Nondebtor Releases in Reorganization Plans Are They Still Viable or a Thing of the Past in the Second Circuit

Journal Issue

May 2006

Column Name

Feature

Citation

ABI Journal, Vol. XXV, No. 4, p. 16, May 2006

Bankruptcy Code

524

Topic Tags

Discharge/Dischargeability

Venue/Jurisdiction

Journal HTML Content

Reorganization plans increasingly include
provisions releasing and permanently enjoining claims against not only
the debtor—who is generally entitled to a discharge1

of all pre-confirmation debts—but also third parties. Arguably,
nondebtor release provisions may be critical to ensuring the reorganized
debtor's fresh start where it would otherwise be faced with
post-confirmation indemnification claims by officers and directors,
lenders, insurance carriers and others. In the Second Circuit,
courts have regularly approved nondebtor release provisions, based on
the appeals court's pronouncement in In re Drexel Burnham Lambert
Group Inc.2 that "[i]n bankruptcy cases, a court may
enjoin a creditor from suing a third party, provided the injunction
plays an important part in the debtor's reorganization plan."
Recently, however, in In re Metromedia Fiber Network
Inc.,3 the Second Circuit for the first time sought to
define and clearly limit the circumstances under which a nondebtor
release may be deemed "important" to the debtor's plan. This
article will examine the Metromedia decision in light of the
statutory framework and prior, divergent circuit decisions on the
issue of nondebtor releases. Statutory Framework In
relevant part, 11 U.S.C. §524(e) provides that "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." Section
524(e) appears to carry forward §16 of the prior Bankruptcy Act
of 1898, which provided that "[t]he liability of a person who is
a co-debtor with, or guarantor or in any manner a surety for, a
bankruptcy shall not be altered by the discharge of such
bankrupt."4 Based on §524(e), some courts have held
nondebtor releases to be per se invalid. Such courts find further
support for their view in the one clear statutory exception: asbestos
mass tort cases under 11 U.S.C. §524(g).5 This
argument appears to ignore the legislative history of §524(g),
which expressly declines to take a position on whether nondebtor
releases in a plan are otherwise enforceable.6 Other
courts maintain that §524(e) does not expressly prohibit nondebtor
releases and relies instead on the "all-writs" clause, 11
U.S.C. §105(a), which authorizes the bankruptcy court to
"issue any order, process or judgment that is necessary or
appropriate to carry out the provisions of [the Bankruptcy
Code]."7 In response, courts that adopt the per se
prohibition argue that §105(a) does not authorize relief
inconsistent with the more specific provisions of §5248 and
"does not...create substantive rights that are otherwise
unavailable under applicable law."9 Distinctions
exist even among courts that are willing to approve nondebtor
releases. For example, some will limit the effect of such releases to
parties who have consented—i.e., voted in favor of the
plan containing the release provisions.10 Others have
approved even nonconsensual third-party releases provided that the
plan containing the release provision is confirmed by appropriate
vote.11 Thus, the venue of the bankruptcy case will be one
factor dictating whether, and under what conditions, nondebtor
releases will be available. Circuit Split Decisions The
Fifth, Ninth and Tenth Circuits have adopted a per se rule
prohibiting nondebtor releases.12 As noted above, these
circuit courts rely on §524(e), which, they argue, precludes
bankruptcy courts from discharging the liability of
nondebtors,13 and they reject the contention that the general
equitable powers bestowed upon the bankruptcy courts by the
"all-writs" clause permits the court to release the
liabilities of non-debtors.14 Initially, in a case decided
under §16 of the old Act, the Seventh Circuit also appeared to
adopt a per se rule prohibiting nondebtor releases in a
plan.15 More recently, however, the Seventh Circuit
departed from its earlier decision and held that §524(e)
"does not purport to limit or restrain the power of the
bankruptcy court to otherwise grant a release to a third party,"
provided that such releases were "consensual and
non-coercive."16 The Third Circuit in Continental
Airlines sustained objections to plan provisions granting a
nonconsensual release to nondebtor parties. The court expressly
declined to rule out nonconsensual releases or to establish a "rule
regarding the conditions under which nondebtor releases and permanent
injunctions are appropriate or permissible."17 The
court found the release there to fail under even the most flexible
test, stating that "[t]he hallmarks of permissible nonconsensual
releases—fairness, necessity to the reorganization and specific
factual findings to support these conclusions—are all absent
here."18 Shortly thereafter, that circuit court
upheld an exculpation clause (except for willful misconduct and gross
negligence) that covered representatives and professionals for the
debtor and creditors committee.19 The Sixth Circuit in

In re Dow Corning Corp.20 held that nonconsensual
nondebtor releases in a plan were permissible in "unusual
circumstances" and listed several factors necessary to validate
such releases, including (1) an identity of interest between the
debtor and third party—e.g., an indemnity relationship,
(2) a substantial contribution of assets by the nondebtor to the
reorganization, (3) necessity of the release and injunction to the
reorganization, (4) overwhelming vote for acceptance of the plan by
the impacted classes, (5) provision for payment of the claims of the
impacted classes, (6) payment in full to creditors who opt not to
settle and (7) specific factual finding to support the release and
injunction.21 The most flexible approach appeared to be
the one adopted by the Second and Fourth Circuit Appeals Courts. In
In re A.H. Robins Co., 22 Drexel23

and Johns-Manville,24 the courts upheld
reorganization plans containing broad releases and permanent injunctions
of claims against nondebtor parties. Each of these plans included the
global settlement of massive tort liability of the debtors and
co-liable parties and channeled creditor claims to trusts funded by
substantial contributions from the nondebtor parties benefiting from
the releases, and was thus rendered feasible and
confirmable.25 Drexel, which approved a class
action settlement agreement that was subject to later confirmation of
a plan, is particularly noteworthy. The court's statement that a
nondebtor release and injunction was proper provided that they played
"an important part in the debtor's reorganization
plan"26 has been frequently cited in support of the
inclusion of nondebtor releases in many reorganization plans, not
limited to the mass tort context.27 The diverse range of
views among the circuits on the viability of nondebtor releases in
reorganization plans and the lack of any clear rules or boundaries
circumscribing the permissible scope and applicability of such releases,
particularly in the Second Circuit, was the setting for the court's
decision in Metromedia. Metromedia: Findings Required
Before Approval In Metromedia, the court affirmed the
order confirming the plan on the ground of equitable mootness and need
not have reached the merits of the nondebtor release at
issue.28 Instead, the court seized the opportunity to clarify
its holding in Drexel.29

<blockquote><blockquote>
<hr>
<big><center>
The diverse range of views among the circuits on the viability of
nondebtor releases in reorganization plans and the lack of any clear
rules or boundaries circumscribing the permissible scope and
applicability of such releases...was the setting for the court's
decision in Metromedia.
</center></big>
<hr>
</blockquote></blockquote>

At the outset, the court stated that "this is not a matter of
factors and prongs,"30 emphasizing that nondebtor
releases were "proper only in rare cases"31 upon
a "finding of circumstances that may be characterized as
unique."32 The court identified two considerations
underlying the reluctance to approve nondebtor releases: the lack of
any express authorization in the Bankruptcy Code, and the fact that
such a release is "a device that lends itself to abuse"
since "it may operate as a bankruptcy discharge without a filing
and without the safeguards of the Code."33 The court
rejected "material contribution" by the nondebtor party to
the estate as sufficient to justify a nondebtor release,34

but also refused to require that consideration be paid to the enjoined
creditors.35 Rather, the court identified the following
findings that are necessary for approval of a nondebtor release:
<blockquote> (i) that the release is important to the plan of
reorganization ("which is what Drexel Burnham at a
minimum requires"); and (ii) that the breadth or scope of
the release—i.e., the parties and claims
covered—is necessary to the plan.36
</blockquote>The court concluded: <blockquote> A nondebtor
release in a plan of reorganization should not be approved absent
the finding that truly unusual circumstances render the release terms
important to success of the plan, focusing on the considerations
discussed above.37 </blockquote>Conclusion

In Metromedia, the Second Circuit clearly enunciated a
requirement for specific factual findings, based on evidence
presented, to demonstrate not only that the proposed nondebtor release
is essential to confirmation of a reorganization plan, but that
"truly unusual circumstances"38 exist to render
the full scope of such release—both as to parties and claims
covered—essential. This requirement merits closer examination by
the lower courts on the justifications for nondebtor releases and
greater limitations on the scope of such releases proposed by plan
proponents. It remains to be seen whether this requirement will be
followed in practice, or whether it will be accorded only lip service
in reliance on the doctrines of equitable mootness and res
judicata39 to eliminate appeals and collateral attacks.
<h3> Footnotes</h3> 1 See 11 U.S.C. §1141(d). 2 960
F.2d 285, 293 (2d Cir. 1992). 3 416 F.3d 136, 141-43 (2d Cir. 2005).

4 11 U.S.C. §34 (repealed Oct. 1, 1979). 5 See,
e.g., In re Lowenschuss, 67 F. 3d 1394, 1402 n6 (9th
Cir. 1995), cert. denied, 517 U.S. 1243 (1996). 6 See 140
Cong. Rec. H10, 766 (daily ed. Oct. 4, 1994) (remarks of Rep. Jack
Brooks); see, also, Collier on Bankruptcy, |524.05
at footnote 18 (15th ed. revised). 7 See, e.g.,

Metromedia, 416 F.30 at 142; In re Continental Airlines,
203 F.3d 203, 211 (3d Cir. 2000). 8 See, e.g.,
Lowenschuss, 67 F.3d at 1402. 9 Metromedia, 416 F.3d at
142 (quoting In re Dairy Mart Convenience Stores Inc., 351 F.3d
86, 92 (2d Cir. 2003). 10 See, e.g., In re Specialty
Equipment Companies, 3 F.3d 1043, 1047 (7th Cir. 1993). 11

See, e.g., In re Johns Manville Corp., 837 F.2d 89
(2d Cir.), cert. denied, 488 U.S. 868 (1988). 12 See
Lowenschuss, supra; In re Zale Corp., 62 F. 3d 746
(5th Cir. 1995); In re Western Real Estate Fund Inc., 922 F.2d
592 (10th Cir. 1990). 13 See, e.g., Underhill v.
Royal, 769 F. 2d 1426, 1432 (9th Cir. 1985). 14 See,

e.g., Lowenschuss, 67 F.3d at 1402. 15 Union Carbide
Corp. v. Newboles, 686 F.2d 593 (7th Cir. 1982). 16 Specialty
Equipment Companies, 3 F.3d at 1047. 17 203 F.3d at 214 and n.
11. 18 Id. 19 In re PWS Holding Corp., 228 F.3d 224
(3d Cir. 2000). 20 280 F.3d 648 (6th Cir. 2002). 21 Id. at
658. 22 880 F.2d 694 (4th Cir. 1989). 23 supra, fn. __.

24 supra, fn. __. 25 See Continental Airlines, 203
F.3d at 212-13. 26 960 F.2d at 293. 27 See, e.g.,
In re Transit Group Inc., 286 B.R. 811, 818 (Bankr. M.D. Fla.
2002) (approving permanent release of lender who agreed to accept
equity for prepetition debt and who provided significant DIP and exit
financing, without which "there would be no plan and no
reorganization"); In re Master Mortgage Investment Fund
Inc., 168 B.R. 930, 938 (Bankr. W.D. Mo. 1994) (injunction was
essential in that there could be no reorganization without principal
creditor settlement); In re Heron, Burchette, Ruckert &

Rothwell, 148 B.R. 660, 689 (Bankr. D.C. 1992) (enjoining actions
against partners of debtor law firm "is the sine qua non
of the debtor's reorganization"). 28 416 F.3d at 143-45. In
contrast, the Third Circuit in Continental Airlines addressed
the merits of the release at issue there only after first determining
that the appeal was not equitably moot. 203 F.3d at 209-11. 29 416
F.3d at 141; see, also, In re XO Communications
Inc., 330 B.R. 394, 436 (Bankr. S.D.N.Y. 2005). 30 Id.
at 142. 31 Id. at 141. 32 Id. at 142. 33

Id. 34 Id. at 143. 35 Id. ("such
consideration has weight in equity, but it is not required").
36 Id. 37 Id. 38 Id. 39 See,

e.g., Continental Airlines, 203 F.3d at 213 n. 10.

Journal Authors

Menachem O. Zelmanovitz

Journal Date

Monday, May 1, 2006 - 12:00

Bankruptcy Rule

2006

none