While a number of circuits have held that bankruptcy courts have authority under § 105(a) of the Bankruptcy Code to insulate nondebtors via prospective releases of liability in a confirmed plan, the practice is constrained in other circuits. These minority circuits view the broad powers vested in the bankruptcy court under § 105 as being tempered in application by the specific restrictive language of § 524(e) of the Bankruptcy Code. Because of this appellate split, the ability of a debtor to grant nondebtor releases in a plan is ripe for statutory resolution or an ultimate appeal on the merits to the U.S. Supreme Court.
Section 105(a) enables bankruptcy courts to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”[i] Section 524(e) limits the application of the discharge provisions to debtors, clearly stating 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.”[ii] Relying in part on § 105(a), a majority of the circuits have permitted nondebtor releases, notwithstanding the language in § 524(e), where the release of such third parties is vital to the debtor’s successful reorganization.
Recently, in Behrmann v. National Heritage Foundation Inc.,[iii] the Fourth Circuit Court of Appeals examined the “circumstances under which a bankruptcy court may approve non-debtor release, injunction, and exculpation provisions as part of a final plan of reorganization under Chapter 11 of the Bankruptcy Code.”[iv] The opinion clearly, and in useful detail, sets forth guidance for the proper application of this equitable relief and describes the circumstances warranting its application.
In that case, the debtor, National Heritage Foundation Inc. (NHF), was a nonprofit public charity formed under Georgia law and based in Virginia that managed donor-assisted funds[v] and charitable annuities for the benefit of other charitable organizations.[vi] Certain close family members holding paid positions as officers and directors of the charity essentially maintained full control of NHF.[vii] Consistent with Georgia law, NHF’s bylaws provided for indemnification of its officers and directors.
NHF commenced its chapter 11 bankruptcy case because of an adverse state court judgment and difficulties in appealing the resultant $6 million claim of the judgment creditor.[viii] NHF, as well as its officers and directors, were concerned about the potential that a number of civil actions could be brought against the fund and its officers and directors by its donors (of which there were more than 9,000) for certain pre-petition acts.[ix] Accordingly, NHF filed a plan of reorganization that sought to discharge the debtor’s obligations and release the officers and directors. In support of the releases, NHF cited both the potential costs of the express indemnifications and the loss to NHF that would result if the officers and directors departed.[x] Creditors objected, asserting that the reorganization was a “sham perpetuated by NHF’s officers and directors to secure immunity for their fraudulent and misleading conduct” and “comprehensive clemency” for the questioned acts leading to the reorganization.[xi] Nevertheless, the bankruptcy court confirmed NHF’s plan.
On appeal, the Fourth Circuit Court of Appeals reversed and remanded to the bankruptcy court. Relying on its own precedent in In re A.H. Robins,[xii] as well as the opinion of the Sixth Circuit Court of Appeals in In re Dow Corning Corp.,[xiii] the court found that whether nondebtor releases are appropriate “will turn on the particular facts and circumstances of the case….” The court warned, however, that nondebtor releases “should be granted cautiously and infrequently.”[xiv]
The court noted a split in appellate authority on this issue. The Second, Third, Sixth and Seventh circuits allow nondebtor releases where exceptional circumstances are present. The First, Eleventh and D.C. Circuits have adopted similar reasoning. This is in contrast with holdings in the Fifth,[xv] Ninth[xvi] and Tenth[xvii] circuits that clearly prohibit releases of nondebtors via a plan of reorganization.
The NHF court found the Dow Corning seven-factor test to be instructive as to the suitability of nondebtor releases as part of a plan of reorganization.[xviii] Per Dow Corning, the seven factors to be considered are as follows:
(1) an identity of interests between the debtor and the third party, usually an indemnity relationship, such that a suit against the non-debtor is, in essence, a suit against the debtor or will deplete the assets of the estate; (2) the non-debtor has contributed substantial assets to the reorganization; (3) the injunction is essential to the reorganization, namely the reorganization hinges on the debtor being free from indirect suits against parties who would have indemnity or contribution claims against the debtor; (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; (6) the plan provides an opportunity for those claimants who choose not to settle to recover in full; and (7) the bankruptcy court made a record of specific factual findings that support its conclusions.”[xix]
In application to NHF, the court stated that the seventh factor, requiring specific findings of fact, was not satisfied. Such specific findings were not present in the record at the bankruptcy court level, thereby preventing a meaningful appellate review.[xx] Accordingly, the Fourth Circuit remanded the matter back to the bankruptcy court to set forth factual findings in support of its initial confirmation of a plan that provided for the releases.
On remand, the bankruptcy court reversed course and held that the facts and circumstances did not warrant the prospective nondebtor releases.[xxi] The debtor challenged this reversal of position, and upon appeal, the district court affirmed the latter holding of the bankruptcy court.[xxii]
The takeaway for practitioners is to proactively address these requirements when evaluating the use of nondebtor releases in the plan itself and at the confirmation hearing. This allows meaningful support for the bankruptcy court’s evaluation of the reorganization plan upon appellate review. The full Dow Corning criteria will not be applicable in all matters, but by addressing each relevant element, a solid foundation will be present for a focused and efficient discussion on the merits.
[i] 11 U.S.C. § 105(a).
[ii] 11 U.S.C. § 524(e).
[iii] Behrmann v. National Heritage Foundation Inc., 663 F.3d 704 (4th Cir. 2011).
[iv] Id. at 706.
[v] Donor Advised Funds spring from an irrevocable gift to a charity, which in turn may promise a periodic return to the donor or donor’s spouse, often for life based upon the earning potential of the investment. The donor charities used NHF as the investment vehicle and did not envision that the promises to pay future returns would be subject to the unrelated general liabilities of NHF.
[vi] National Heritage Foundation Inc. v. Behrmann, 2013 U.S. Dist. LEXIS 49081, *3-4 (E.D. Va., April 3, 2013).
[vii] Id.
[viii] Id. at *4.
[ix] Behrmann v. National Heritage Foundation Inc., 663 F.3d at 707-708.
[x] Id.
[xi] Id. at 709.
[xii] Menard-Sanford v. Mabey (In re A.H. Robins Co.), 880 F.2d 694, 701 (4th Cir. 1989).
[xiii] In re Dow Corning Corp., 280 F.3d 648, 658 (6th Cir. 2002).
[xiv] Behrmann v. National Heritage Foundation Inc., 663 F.3d at 711-712.
[xv] See, e.g., Bank of New York Trust Co. NA v. Official Unsecured Creditors' Comm. (In re Pacific Lumber Co.), 584 F.3d 229 (5th Cir. 2009); Feld v. Zale Corp. (In re Zale Corp.), 62 F.3d 746 (5th Cir. 1995).
[xvi] See, e.g., Maxitile Inc. v. Jiming Sun (In re Maxitile Inc.), 237 Fed. Appx. 274 (9th Cir. 2007); In re American Hardwoods, 885 F.2d 621 (9th Cir. 1989); In re Redco Dev. Co. LLC, 2011 Bankr. LEXIS 4963 (Bankr. D. Or. Dec. 15, 2011)); but see Linda Vista Cinemas L.L.C. v. Bank of Ariz. (In re Linda Vista Cinemas L.L.C.), 2011 U.S. Dist. LEXIS 52885 (D. Ariz. May 5, 2011).
[xvii] See, e.g., In re W. Real Estate Fund, 922 F.2d 592 (10th Cir. 1990); Andersen v. Higher Educ. Assistance Found. (In re Andersen), 215 B.R. 792 (B.A.P. 10th Cir. 1998); Webster Capital Fin. Inc. v. Newby, 2013 U.S. Dist. LEXIS 19703 (D. Kan. Feb. 14, 2013).
[xviii] Behrmann v. National Heritage Foundation Inc., 663 F.3d at 712.
[xix] Id. at 711-12 (quoting In re Dow Corning Corp., 280 F.3d at 658) (emphasis added).
[xx] Id. at 713.
[xxi] In re National Heritage Foundation Inc., 478 B.R. 216 (Bankr. E.D. Va. 2012).
[xxii] National Heritage Foundation Inc. v. Behrmann, 2013 U.S. Dist. LEXIS 49081 (E.D. Va., April 03, 2013).