United States: Third-Party Releases – Better Make Sure They Are Adequately Disclosed

In Re Lower Bucks Hospital, No. 13-1311 (3d Cir., July 3, 2014)

CASE SNAPSHOT

In a recent non-precedential holding, the Third Circuit Court of Appeals affirmed a decision of the bankruptcy court finding that the disclosure of a third-party release in the settlement agreement and the disclosure statement accompanying a plan of reorganization was inadequate, and therefore the bankruptcy court was justified in striking the release provision from both the settlement agreement and the plan.

FACTUAL BACKGROUND

The chapter 11 debtor brought an action against the indenture trustee as the holder of secured notes, seeking a declaration by the bankruptcy court that the liens of the indenture trustee were voidable because of faulty financing statements that were ultimately corrected - but within the preference period. The indenture trustee asserted that the bonds were secured by the hospital's gross revenues. However, the hospital had changed its name after the original financing statements were filed. The original financing statements were not corrected to reflect the new name of the debtor until long after its name change, and the corrected financing statements were filed within 90 days of the bankruptcy filing.

Ultimately the case was settled and the settlement was reduced to a written agreement. The settlement agreement contained a release of the indenture trustee that was binding not only upon the debtor and the creditors committee, but also upon the bondholders who were not parties to the agreement. The proposed settlement was presented to the bankruptcy court judge as an attachment to a motion filed under Bankruptcy Rule 9019 seeking to have the agreement approved. Evidently neither the counsel to the debtor nor the counsel to the indenture trustee brought the contents of the third-party release to the bankruptcy judge's attention, and the judge approved the settlement.

Not long after the settlement was approved, the debtor filed its proposed plan of reorganization and disclosure statement. Those documents included the same third-party release, releasing the indenture trustee of any and all wrongdoing and causes of action by all creditors, including the bondholders. In neither document was the release highlighted or emphasized. At the disclosure statement hearing, the bankruptcy judge was not made aware of the release, which had not been highlighted, and was not conspicuous. The judge approved the disclosure statement and it was thereafter distributed to creditors, together with the plan.

Soon after the disclosure statement was approved and disseminated, a bondholder filed a motion asking the bankruptcy court to reconsider its earlier order approving the settlement agreement. The same bondholder then filed a putative class action in the Eastern District of Pennsylvania alleging that the bond trustee breached its fiduciary duties to the bondholders by failing to maintain proper financing statements with respect to their security interests in the debtor's gross revenues. The objecting bondholder also filed an objection to the plan, arguing that the third-party release was an "impermissible, noncrucial, nondebtor third party release" that was not properly disclosed.

Upon reviewing the objector's motion, the bankruptcy court entered an order amending its prior order approving the settlement agreement. In his restated order, the bankruptcy judge made clear that the bondholders retained their right to bring claims against the indenture trustee, thus rendering the third-party release ineffective as to the bondholders.

At the plan confirmation hearing, the parties agreed to sever from the plan the third-party release and to have that considered at a separate hearing. The plan was then confirmed without the third-party release. At the hearing on the third party release, the bankruptcy court judge found that the disclosure of that release had been inadequate, both in the settlement agreement and in the disclosure statement, and thus denied the motion to approve the release. His opinion highlighted his view that the parties had been intentionally tight lipped about the release despite numerous opportunities to bring the existence and breadth of the release provision to his attention. While the bankruptcy court did not accuse the attorneys for the debtor and indenture trustee of intentionally misleading or deceiving the court, the court did find the actions of counsel very troubling and concluded that the third-party releases were not made clear to him or to the parties they were intended to bind. He also found that the bondholders were not bound by the third-party releases based upon his finding that the disclosure of the third-party release provisions in the settlement agreement and disclosure statement was inadequate.

The district court heard the initial appeal of the bankruptcy court's decision and affirmed same. The Third Circuit analyzed the bankruptcy court's decision using the abuse of discretion standard. However, it did exercise de novo review over the procedural aspects of the bankruptcy court's decision to revisit and ultimately amend its earlier determination about the adequacy of disclosure within the settlement agreement and the disclosure statement.

COURT ANALYSIS

The Third Circuit noted that the third-party release acts as an injunction because in releasing the bond trustee from any liability to creditors, it essentially enjoins bondholders under the applicable bond documents from bringing actions against the trustee. Because the release provision functions similarly to an injunction, the court held that Federal Rule of Bankruptcy Procedure 3016(c), which governs the manner in which injunctions must be disclosed, also applies to a release that essentially serves the same purpose. Bankruptcy Rule 3016(c) requires that any injunction contained within a plan and disclosure statement must describe in specific and conspicuous language (bold, italic or underlined texts) any acts to be enjoined and the entities subject to the injunction.

The court noted that based upon the facts, the bankruptcy judge did not abuse his discretion in denying approval of the third-party release. The court agreed with the bankruptcy court that the disclosure statement's failure to highlight the third-party release or to italicize, underline or boldface it was sufficient to render its disclosure inadequate. Further, the plan was similarly deficient in terms of adequately disclosing the third-party release, especially in light of all of the other information contained therein. The release was not included within key sections of the plan, such as: (1) Summary of Key Terms of the Plan; (2) Summary of Distributions Under the Plan; (3) The Bond Trustee Litigation; (4) Treatment of Claims Against the Debtors; and (5) Conditions Precedent to Confirmation of the Plan.

The court also rejected the indenture trustee's argument that it was incorrect for the bankruptcy court to reverse its initial ruling approving the settlement agreement in toto. Under Federal Rule of Bankruptcy Procedure 9024, which incorporates Rule 60(b) of the Federal Rules of Civil Procedure, bankruptcy courts, like district courts, may revisit and reconsider prior orders in the case of "mistake, inadvertence, surprise....excusable neglect," "newly discovered evidence" or "any other reason that justifies relief." Because the bankruptcy judge was unaware of the release that was due "in no small part to the parties' failure to disclose adequately or otherwise draw the Court's attention to the" release provision, he was correct to revisit his earlier order approving the agreement that contained the release.

While the Third Circuit noted that there are non-consensual third-party releases that are appropriately included in plans of reorganization, such releases must be supported by a finding that the release is "both necessary to the plan and given in exchange for fair consideration." In re Continental Airlines, 203 F.3d 203, 214. (3d Cir. 2000). In Continental, the court identified the hallmarks of a permissible non-consensual release as "fairness, necessity to the reorganization, and specific factual findings to support these conclusions." Id. at 214. In this case, because disclosure of the non-consensual third-party release was not adequate, there was no showing that the release was fair to the parties being impacted by it, i.e., the bondholders.

PRACTICAL CONSIDERATIONS

While this decision may be non-precedential, it is very important nonetheless. The Third Circuit made it quite clear that the burden is on the parties desiring the inclusion of a third-party release to make sure it is adequately disclosed to those persons affected by it, and "failure to do so in a clear and conspicuous manner risks excision of the release from the plan."

This article is presented for informational purposes only and is not intended to constitute legal advice.

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