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Proposed Legislation May Limit Chapter 11 Plan Releases

August 25, 2021

Chapter 11 plans of reorganization provide creditors with recoveries (cash or new securities) in exchange for a release and discharge of all claims against the debtor. Many Chapter 11 plans go a step further to release claims against related entities and persons who are not debtors in the case. Members of Congress have recently proposed legislation that could prohibit such nonconsensual third-party releases.

Recent high-profile cases have sharpened the scrutiny of these so-called “nondebtor releases.” Proposed reorganization plans in Purdue Pharma, Boy Scouts of America, and USA Gymnastics seek to release nondebtor parties from any liability related to the relevant debtors’ business activities. The nondebtor releases in these cases have generated significant public controversy, which has reached the halls of Congress, where several sponsors[1] have proposed the Nondebtor Release Prohibition Act of 2021.

The proposed legislation would prohibit nonconsensual third-party releases. It would also bar third-party releases that are “consensual” only through “opt-out” provisions. As currently proposed, the legislation would preserve only expressly consensual third-party releases and does not impact releases of estate claims.

The timing and likelihood of passage of the legislation are uncertain but should be watched closely by practitioners. Should the bill become law, it may create substantial changes in large Chapter 11 reorganization cases.

What Is a Nondebtor Release?

Nondebtor releases extinguish liability between two nondebtors through a Chapter 11 plan. They typically provide that confirmation of a plan will bind the debtor’s creditors to release of their personal claims against various third parties, such as the debtor’s directors and officers, lenders, committee members, advisors, private equity sponsors, and other stakeholders involved in a reorganization.

Nondebtor releases are different from estate or debtor releases, which extinguish liability, usually through a settlement, that a nondebtor might owe to the debtor and its estate, and are authorized by Congress.[2] For example, fraudulent transfer claims are owned by the estate and can only be settled by the estate. The legislation does not change this.

Nondebtor releases are frequently employed in large commercial Chapter 11 cases (so-called “mega cases”) to provide a comprehensive “clean slate” for the parties involved in the failed business venture. Advocates argue that they protect against nuisance and bankruptcy-related litigation following the restructuring.[3] For example, the debtors’ lenders and advisors facilitating a court-approved restructuring expect protection against third-party claims relating to the debtor and its restructuring. Opponents point to a lack of statutory authority.

Nondebtor releases are also a tool for using Chapter 11 to effect global settlements. The Boy Scouts of America and USA Gymnastics plans propose to release nondebtors in exchange for their contributions to trusts that a plan would form for the benefit of sexual abuse victims. If the plans are confirmed and become effective, victims of abuse would have access to these funds, and otherwise be barred from bringing claims against the released parties.

Nondebtor releases have always been controversial—what is new is that the controversy has become public. As the US Court of Appeals for the Second Circuit explained:

[A] nondebtor release is a device that lends itself to abuse. By it, a nondebtor can shield itself from liability to third parties. In form, it is a release; in effect, it may operate as a bankruptcy discharge arranged without a filing and without the safeguards of the Code. The potential for abuse is heightened when releases afford blanket immunity.[4]

 

The statutory authority for bankruptcy courts to grant nondebtor releases has also been the subject of controversy: claims are a form of property, and Congress gave bankruptcy judges no express power to modify a nondebtor’s property interest in a claim against another nondebtor.[5] Some courts have concluded that without clear statutory authority, third-party releases are categorically prohibited.[6]

These cases have fanned the embers of this smoldering controversy.[7] Rarely have Chapter 11 plan mechanics attracted so much attention from the public, politicians, and the media.

Types of Nondebtor Releases

There are two categories of nondebtor releases: consensual and nonconsensual. The legislation targets both.

Consensual nondebtor releases require the consent of the party granting the release. Debtors have been creative in constructing methods to obtain “consent.” Some courts have permitted debtors to treat creditor votes accepting a Chapter 11 plan as sufficient manifestation of consent to the plan’s release provisions.[8] Other courts require claimants to affirmatively “opt in” to the releases by returning a form/ballot that evidences their consent. Still others find “consent” in a creditor’s failure to “opt out” of a release.[9] “Opt out” courts treat the silence or nonresponse of the claimant as manifestation of consent to granting the release; if the creditor does not indicate on its form/ballot that it opts out, it will be deemed to grant the release.[10]

Nonconsensual nondebtor releases, as the name suggests, are granted by a court regardless of whether claimants consent. While permissible in a majority of jurisdictions, they are granted only in “rare cases”[11]—typically cases involving mass torts and substantial contribution to a settlement fund. Nonconsensual releases require a showing of one or more factors such as whether (1) the enjoined claims would indirectly impact the debtor’s reorganization by way of indemnity or contribution; (2) the enjoined claims were channeled to a settlement fund rather than extinguished; (3) the plan otherwise provided for the full payment of the enjoined claims; and/or (4) the estate received substantial consideration from the party to be released.[12]

Proposed Legislation

The legislation proposes to limit third-party releases to circumstances where clear affirmative consent has been obtained. It begins with a blanket prohibition:

[T]he court may not . . . with respect to the liability of an entity other than the debtor or the estate on, or the liability of property of an entity other than the debtor or the estate for, a claim or cause of action of an entity other than the debtor or the estate—(A) approve any provision, in a plan of reorganization or otherwise, for the discharge, release, termination, or modification of such liability; or (B) order the discharge, release, termination, or modification of such liability.[13]

This bar is subject to exception, but only if “[the releasing] entity expressly consents in a signed writing . . . given only after clear and conspicuous notice to such entity of the proposed disposition in language appropriate for the typical holder of such claim or cause of action.”[14] This would prohibit both nonconsensual and “opt-out” nondebtor releases.

The legislation would also prohibit plan provisions that condition a claimant’s plan treatment on whether it consents to plan releases.[15] The bill would foreclose the practice of conditioning an enhanced recovery on the creditor’s affirmative consent to a release.[16] This feature would eliminate the ability, even on a clearly consensual basis, for debtors and nondebtors to offer claimants consideration for a release that would provide finality for debtors and nondebtors regarding the issues that caused the insolvency.

Potential Impacts

If enacted, the bill would prohibit courts from approving nondebtor releases where the Chapter 11 plan in which they are proposed

  • treats votes accepting the plan as creditor “consent” to release that creditor’s claim against a nondebtor;
  • provides for a lesser distribution to creditors that do not consent to a release and a higher distribution for creditors that do consent;
  • provides nonconsensual nondebtor releases, regardless of any rights to indemnity held by the released party, any co-liability of the released party, or any other basis that traditionally has been asserted to justify nonconsensual releases;
  • requires that creditors opt out of nondebtor releases or oppose the plan to avoid being deemed to consent to nondebtor releases; or
  • contemplates a payment from a nondebtor defendant into a settlement trust, against which released claims are to be asserted.

The proposed legislation would only permit nondebtor releases where creditors expressly consent in a signed writing. As drafted, the bill eliminates the ability to offer the incentive of improved creditor returns to obtain global compromise and may make it more difficult to obtain the sufficient consents from large creditor bodies in certain complex cases.

A likely consequence of the bill would be to eliminate bankruptcy restructurings as vehicles for large tort settlements, or to generate complex workarounds, such as combined Chapter 11 plans and class action proceedings. Tort defendants would be less likely to contribute substantial sums in settlement, knowing that they might still be liable to tort plaintiffs outside of Chapter 11.

The bill’s impact on other aspects of case administration and exculpation rights remains uncertain. Even if third parties might not “release” claims against debtor-in-possession (DIP) lenders, creditors’ committees, and the like, whether there are valid claims in those areas is quite a different question. Bankruptcy courts will still be able to make findings of fact about the good faith of estate fiduciaries, and the fairness of bankruptcy arrangements, that might as a practical matter foreclose most claims.

The bill could provide much needed certainty and uniform treatment of releases in the circuit courts. Uniformity and certainty will decrease litigation associated with approval of nondebtor releases (a hotly disputed issue in many cases), which will reduce plan confirmation costs. It would also reduce forum shopping since the availability of nondebtor releases would be uniform across jurisdictions.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

New York
Kurt A. Mayr

Boston
P. Sabin Willett

Century City
David M. Riley



[1] Senators Elizabeth Warren (D-Mass.), Dick Durbin (D-Ill.), and Richard Blumenthal (D-Conn.) and Representatives Jerrold Nadler (D-NY) and Carolyn B. Maloney (D-NY).

[2] See 11 U.S.C. § 1123(b)(3)(A) (authorizing “settlement or adjustment of any claim or interest belonging to the debtor or to the estate”).

[3] This is not merely hypothetical: a defendant and former debtor that did not receive a third-party release in its bankruptcy has recently petitioned the US Supreme Court to decide issues of preemption of state law tort claims premised on a misuse of bankruptcy proceedings, or that seek to impose liability based on the fact of bankruptcy. Pilevsky v. Sutton 58 Assocs. LLC, Case No. 20-1483, Pet. for Writ of Certiorari (Apr. 20, 2021).

[4] In re Metromedia Fiber Network, Inc., 416 F.3d 136, 142 (2d Cir. 2005).

[5] See, e.g., In re Dow Corning Corp., 280 F.3d 648, 656 (6th Cir. 2002) (“The Bankruptcy Code does not explicitly prohibit or authorize a bankruptcy court to enjoin a non-consenting creditor's claims against a non-debtor to facilitate a reorganization plan.”).

[6] See, e.g., In re W. Real Estate Fund, Inc., 922 F.2d 592, 600 (10th Cir. 1990) (“Obviously, it is the debtor, who has invoked and submitted to the bankruptcy process, that is entitled to its protections; Congress did not intend to extend such benefits to third-party bystanders.”), modified by Abel v. West, 932 F.2d 898 (10th Cir. 1991).

[7] Warren, Nadler, Durbin, Blumenthal, Maloney Announce Legislation to Eliminate Non-Debtor Releases, Prevent Corporations and Private Entities from Escaping Accountability in Bankruptcy Proceedings (July 28, 2021).

[8] See, e.g., In re SunEdison, Inc., 576 B.R. 453, 460 (Bankr. S.D.N.Y. 2017).

[9] See, e.g., In re Indianapolis Downs, LLC, 486 B.R. 286, 305 (Bankr. D. Del. 2013); In re Wash. Mut., Inc., 442 B.R. 314, 355 (Bankr. D. Del. 2011) (“[A]ny third party release is effective only with respect to those who affirmatively consent to it by voting in favor of the Plan and not opting out of the third party releases.”).

[10] Opt-out provisions place a more significant burden on the claimant and have been criticized by a number of courts. See, e.g., In re SunEdison, Inc., 576 B.R. at 460; In re Chassix Holdings, Inc., 533 B.R. 64, 78 (Bankr. S.D.N.Y. 2015); In re Firstenergy Sols. Corp., 606 B.R. 720, 733 (Bankr. N.D. Ohio 2019).

[11] Metromedia, 416 F.3d at 141; see also In re Cont'l Airlines, 203 F.3d 203, 212–13 (3d Cir. 2000) (recognizing that nondebtor releases have been approved only in “extraordinary cases”).

[12] Metromedia, 416 F.3d at 142.

[13] Proposed § 113(a)(1).

[14] Proposed § 113(b)(5).

[15] Proposed § 113(b)(5)(B) (“[S]uch consent cannot be given by . . . accepting a proposed plan.”).

[16] Proposed § 113(b)(5)(C) (“[T]reatment of such entity, and any claims or interests of such entity, under a plan cannot be more or less favorable by reason of such entity’s consent or failure to consent.”).