Beware of third-party releases in bankruptcy
14 DECEMBER 2015 7:08 AM
During a bankruptcy, what if the debt sought to be discharged in the plan is owed by another party?
Bankruptcy is a well-known method for a company to restructure its debts with creditors. Creditors of the bankrupt company (the debtor) typically have a general awareness that the bankruptcy filing may limit the amount of money that can be recovered on their claim. In fact, creditors lacking an enforceable security interest in the debtor's property (unsecured creditors) sometimes recover nothing in a bankruptcy case.
Bankruptcy law provides that a creditor's recovery against the debtor is limited to the amount doled out to creditors under a confirmed Chapter 11 plan of reorganization. A debtor receives a discharge that acts as a broad release against any claim a creditor may have for additional amounts owed. The policy reason behind granting a discharge to a debtor is that the debtor should be given a chance to emerge from bankruptcy and to seek a profitable future without dealing with claims and other matters that were addressed—or should have been addressed—in the bankruptcy case.
But what if the debt sought to be discharged in the plan is owed by another party?
Consider, for example, two companies (Company A and Company B) in the food production business. Company A receives the food from various agricultural providers and processes the food at a plant in Denver. The processed food is sent to Company B's plant in Phoenix where Company B packages the food and arranges for shipment. While the companies are independent, they enjoy a profitable relationship for many years providing food to hotels and restaurants around the country.
The profits end, however, when a number of guests at a hotel in Miami suffer a bout of food poisoning. The guests file lawsuits against not only the Miami hotel, but also against Company A and Company B on the grounds that they are jointly and severally liable for placing contaminated food into the stream of commerce. Company B has operated conservatively and is able to avoid a bankruptcy filing. Company A, on the other hand, is mired in debt and a Chapter 11 bankruptcy filing is its only alternative. The Miami hotel, therefore, sees recovery against Company B as the only realistic hope for recouping judgments the Miami hotel might have to pay to the injured guests.
Company A's Chapter 11 reorganization is premised on a continuing relationship with Company B. In other words, if Company B were to go out of business, Company A could not survive and would liquidate. A liquidation would mean little to no recovery for Company A's unsecured creditors. A reorganization, on the other hand, would pay unsecured creditors approximately 40% of their claims.
Company B understands this dynamic and sees an opportunity. Company B advises Company A that Company B will provide a portion of the funding that Company A needs to emerge from bankruptcy, on the condition that the bankruptcy plan include a broadly-worded release of Company B. Company A readily agrees, not only because Company A needs the money to fund its plan, but also because Company A is hopeful that a release of claims against Company B will prevent the Miami food-poisoning claims from swamping Company B and driving it out of business. Some of the claimants, including the Miami hotel, vigorously oppose the release of Company B because they want the opportunity to collect against Company B's substantial assets.
Will a bankruptcy court permit such third-party releases?
Federal appeals courts are split on this issue and, therefore, the answer will depend on the location of the bankruptcy court.
The answer might also depend on how the releases are structured in the plan. Company A might put into place a mechanism—typically a "check the box" option in a plan voting ballot—where creditors can voluntarily determine whether they release their claims against Company B. Courts are much more likely to enforce those releases because they are deemed voluntary.
Sometimes, however, debtors seek to use a Chapter 11 plan to put into place non-consensual third-party releases. Some courts flatly refuse to permit such releases on the grounds that they are contrary to a provision on the Bankruptcy Code providing that a discharge of a debtor's debt has no effect on the liability of third parties. For example, the Fifth Circuit made that position clear in the case In re Pacific Lumber, 584 F.3d 229 (5th Cir. 2009). Other courts, however, permit non-consensual third-parity releases when there is a showing that the releases are necessary to an effective reorganization.
In the example above, Company A would seek to establish this standard through evidence showing that Company's B's plan funding is needed and also showing that if Company B had to deal with the Miami food poisoning claims it would go out of business and that Company A's reorganization is premised on Company A's relationship with Company B. In jurisdictions permitting non-consensual third-party releases, those facts could be sufficient to obtain the third-party releases.
This split in authority among federal appeals courts is significant. Third-party releases can greatly expand the scope of a bankruptcy case by affecting parties who might not even have a claim against the debtor in the first place. In the example above, approving the non-consensual release of Company B could severely limit the Miami hotel's ability to recover on losses it otherwise would have been fully entitled to recover under state tort law.
The case law on this issue continues to develop. In October 2015, the Court of Appeals for the Eleventh Circuit, in the case In re Seaside Engineering, 780 F.3d 1070 (11th Cir. 2015), affirmed a Chapter 11 plan containing non-consensual third-party releases over the objection of the debtor's equity holder. The equity holder appealed to the United States Supreme Court, thereby giving the court an opportunity to address the current split amount federal courts of appeal. The Supreme Court, however, passed on the opportunity by denying review of the Seaside Engineering decision. For the foreseeable future the split in authority will remain and creditors will need to be aware that their claim may be released, and their ability to recover severely restricted, by a bankruptcy court order, even when the party owing them money has not filed bankruptcy.
Jason Binford is a director in the Dallas-based law firm of Kane Russell Coleman & Logan PC where he practices in the firm’s Insolvency, Bankruptcy & Creditor Rights section. His experience includes representation of debtors and creditors in large to mid-size Chapter 11 and Chapter 7 cases. He has significant familiarity and expertise in issues unique to vendor creditors, as well as 363 sales, intellectual property, landlord/tenant and franchise issues.
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