United States: Gatekeeping Provisions In Chapter 11 Plans May Provide An Alternative To Nonconsensual Nondebtor Releases

Where broad nonconsensual nondebtor releases are unavailable, the Fifth Circuit has endorsed gatekeeping provisions and injunctions to protect certain nondebtor plan participants from post-confirmation litigation.

TAKEAWAYS

• The Fifth Circuit prohibits broad nonconsensual nondebtor releases but has approved "gatekeeping" to minimize post-confirmation litigation that could undermine a reorganization.
• "Gatekeeping" is not a release. It is an injunction preventing lawsuits against critical plan participants before the bankruptcy court determines whether there is a "colorable claim" that it or some other court will adjudicate.
• This alternative may be utilized more often if the Supreme Court rules that nonconsensual nondebtor releases are unavailable under the Bankruptcy Code.

Anondebtor release releases the claims of a nondebtor party against another nondebtor party related to a debtor, potentially for both pre-petition and post-petition conduct. A nondebtor exculpation is a limited release of claims against nondebtor parties who participated in a bankruptcy case, e.g., trustees and creditor committee members, and typically concerns post-petition conduct. A nondebtor release or exculpation is "nonconsensual" if imposed on a releasing party without its explicit or, in some cases, implicit consent.

Nonconsensual nondebtor releases have been a key reason businesses facing mass tort claims have filed for bankruptcy. They hope chapter 11 will result in a faster, less expensive resolution of mass tort claims than class actions or multidistrict litigation. This relief emerged from the landmark asbestos case Johns-Manville, after which Congress enacted 11 U.S.C. § 524(g), which provides for nonconsensual nondebtor releases within a framework that channels asbestos liability claims away from a debtor to a trust designed to process and pay those claims.

Congress never expanded the application of section 524(g) to include other mass torts, and the Circuits have split on the authority of bankruptcy courts to grant nonconsensual nondebtor releases outside of the asbestos context. The Second, Third, Fourth, Sixth, Seventh, Ninth and Eleventh Circuits allow varying degrees of nonconsensual nondebtor releases in non-asbestos cases, whereas the Fifth and Tenth Circuits categorically bar nonconsensual nondebtor releases outside asbestos.

In 2021, several members of Congress introduced the Nondebtor Release Prohibition Act, a bill to amend the Bankruptcy Code to prohibit nonconsensual nondebtor releases other than as already provided in section 524(g) for asbestos cases, but the bill never made it to the floor for a vote.

The Supreme Court recently recalled and stayed the mandate of the Second Circuit approving nonconsensual nondebtor releases in In re Purdue Pharma L.P., 69 F.4th 45 (2d Cir. 2023), cert. granted sub nom. Harrington v. Purdue Pharma, L.P., No. 23-124, 2023 WL 5116031 (U.S. Aug. 10, 2023). The Supreme Court will hear argument in December 2023 on "whether the Bankruptcy Code authorizes a court to approve, as part of a plan of reorganization under Chapter 11 of the Bankruptcy Code, a release that extinguishes claims held by nondebtors against nondebtor third parties, without the claimants' consent." A decision is expected by June 30, 2024.

While broad releases for nondebtor parties making a monetary contribution to a plan of reorganization, e.g., the Sackler family in Purdue, have drawn much attention, narrower releases for essential nondebtor plan participants have enjoyed some success, even under a less expansive view of bankruptcy courts' authority to grant such releases.

Highland Capital – The Fifth Circuit Decision

Mass tort scenarios run the risk of overwhelming a potential debtor who lacks the resources to litigate (much less satisfy) claims. Although Highland Capital was not a mass tort case, the debtor was under threat of "vexatious litigation" from James Dondero, the investment firm's founder and former CEO, who allegedly wanted to "burn the place down." Nexpoint Advisors, L.P. v. Highland Capital Mgmt., L.P. (In re Highland Capital Mgmt., L.P.), 48 F.4th 419, 426 (5th Cir. 2022).

Instead of appointing a chapter 11 trustee, the creditors' committee selected three independent directors to act as a "quasi-trustee" whose cramdown plan was ultimately confirmed by the bankruptcy court. Because of Dondero's litigation posture, the plan proposed to protect nearly all the bankruptcy participants from further litigation outside bankruptcy court. There was a risk that the debtor's officers, employees, trustees and oversight board members would resign rather than be the target of more litigation brought by Dondero, and that departure of professionals could result in significant deterioration of asset value. Id. at 431.

To minimize these risks, the Highland Capital plan proposed an exculpation provision enforced by an injunction and "gatekeeper" provision. The plan's exculpated parties were numerous and included the debtor, its employees, its general partner, the independent directors, the creditors' committee members, successor entities, the oversight board created to monitor plan implementation, retained professionals and "Related Persons." Id. at 427. The bankruptcy court, as gatekeeper, would first determine whether any party seeking to bring a claim against an exculpated party had a "colorable claim," second authorize the party to bring the claim, and third adjudicate the claim if the bankruptcy court had jurisdiction over the merits. Id.

This gatekeeping construct is based on the so-called "Barton Doctrine," which generally holds that bankruptcy courts supervise bankruptcy trustees, and any misdeeds of trustees (or debtors-in-possession) should be brought in bankruptcy court. Barton v. Barbour, 104 U.S. 126, 128 (1881). In this way, bankruptcy courts can prevent suits against trustees in non-bankruptcy courts.

The Fifth Circuit accepted the gatekeeping provisions as a function that bankruptcy courts traditionally perform. To prevent pursuit of bankruptcy-specific claims against certain insiders outside of the bankruptcy courts, the Fifth Circuit permits bankruptcy courts to issue injunctions and channeling orders. While not a release, the injunction could limit improper suits against chapter 11 insiders while still preserving the plaintiff's right to assert claims.

The Fifth Circuit, however, also rejected the breadth of parties protected by the plan's nonconsensual exculpations as being beyond the bankruptcy court's authority under 11 U.S.C. § 524(e). The Fifth Circuit held that the bankruptcy court's authority to exculpate nondebtors is limited to the creditors' committee members under Hilal v. Williams (In re Hilal), 534 F.3d 498 (5th Cir. 2008) and the independent directors (acting as quasi-trustee of the debtor-in-possession) under 11 U.S.C. § 1107(a).

Highland Capital – The Bankruptcy Court Exercising Its Gatekeeping Function

Just last week, on August 25, 2023, the U.S. Bankruptcy Court for the Northern District of Texas exercised the gatekeeping provisions in the Highland Capital plan by denying Hunter Mountain Investment Trust (HMIT) leave to file a complaint against the debtor's CEO James Seery and others. Although Dondero denies that he controls HMIT, he and his family are its beneficiaries.

The proposed complaint alleged that Seery breached fiduciary duties and conspired to induce unsecured creditors to sell their claims at a discount to purchasers, allegedly friendly with Seery, who would approve of Seery's allegedly excessive compensation demands, and that the discounted sale resulted in less money to pay off the creditor body in full and diminished the likelihood that HMIT will realize any recovery on its contingent Class 10 former equity interest. In re Highland Capital Mgmt., L.P., No. 19-34054-sgj-11, 2023 Bankr. LEXIS 2104, at *58 (Bankr. N.D. Tex. Aug. 25, 2023).

The Bankruptcy Court held a full-day evidentiary hearing admitting more than 80 exhibits and receiving testimony from Seery, Dondero and HMIT's administrator. Id. at 72. The Bankruptcy Court concluded that HMIT lacked standing to bring the proposed claims and that, even if HMIT had standing, it "has not met its burden under the Gatekeeper Colorability Test of showing that ... the Proposed Claims are not without foundation, not without merit, and not being pursued for an improper purpose." Id. at 155.

Conclusion

Debtors may consider adding gatekeeper provisions to their plans, especially with uncertainty pending the Supreme Court's decision in Purdue. Adding a gatekeeper provision is a form of protection that, if a release of an essential chapter 11 participant is unenforceable, can prevent improper litigation against plan participants.

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