An Objection to Third-Party Releases Must Be Raised in Bankruptcy Court

Although the Fifth Circuit is among the more restrictive in allowing chapter 11 plans to include third-party releases, District Judge Lee H. Rosenthal of Houston explained why a creditor must object to confirmation in bankruptcy court, otherwise the creditor will be bound by the release even if it might have been improper.

The Facts

The creditor believed he had a discrimination claim against the chapter 11 debtor and against the debtor’s nonbankrupt former corporate parent. Although given notice of the bankruptcy case, the creditor did not file a claim before the bar date.

After the bar date, the creditor filed a motion to modify the automatic stay and permit suit against the debtor. The bankruptcy court denied the motion, but the creditor did not appeal.

The debtor proposed a plan including a third-party release barring creditors from bringing claims against the nonbankrupt former parent. The creditor did not object to the plan, which the bankruptcy court confirmed.

After confirmation, the creditor mounted an arbitration against the former parent. On motion by the former parent, the bankruptcy court enjoined the creditor from pursuing the claim. The creditor appealed, arguing that the bankruptcy court lacked jurisdiction to issue a third-party release.

Judge Rosenthal upheld the injunction and the third-party release in a February 8 opinion.

The Supreme Court on Preclusion

Judge Rosenthal began with Travelers Indemnity Co. v. Bailey, 557 U.S. 137 (2009).

Since the confirmation order was final, the Supreme Court held in Travelers that the creditor was barred by the doctrine of preclusion from challenging releases granted by the bankruptcy court because the creditor had been a party to the bankruptcy proceedings.

Like the creditor in Travelers, Judge Rosenthal said that the creditor in his appeal was a party because he had notice of the bankruptcy and thus had an opportunity to challenge the release.

Citing Travelers, Judge Rosenthal said, “Preclusion bars [the creditor] from raising the same claims he could have asserted in the bankruptcy court . . . .”

An Overview of Fifth Circuit Law

Beyond Travelers, Judge Rosenthal’s opinion is a summary of the contours and boundaries of permissible third-party releases in the Fifth Circuit. She said there is a circuit split “as to the scope of a bankruptcy court’s power to approve a release of creditors against a nondebtor.” She listed several circuits allowing nondebtor third-party releases “in some circumstances.”

The Fifth Circuit, on the other hand, does not permit nonconsensual third-party releases. In re Vitro S.A.B. de CV, 701 F.3d 1031 (5th Cir. 2012). However, Judge Rosenthal said that the Fifth Circuit does permit consensual third-party releases.

Judge Rosenthal therefore examined whether the release was consensual and sufficiently related to the chapter 11 case to confer subject matter jurisdiction on the bankruptcy court.

The creditor contended that a consensual release requires affirmative action. Judge Rosenthal disagreed, even though, she said, the Fifth Circuit has not defined “consensual” in this context.

Although the creditor did not file a claim, he still could have participated in the chapter 11 case by objecting to confirmation and the inclusion of third-party releases. In that regard, Judge Rosenthal understood Fifth Circuit law to mean that a creditor who did not object to confirmation may not take an appeal from confirmation.

Judge Rosenthal therefore concluded that the third-party release was consensual because the creditor had notice but did not object.

Next, Judge Rosenthal analyzed whether the creditor’s claims were “related to” the bankruptcy and thus within the bankruptcy court’s subject matter jurisdiction.

The creditor relied on In re Zale Corporation, 62 F.3d 746 (5th Cir. 1995), where the Fifth Circuit held that an indemnification claim did not give rise to “related to” jurisdiction allowing the bankruptcy court to discharge claims against a third party.

However, Judge Rosenthal said, Zale involved a nonconsensual release where the creditor had objected in bankruptcy court. The case on appeal involved a consensual release where the creditor had failed to object.

Therefore, Judge Rosenthal said, the bankruptcy court had “related to” jurisdiction because he found several ways in which the creditor’s claim against the nonbankrupt former parent could “conceivably” affect the debtor’s estate.