The permanent release of a nondebtor from a debt owed to a third party in a chapter 11 plan is barred per se in some courts and must meet a high standard to be allowed in others. The U.S. Bankruptcy Court for the District of Colorado in In re Midway Gold US Inc. addressed this issue in connection with confirmation of the joint chapter 11 plan of 14 debtor entities in the gold mining and exploration business.[1]
As a threshold issue, the Midway court looked to whether third-party releases are ever allowed in the Tenth Circuit or whether they are barred per se as had been argued and applied in other cases. The court analyzed the Western Real Estate case and concluded a chapter 11 plan could not “bar litigation against nondebtors for the remainder of the discharged debt” and that the court’s authority under § 105(a) could not be used in a manner inconsistent with § 524(e). However, such finding did not translate into an absolute bar of all nondebtor releases in all circumstances.[2]
In connection with its analysis of the nondebtor release, the Midway court reviewed the treatment of nondebtor releases in other circuits and found that while the “Fifth and Ninth Circuits have held a bankruptcy court does not have authority to issue and enforce third-party non-debtor releases in a Chapter 11 plan,” these circuits are in the minority.[3] Rather, the Midway court sided with the majority, represented by the First, Second, Third, Fourth, Sixth, Seventh, Eighth and Eleventh Circuits, permitting third-party releases under certain narrow circumstances.
Section 524(e) of the Bankruptcy Code provides in pertinent part 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.” The majority of the circuits view this language as a “savings clause” that preserves post-confirmation rights (e.g., the right to pursue a nondebtor for a debt) rather than “an absolute bar to third-party releases.”[1]
Further, the court observed that, read together, §§ 105(a),[2] 1123(b)(3)(A)[3] and 1123(b)(6)[4] indicate that “enjoining a creditor's claims against a nondebtor may be necessary, and within the bankruptcy court’s authority, to achieve a successful reorganization.”[5]
Before forging its own path, the court examined the standards used by the other circuits in determining whether nondebtor releases are acceptable, some of which overlap. The First and Eighth Circuits look generally to the following nonexclusive list of factors outlined in the case In re Master Mortg. Fund (the “Master Mortgage Factors”), including whether:
(1) there is an identity of interest between the debtor and the third party, usually an indemnity relationship, such that a suit against the nondebtor is, in essence, a suit against the debtor or will deplete assets of the estate;
(2) the nondebtor has contributed substantial assets to the reorganization;
(3) the injunction is essential to reorganization (i.e., without it, there is little likelihood of success);
(4) a substantial majority of the creditors agree to such injunction; specifically, the impacted class (or classes) has “overwhelmingly” voted to accept the proposed plan treatment; and
(5) the plan provides a mechanism for the payment of all, or substantially all, of the claims of the class or classes affected by the injunction.[6]
The Midway court found that courts in the Third Circuit do not have a specific test, although a Delaware bankruptcy court has looked to the Master Mortgage Factors as a foundation along with “other relevant factors.”[7] Third-party nondebtor releases are allowed in the Second and Seventh Circuit only “when truly ‘unusual circumstances’ exist.”[8] The Sixth Circuit also restricts allowing such releases to “unusual circumstances” and further looks to a set of seven factors, certain of which are identical or substantially similar to the Master Mortgage Factors referred to as the “Dow Corning Factors.” The Midway court found that the U.S. Courts of Appeals for the Fourth and Eleventh Circuits have also looked to the Dow Corning Factors.[1]
After analyzing Western Real Estate and the other circuits, the Midway court determined that “while § 524(e) does not expressly provide for the release of a third party's claims against a nondebtor, § 524(e) does not expressly preclude such releases.” However, such releases are not given “carte blanche” and are acceptable only “in certain, and very limited, circumstances if the release is “appropriate” and not inconsistent with any other provision of the Bankruptcy Code, including § 524(e).”[2]
For its own approach, the Midway court found that “the Court must parse out exactly who is releasing whom from what.”[3] In other words, the court stressed the importance of distinguishing “between the Debtors’ release of nondebtors and third parties’ release of nondebtors” and to “find the release to be necessary for the reorganization and appropriately tailored to apply only to claims arising out of or in connection with the reorganization itself, and not to matters which would have no effect upon the estate.”[4] If not, there is potential for a jurisdictional issue that would preclude the authority of the bankruptcy court to enter a final order.
The court further warned against the releases providing “nondebtors with ‘blanket immunity’ for all times, transgressions and omissions and may not include immunity from gross negligence or willful misconduct.”[5] As the Midway court summarized it, “[i]t is not the intention of the Court to permit nondebtors to purchase immunity from unrelated torts, no matter how substantial their contribution to a debtor’s reorganization.”[6]
In summary, most jurisdictions will allow third party releases of nondebtors — but only in certain narrow circumstances. Courts will determine the issue based on the facts and dynamics of each case and will require that such releases be fully justified. Plan proponents must walk the tightrope of providing for the releases necessary to have a plan accepted while avoiding overbroad language and staying within the lines of bankruptcy jurisdiction.
[1] In re Midway Gold US Inc., 575 B.R. 475 (Bankr. D. Colo. 2017).
[2] In re Western Real Estate Fund Inc., 922 F.2d 592 (10th Cir.1990), modified sub nom., Abel v. West, 932 F.2d 898 (10th Cir. 1991). Western Real Estate involved a claim for legal fees by the debtor’s pre-petition attorney against the debtor and a third party. The attorney sued the third party in state court. The debtor, which was liable to the third party for indemnification, sought and obtained a permanent injunction in the bankruptcy court against the attorney from ever pursuing the nondebtor to recover the debt (or that portion of the debt unpaid by the debtor through the bankruptcy). On appeal, the Tenth Circuit Court of Appeals found that this permanent injunction “in essence, discharged [the third party’s] liability to the [attorney].” The Tenth Circuit thus limited the injunction imposed by the bankruptcy court to only bar the attorney from seeking recovery from the third party during the pendency of the bankruptcy case and removed the permanent injunction. Underlying the Tenth Circuit’s reasoning was the concept that a bankruptcy discharge does not result in the extinguishment of the debt, but rather results in the release of the debtor from personal liability. Therefore, the debt continues to exist “and can be collected from any other entity that may be liable.” In other words, the attorney could still seek payment from the nondebtor entity, even though the debt was discharged as to the debtor. To hold otherwise, and prohibit the attorney from pursuing the debt from the nondebtor, would violate § 524(e).
[3] In re Midway Gold, 575 B.R. at 501.
[4] Id. at 501-02.
[5] Section 105 grants the court power to act in ways that carry out the other provisions of the Code, such as approving plans.
[6] Section 1123(b)(3)(A) permits the settlement or adjustment of the debtor’s/estate’s claims or interests.
[7] Section 1123(b)(6) permits the inclusion of provisions not otherwise inconsistent with the Code).
[8] Id. at 502. The Midway court also recognized that “[a]t least one bankruptcy court has noted “inclusion in a plan of reorganization of a narrow release of claims relating to the bankruptcy case, running in favor of the debtor, the creditors committee and all professionals and advisors, now appears to be de rigeur in cases filed in New York and Delaware.” Id. But it found that nevertheless, the majority viewed the releases as “proper only in rare cases” and harder to justify in nonreorganization cases. Id.
[9] Id. at 503 (citing In re Master Mortg. Inv. Fund Inc., 168 B.R. 930, 935 (Bankr. W.D. Mo. 1994).
[11] Id. at 504. It should be noted that shortly after the Midway decision, the U.S. Bankruptcy Court for the Southern District of New York (without referencing Midway) issued an opinion on third-party releases in the SunEdison case and stated the following:
[C]ourts may consider whether the estate has received a substantial contribution, whether the enjoined claims are channeled to a settlement fund rather than extinguished, whether the enjoined claims would indirectly impact the debtor’s reorganization through claims of indemnity or contribution, whether the plan otherwise provides for payment in full of the enjoined claims and whether the creditor has consented. Nevertheless, the test is not “a matter of factors and prongs,” and a third-party release will not be tolerated “absent findings of circumstances that may be characterized as unique.”
In re SunEdison Inc., Case No. 16-10992 (SMB), 2017 WL 5176651, at *6 (Bankr. S.D.N.Y. Nov. 8, 2017).
[12] In re Midway Gold, 575 B.R. at 505.
[13] Id. at 505-06.
[14] Id. at 506.
[15] Id.
[16] Id. at 506.
[17] Id.