations of § 524(e) and whether it bars the release and exculpation of third parties. Purdue resolved this split as far as third-party releases, but did not specifically address exculpation.24

Harrington v. Purdue Pharma’s Ruling on Third-Party Releases

Purdue has raised doubt about third-party exculpation permissibility because the Supreme Court held that nonconsensual third-party releases are impermissible, and exculpation clauses are similar to third-party releases.25 Purdue Pharma manufactured a drug called Oxycontin and was accused of deceptive marketing.26 Many people overdosed on Oxycontin; facing mass tort liability,27 Purdue filed for bankruptcy. Purdue Pharma’s owners, the Sackler family, offered to contribute $4 billion to the estate in exchange for a personal release from liability.28 The plan was approved, but the U.S. Trustee appealed.29 The Supreme Court granted certiorari.30

Purdue focused on whether courts have the power to authorize nonconsensual third-party releases and from where that power may come. The plan proponents argued that § 1123(b) was the wellspring of that power.31

Section 1123(b) has five provisions “address[ing] claims and property damage belonging to a debtor or its estate.” However, § 1123(b)(6) provides that a plan may “include any other appropriate provision not inconsistent with the applicable provisions of this title.” The plan proponents argued that § 1123(b)(6) grants the court equitable power to approve a nonconsensual third-party release.32

Unpersuaded, the Court held that § 1123(b)(6) should be interpreted in the context of surrounding provisions, and § 1123(b)(1)-(5) are specifically geared toward the debtor’s claims — not third-party claims.33 Thus, the ability to excuse third-party actions cannot be ascribed to § 1123(b)(6).

The plan proponents also contended that § 105(a) grants the Court equitable power to allow third-party releases, but the Court disagreed — again.34 Section 105(a) provides that courts can “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of” the Bankruptcy Code. However, the Court noted that this only allows the judiciary to carry out existing Code provisions, and nothing expressly authorizes third-party releases.35

Implications of the Supreme Court’s Purdue Holding

The Supreme Court held that the Bankruptcy Code does not grant courts the equitable power to authorize nonconsensual third-party releases, which raises the question of whether courts have the equitable power to authorize third-party exculpation clauses. As exculpation clauses are a species of third-party release, a strict reading of the Court’s holding seems to also preclude exculpation clauses. The Court held that the Code does not “provide ... a bankruptcy court with a roving commission to resolve all such problems that happen its way, blind to the role other mechanisms (legislation, class actions, multi-district litigation, [and] consensual settlements, among others) play in addressing them.”36 Furthermore, the Court held that the plan proponents failed to identify any provision bestowing courts with the equitable power to authorize nonconsensual third-party releases; thus, it is questionable whether any provision grants the equitable power to permit third-party exculpation.37

Exculpation proponents might argue that the Court’s holding did not address exculpation clauses, as the Court stated that it was narrowing its holding to only nonconsensual third-party releases.38 The Court only ruled on the issue that was presented, so just because nonconsensual third-party exculpation was specifically precluded, it does not mean that it is allowed. The Court’s holding prohibits third-party exculpation by implication, but it recently denied certiorari for a petition filed after Purdue asking for a ruling specifically on exculpation.39 How the courts will interpret Purdue in the context of exculpation is unknown at this time.

Implications of NexPoint Advisors v. Highland Capital Management

Although it was decided pre-Purdue, NexPoint Advisors v. Highland Capital Management40 is a blueprint for future rulings because the Fifth Circuit held that nonconsensual third-party releases are impermissible.41 Highland is also a good example of when an exculpation clause is needed to protect parties from vexatious litigation.

Highland Capital was in dire financial straits and filed for bankruptcy.42 Co-founder James Dondero was allegedly unhappy, as he had to step down from his position and he disagreed with the reorganization process.43 Dondero allegedly tried to frustrate the bankruptcy process by interfering with Highland Capital’s management, and blocking trades between the company and its clients.44 An exculpation clause in the reorganization plan covered a wide range of people: debtors, creditors and other professionals — but excluded Dondero.45 The bankruptcy court approved the reorganization plan, including the exculpation clause, and Dondero appealed.46

The Fifth Circuit held that the exculpation clause was invalid because it was overbroad and exculpated third parties.47 Highland Capital argued that the plan only exculpated post-petition conduct related to the case and thus should be valid.48 However, the court specifically referenced § 524(e), which “categorically bars third-party exculpations absent express authority in another provision of the Bankruptcy Code.” Highland Capital failed to identify any other provisions authorizing third-party exculpation.49

The Fifth Circuit identified two sources of authority that explicitly allow exculpation: one that permits it in asbestos cases, and another that allows for creditors’ committee member exculpation.50 However, the court noted that the debtors failed to unearth any provisions granting the court power to authorize third-party exculpation.51

The court upheld a gatekeeping provision.52 Invoking the Barton doctrine, the Fifth Circuit held that bankruptcy courts have the power to oversee claims brought against the trustee or other bankruptcy court-appointed officers.53 Thus, because neither Highland nor Purdue allowed third-party releases (but Highland still allowed gatekeeping provisions), they might still be permissible post-Purdue, albeit for a more limited range of parties than exculpation clauses cover.

Recommendation

As third-party exculpations are no longer permissible under Purdue, there is a possible legislative solution: Amend the Bankruptcy Code to explicitly allow for exculpation and to set its parameters. This would protect third-party exculpation in the future and would promote participation in the administration of restructuring. This action is not entirely unprecedented, as Congress chose to amend the Code and specifically allow for nonconsensual third-party releases from asbestos liability under § 524(g).54

There are also several considerations when filing for chapter 11 post-Purdue. Purdue applies to nonconsensual third-party releases,55 which heightens the importance of getting a consensual exculpation clause, as nonconsensual exculpation might no longer be allowed. In addition, while filing for chapter 11 is sometimes unavoidable, if the company can still operate, it might not be worth filing for chapter 11 because courts can no longer authorize nonconsensual third-party releases for such key parties as shareholders and executives.56 As such, courts could approve exculpation clauses for key parties. International entities also might want to consider filing their bankruptcy cases abroad in a country that still allows nonconsensual third-party releases57 and exculpation

Conclusion

Only time will tell whether third-party exculpation will be permissible after Purdue. In Purdue, the Supreme Court held that the Bankruptcy Code does not grant courts the equitable power to authorize nonconsensual third-party releases.58 Exculpation is a subspecies of a third-party release, so the implication of the Court’s holding might be that there is also no equitable power to authorize nonconsensual exculpation.59 A law could be passed specifically authorizing third-party exculpation, but absent legislation, it is important to consider that Purdue only applies to nonconsensual third-party releases,60 so consensual exculpation clauses might still be permissible. If the company can still operate, exculpation might be impossible and it might not be worth filing for chapter 11 if it puts key parties at risk.61

In addition, international companies may want to consider filing abroad where third-party releases and exculpation clauses are still permitted.62 Ultimately, protecting participants from litigious parties is an important way to ensure participation in bankruptcy administration, but absent legislative action, third-party exculpation might no longer be possible when filing a chapter 11 case.

Michael Lathwell is a third-year student at the University of Illinois College of Law in Champaign, Ill., and editor-in-chief of the University of Illinois Law Review.

Editor’s Note: ABI held a webinar shortly after the Supreme Court issued its decision in Purdue. To listen to the abiLIVE recording, please visit abi.org/newsroom/videos. ABI also published a digital book, The Purdue Papers, a compilation of 3,500+ pages of amicus briefs, petitions and other related background material. To order your downloadable copy, visit store.abi.org.