Ninth Circuit Prohibition on Third-Party Injunctions Is Inapplicable in Chapter 9

The Ninth Circuit is among the three circuits that categorically prohibit so-called third-party releases in chapter 11 plans.

 

So, how did the City of San Bernardino, Calif., manage to include a third-party injunction in its chapter 9 municipal debt-adjustment plan?

 

As Bankruptcy Judge Meredith A. Jury explained in her March 7 opinion, the answer is simple. Section 524(e) is not applicable in chapter 9 cases under Section 901.

 

Third-Party Releases in Chapter 11

 

A third-party release is a provision in a chapter 11 plan that bars creditors from suing non-debtors, typically officers, directors, and professionals involved in the reorganization. 

 

Six circuits permit third-party releases, although not willy-nilly. For ABI’s discussion of recent cases where courts in those circuits erect a high barrier, click here, here, and here.

 

Third-party releases have been prohibited in the Ninth Circuit since American Hardwoods Inc. v. Deutsche Credit Corp. (In re American Hardwoods Inc.), 885 F.2d 621 (9th Cir. 1989), when the appeals courts held there was no jurisdiction to impose the injunction. Six years later, the Ninth Circuit dropped the other shoe in Resorts International Inc. v. Lowenschuss (In re Lowenschuss), 67 F.3d 1394 (9th Cir. 1995), by holding that third-party releases are inconsistent with Section 524(e).

 

With an exception not applicable, Section 524(e) says that the “discharge of a debt of the debtor does not affect the liability of any other entity” for “such debt.”

 

The San Bernardino Bankruptcy

 

San Bernardino was one of three California cities to undergo municipal debt adjustment in chapter 9. The city confirmed a plan on Feb. 7, 2017. In her March 7 opinion, Judge Jury explained why she allowed the city to include the third-party injunction in the plan.

 

San Bernardino had an estimated $200 million of claims in class 13, covering general unsecured creditors. Many of those claims were held by litigation plaintiffs, including people claiming civil rights violations committed by police officers.

 

Although the plan paid only 1% of claims in that class, litigation claimants could pursue their suits against individual police officers unless the plan cut off their rights to sue.

 

A California statute compounded the problem for San Bernardino, because state law requires municipalities to indemnify and defend their workers. To obviate the possibility that San Bernardino’s discharged debt to lawsuit plaintiffs would come in through the back door via the indemnification obligation, the city included the third-party injunction in the plan.

 

Judge Jury’s Rationale

 

Judge Jury easily found jurisdiction to issue the injunction. The California indemnification statute, she said, gives rise to “related to” jurisdiction because a judgment against a police officer would end up being a claim on the city’s treasury. 

 

She found authority for the injunction in Section 105(a), the so-called All Writs Act, because Section 109(a) does not make Section 524(e) applicable in chapter 9 cases.

 

However, Judge Jury was not willing to allow a city to scatter third-party injunctions like beads at a Mardi Gras parade. The standards for deciding when a third-party, chapter 9 injunction can be issued is a question of first impression in the Ninth Circuit, she said. The other two notable chapter 9 cases in California – for Vallejo and Stockton – did not have the injunctions in their plans.

 

To pass muster, Judge Jury said the injunction must be express in the plan; it must be an integral part of the reorganization, and it must be “supported by specific factual findings regarding the necessity of the injunction.”

 

San Bernardino passed the test in spades. Among other things, Judge Jury recited pages of fact findings to show that the city could not provide municipal services were it liable to indemnify police officers in civil rights suits.

 

Although Judge Jury had given her reasons for the injunction orally at the confirmation hearing in December, she wrote the opinion because creditors are appealing. The appeal will be heard by a district judge, not by the Ninth Circuit Bankruptcy Appellate Panel.

 

The opinion is In re City of San Bernardino, 12-28006 (Bankr. C.D.Calif. March 7, 2017).