In a “code-driven” discipline such as bankruptcy, third-party releases are a rare breed. As a form of equitable relief available to certain nondebtors in certain court-decreed circumstances in certain circuits, they are shrouded in a level of uncertainty seldom seen elsewhere. A recent holding from In re FirstEnergy Solutions Corp. that denied the approval of the debtors’ disclosure statement because it contained fatally flawed releases highlights this confusion and offers much-needed guidance to future plan proponents.
Third-Party Releases in a Nutshell
Chapter 11 debtors sometimes seek to release or limit claims against nondebtors in their reorganization plans. Such third-party releases may help achieve concessions from key parties to sidestep protracted confirmation battles, incentivize lenders to fund the plans, or avoid future indemnification claims against debtors in mass-tort cases. But they are also controversial — especially to the extent they are nonconsensual — because they extend de facto discharges of certain liabilities to nondebtors without explicit authorization under the Bankruptcy Code.
Although § 524(g)[1] limits certain personal-injury claims against nondebtors by channeling them into a trust, it does so only in the context of asbestos-related claims that are derivative of those against the debtor.[2] Courts otherwise find their authority to approve nonconsensual third-party releases under the ever-versatile § 105(a), which permits “any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code].”[3] This is the majority view held by the Second,[4] Third,[5] Fourth,[6] Sixth,[7] Seventh[8] and Eleventh [9] circuits, each requiring various showings of special circumstances as further justification. The issue has not been decided at the circuit level in the First or Eighth Circuits, although the First Circuit Court of Appeals has indicated receptiveness to the majority view in dicta[10] while a lower Eighth Circuit court developed an often-cited test for approving such releases.[11]
The Fifth,[12] Ninth[13] and Tenth[14] circuits adopt the minority view, which generally holds that § 524 overrides the court’s equitable powers under § 105(a) because permanent injunctions or releases are discharges under § 524(a)(2),[15] and discharging a debtor’s debt “does not affect the liability of any other entity on, or the property of any other entity for, such debt” under § 524(e).[16] The D.C. Circuit Court of Appeals has not directly addressed the issue, though it held in one case that a plan seeking to release both direct and derivative claims against third-party guarantors violated § 1123(a)(4) because the direct claims were more valuable but did not receive additional compensation under the plan.[17]
Lessons from FirstEnergy
FirstEnergy Solutions Corp. (together with its debtor affiliates, “FES”) is a subsidiary of FirstEnergy Corp. (together with its nondebtor affiliates, “FE”) that generates electricity for the Northeast and Midwest. After petitioning for chapter 11 relief in March 2018,[18] FES announced planned to close several coal and nuclear plants and entered a settlement agreement under which FE agreed to pay it $225 million and issue it $628 million in notes to facilitate a clean break.[19] The settlement agreement required any FES plan to include sweeping releases for FE and related individuals (e.g., officers, directors and professionals) from “existing or hereinafter arising” causes of action “related in any way” to the debtors, the debtors’ businesses or property, intercompany transactions among the debtors and nondebtor affiliates, the chapter 11 cases or the plan.[20] It also purported to require an injunction in the settlement approval order and any confirmation order against pursuing such claims.[21] The court declined to endorse these provisions in its settlement approval order,[22] deferring any battle over their legitimacy until FES included them in a plan.
But when FES proposed its plan,[23] it faced a host of objections at the disclosure-statement stage from state and federal regulatory agencies as well as nonprofit environmental groups concerned that the releases could allow FE to escape potential clean-up liability associated with the plant closures. They argued that the releases rendered the plan “patently unconfirmable”[24] because the court did not have subject-matter jurisdiction over causes of action that would have no effect on the debtors’ estate, and because the releases failed to satisfy the “unusual circumstances” required in the Sixth Circuit under Dow Corning.[25]
Those circumstances comprise seven factors: (1) an identity of interests, such as the debtor’s indemnification of the third party; (2) a substantial contribution to the reorganization by the third party; (3) the essential nature of the release to the reorganization; (4) an “overwhelming” vote by the impacted classes in favor of the plan; (5) a mechanism for payment to substantially all classes affected by the release under the plan; (6) full recovery by nonsettling claimants under the plan; and (7) specific factual findings by the court to support its analysis.[26]
In a comprehensive oral ruling, Judge Alan Koschik quickly dispensed with the jurisdiction issue, holding that Sixth Circuit bankruptcy courts clearly have subject-matter jurisdiction over “matters concerning non-consensual third-party releases in the context of a proposed plan of reorganization.”[27] But he observed that most third-party releases are granted to parties who are secondarily liable on claims against the debtor in exchange for “significant contributions” to address those claims through a confirmable plan.[28]
Because FES is an FE spinoff, Judge Koschik noted that a substantial part of its property and business was formerly owned by FE, which meant that the proposed release included claims lying solely against FE arising from that ownership.[29] Remarking that this fact alone “turns many of the Dow Corning factors on their heads,”[30] he held that there could be no identity of interests with respect to such claims.[31] He further held that although the financial contribution by FE was “important and advantageous[,] . . . non-debtors should not be able to simply buy their own release or quasi-discharge,”[32] and that the releases could not be essential to reorganization because FES volunteered to honor any environmental obligations that arose, thereby mitigating the potential benefit from avoiding indemnification liability through a release.[33] Turning to the fourth factor, Judge Koschik held that the impacted creditors — namely, the regulatory agencies with unliquidated environmental claims — could not vote for the plan because they could not vote at all, and that it would be improper to lump them in with other classes of unsecured creditors because they would receive no benefit under the plan.[34] In a similar vein, he also held that the “hopes and prayers of a plausibly feasible reorganization” could not constitute a mechanism for payment as a matter of law and that the plan made no other provision for addressing long-term environmental obligations that may arise.[35] Judge Koschik declined to approve the disclosure statement because the releases failed to meet four out of seven of the Dow Corning factors, while failure to meet even one factor is enough to render them ineligible for confirmation.
Judge Koschik’s decision offers several important lessons. First, a release must be tailored to avoid encompassing claims lying solely against third parties and a fatal loss of identity of interests. Second, a substantial contribution to the reorganization — here, nearly $1 billion — does not lessen the importance of the other factors. Third, a well-intentioned pledge by the debtor to assume the released third-party obligations can backfire. Fourth, unliquidated claimholders are impossible to account for when they can neither vote nor receive a benefit under the plan. Finally, a mechanism for paying impacted creditors requires a special accommodation such as a channeling trust or fund.
Undeterred by the ruling, FES soon entered an agreement with FE that allowed it to file a new plan without the offending releases.[36] But thanks to its foray into clouded waters, third-party releases — at least in the Sixth Circuit — have gained some welcome contours, providing a clearer path forward not only for FES as it looks to emerge from chapter 11 this year, but also for future debtors negotiating their own grand bargains toward solvency.
[1] 11 U.S.C. § 524(g).
[2] See, e.g., In re Combustion Eng’g, Inc., 391 F.3d 190, 234 (3d Cir. 2004).
[3] U.S.C. § 105(a); see also 11 U.S.C. § 1123(b)(6) (allowing “appropriate [plan] provisions not inconsistent with the applicable provisions of [the Bankruptcy Code]”); In re Dow Corning Corp., 280 F.3d 648, 656–57 (6th Cir. 2002).
[4] In re Metromedia Fiber Network Inc., 416 F.3d 136, 141–42 (2d Cir. 2005).
[5] See In re Lower Bucks Hosp., 571 Fed. Appx. 139, 144 (3d Cir. July 3, 2014); see also In re Cont’l Airlines, 203 F.3d 203, 214 (3d Cir. 2000).
[6] Behrmann v. Nat’l Heritage Found., 663 F.3d 704, 711–12 (4th Cir. 2011).
[7] Dow Corning, 280 F.3d at 658.
[8] In re Aradigm Commc’ns Inc., 519 F.3d 640, 657 (7th Cir. 2008).
[9] In re Seaside Eng’g & Surveying Inc., 780 F.3d 1070, 1076–77 (11th Cir. 2015).
[10] See Monarch Life Ins. Co. v. Ropes & Gray, 65 F.3d 973, 983 (1st Cir. 1995) (“Though there is conflicting authority on the ‘jurisdictional’ reach of section 105(a), the confirmation order cited precedent for a broad-based ‘incidental’ injunctive provision.”); see also In re Charles St. African Methodist Episcopal Church of Boston, 499 B.R. 66, 100 (Bankr. D. Mass. 2013) (recognizing that most courts within the First Circuit authorize third-party releases in certain circumstances).
[11] See In re Master Mortg. Inv. Fund Inc., 168 B.R. 930, 937 (Bankr. W.D. Mo. 1994).
[12] In re Pacific Lumber Co., 584 F.3d 229, 252–53 (5th Cir. 2009).
[13] In re Lowenschuss, 67 F.3d 1394, 1401–02 (9th Cir. 1995).
[14] In re W. Real Estate Fund Inc., 922 F.2d 592, 600–01 (10th Cir. 1990), amended by Abel v. West, 932 F.2d 898 (10th Cir. 1991).
[15] 11 U.S.C. § 524(a)(2).
[16] 11 U.S.C. § 524(e); see also, e.g., In re Am. Hardwoods Inc., 885 F.2d 621, 626 (9th Cir. 1989).
[17] In re AOV Indus. Inc., 792 F.2d 1140, 1151 (D.C. Cir. 1986) (citing 11 U.S.C. § 1123(a)(4)).
[18] In re FirstEnergy Solutions Corp., Case No. 18-50757 (Bankr. N.D. Ohio).
[19] FirstEnergy, Case No. 18-50757, Settlement Agreement, Dkt. No. 1465, Ex. 1.
[20] Id. at § 6.3.
[21] Id. at § 6.4.
[22] FirstEnergy, Case No. 18-50757, Order Granting Motion of Debtors to Approve Settlement, Dkt. No. 1465, 19.
[23] FirstEnergy, Case No. 18-50757, Third Am. Joint Plan of Reorganization of FirstEnergy Solutions Corp., et al., Pursuant to Chapter 11 of the Bankruptcy Code, Dkt. No. 2430, Art. VIII, § E; see also id. at §§F–H.
[24] Id.
[25] Dow Corning, 280 F.3d at 658.
[26] Id.
[27] FirstEnergy, Case No. 18-50757, Tr. of Oral Ruling, Apr. 4, 2019, 9:19–21.
[28] Id. at 14:7–1.
[29] FirstEnergy, Case No. 18-50757, at 19:1 –25; 20:1–5.
[30] Id. at 24:11–12.
[31] Id. at 20:13–15.
[32] Id. at 22:15; 23:4–5.
[33] Id. at 25:7–16.
[34] Id. at 27:6–21.
[35] Id. at 28:23–25; 29:1–3.
[36] FirstEnergy Solutions, Case No. 18-50757, Fourth Am. Joint Plan of Reorganization of FirstEnergy Solutions Corp., et al., Pursuant to Chapter 11 of the Bankruptcy Code, Dkt. No. 2529.