Reliance Upon J. Alix Protocol May Preclude Exculpation in Fifth Circuit

A New Exception to a Strict Fifth Circuit Prohibition

It is well settled in the Fifth Circuit that chapter 11 plans providing for nonconsensual releases of claims against parties other than a debtor violate § 524(e) of the Bankruptcy Code and are strictly prohibited. [1] This prohibition has generally been interpreted broadly; for example, post-confirmation injunctions that effectively discharge nondebtor liability have also been found to violate § 524(e).[2] Additionally, subject to certain limited exceptions, the Fifth Circuit has held that § 524(e) bars exculpatory provisions in a chapter 11 plan for nondebtors. [3] That bar to nondebtor exculpation has, thus far in the Fifth Circuit, [4] also precluded broad exculpation for estate professionals. [5]

Recently, in NexPoint Advisors, L.P. v. Highland Cap. Mgmt., L.P. (In re Highland Cap. Mgmt., L.P.), [6] the Fifth Circuit Court of Appeals once again reiterated § 524(e)’s prohibition of nondebtor exculpation while also examining certain recognized exceptions. Summarizing Fifth Circuit precedent, the Highland court explained that “exculpation [provisions] in a Chapter 11 reorganization plan [must] be limited to the debtor, the creditors’ committee and its members for conduct within the scope of their duties, […] and the trustees within the scope of their duties.” 7 In what may constitute a potentially significant expansion of Fifth Circuit law, however, the Highland court found that exculpation of court-approved “Independent Directors” employed by the debtors’ estate did not violate § 524(e) given that such independent directors were appointed “to act together as the bankruptcy trustee” for the debtor. [8]

In upholding exculpation for the Highland independent directors, the Fifth Circuit has seemingly recognized an additional exception to the otherwise strict prohibition against nondebtor releases/exculpation for estate-employed fiduciaries. There is, of course, a catch to this new exception. To qualify, the employed fiduciary must either be “court-appointed” or “court-approved.”

While the Highland opinion is noteworthy for its holdings regarding third-party release practice in the Fifth Circuit, practitioners should also be mindful of a potential ancillary impact. Having seemingly conditioned eligibility for exculpation upon a fiduciary’s status as either “court-appointed” or “court-approved,” the Fifth Circuit has indirectly called into question the continued viability of employing interim officers or directors on behalf of a debtor pursuant to § 363(b) of the Bankruptcy Code.

The J. Alix Protocol: A Misuse of § 363(b)?

Section 363(b) does not contemplate either the appointment or the approval of retention of “professional persons.” Rather, 11 U.S.C. § 363(b) is a statutory provision of the Bankruptcy Code that grants authority to a bankruptcy court to authorize a debtor’s use of estate assets outside of the ordinary course of business. Nonetheless, largely due to the promulgation of the J. Alix Protocol favored by the U.S. Trustee program, debtors frequently seek to employ post-petition officers or directors under § 363(b).

The J. Alix Protocol, in simple terms, provides that debtors should retain “professional persons” pursuant to § 363, but also apply the relevant disclosure and conflict provisions of § 327(a). The protocols were first instituted in an effort to resolve the U.S. Trustee’s objections to the engagement of officers and directors and their financial advisory firms when the officer or director had served in such a role pre-petition.

The practice is not favored in the U.S. Bankruptcy Court for the Southern District of Texas. In In re McDermott Int’l Inc. [9], Judge Jones, then Chief Bankruptcy Judge of the Southern District of Texas, provided an opinion that pointedly rejected both the concerns of the U.S. Trustee in promoting the J. Alix Protocol and those arguments supporting the use of § 363(b). McDermott concludes that “[t]he cases cited for authority of the employment under § 363(b) have little to do with the employment of professional persons.” [10] Indeed, most case law developed around § 363(b) in the employment context focuses on the debtor’s use of estate funds outside of the ordinary course of business and whether a sound business justification exists for such expenditure. [11] “Although [§ 363] has been utilized ... to authorize the retention of professional persons, the language itself deals only with the use of estate property, not the conditions under which a professional person may be employed.” [12]

Are § 363 Fiduciaries “Court-Approved”?

With the lessons of McDermott in mind, a close reading of Highland [13] highlights the vulnerability of employing estate fiduciaries under § 363 or sections of the Bankruptcy Code other than §§ 327 or 328 — in the Fifth Circuit, at least. Specifically, because an order under § 363 merely approves a debtor’s use of property, as opposed to the approval of the professional retained, estate fiduciaries employed pursuant to § 363 might not qualify for exculpation under Highland.

The potential concern can be inferred from the Highland court’s discussion of the Barton Doctrine, which it found to be analogous to certain provisions of the challenged plan. The Highland Court notes: “[t]he Advisors also maintain that Highland Capital is neither a receiver nor a trustee, so Barton has no application here. We disagree. Highland Capital, for all practical purposes, was a debtor in possession entitled to the rights of a trustee.” Highland, 48 F.4th at 439 n. 17 (citations omitted).

Read as a whole, then, to qualify for exculpation as a nondebtor, an estate-employed fiduciary must (1) perform the same essential functions as a trustee, and (2) be court-“approved.” Unfortunately, the Fifth Circuit did not elaborate upon the meaning of “court-approved” as it pertains to estate professionals, and the underlying case facts are not particularly instructive. [14] That said, as discussed above, because an order pursuant to § 363 merely approves the debtors’ use of property, a fiduciary employed pursuant to § 363 might not qualify as “court-approved.”

Indeed, there is precedent for limiting the benefits awarded to professional persons engaged pursuant to § 363 rather than § 327. In In re Arlington Automatics Inc., for example, the bankruptcy court analyzed whether an individual providing functions central to the administration of the estate — namely, the debtor’s ability to obtain a cash-collateral order and then to operate under the cash-collateral order — could receive compensation having not been retained under § 327. [15] The Arlington court denied compensation to the professional on the grounds that he was a “professional person” and was required to be retained under § 327(a). [16]

Similarly, a court applying Highland may find that under § 363(b), a “professional person” has neither “been court approved” nor “court appointed” and, therefore, is not eligible for exculpation without violating § 524(e). Accordingly, to be eligible for exculpation under a chapter 11 plan, an estate fiduciary should seek court approval pursuant to § 327 of the Bankruptcy Code.

As courts continue to grapple with the J. Alix Protocol, practitioners, particularly in the Fifth Circuit, should be aware that “professional person[s]” retained under § 363 might not enjoy certain protections including, but not limited to, exculpation that would otherwise be afforded a “professional person” approved and retained under § 327(a).