In a recent decision, the United States Court of Appeals for the Eleventh Circuit reaffirmed its position sanctioning, under appropriate circumstances, nonconsensual third party release provisions in chapter 11 plans. In SE Prop. Holdings, LLC v. Seaside Eng'g & Surveying, Inc.(In re Seaside Eng'g & Surveying, Inc.), 780 F.3d 1070 (11th Cir. 2015), the Eleventh Circuit affirmed bankruptcy and district court decisions approving a debtor's chapter 11 plan that released the debtor's former principals over the objection of a noninsider equity holder. In so ruling, the Eleventh Circuit maintained its alignment with the majority position on the third party release issue, along with the Second, Third, Fourth, Sixth, and Seventh Circuits.
Validity of Nonconsensual Third Party Releases in a Chapter 11 Plan
The federal circuit courts of appeal are split as to whether a
bankruptcy court has the authority to approve chapter 11 plan
provisions that, over the objection of creditors or other
stakeholders, release specified nondebtors from liability and/or
enjoin dissenting stakeholders from asserting claims against such
nondebtors. The minority view, held by the Fifth, Ninth, and Tenth
Circuits, bans such nonconsensual releases on the basis that
section 524(e) of the Bankruptcy Code, which provides generally
that "discharge of a debt of the debtor does not affect the
liability of any other entity on, or the property of any other
entity for, such debt," prohibits them. See Bank of N.Y.
Trust Co. v. Official Unsecured Creditors' Comm. (In re Pac.
Lumber Co.), 584 F.3d 229 (5th Cir. 2009); In re
Lowenschuss, 67 F.3d 1394 (9th Cir. 1995); In re W. Real
Estate Fund, Inc., 922 F.2d 592 (10th Cir. 1990).
On the other hand, the majority of circuits to consider the
issue—the Second, Third, Fourth, Sixth, and Seventh
Circuits—have found such releases and injunctions
permissible, under certain circumstances. See In re Drexel
Burnham Lambert Group, Inc., 960 F.2d 285 (2d Cir. 1992);
In re Continental Airlines, 203 F.3d 203 (3d Cir. 2000);
In re A.H. Robins Co., Inc., 880 F.2d 694 (4th Cir. 1989);
In re Dow Corning Corp., 280 F.3d 648 (6th Cir. 2002);
In re Airadigm Communications, Inc., 519 F.3d 640 (7th
Cir. 2008). For authority, these courts generally rely on section
105(a) of the Bankruptcy Code, which authorizes courts to
"issue any order, process, or judgment that is necessary or
appropriate to carry out the provisions of [the Bankruptcy
Code]." Moreover, as the Seventh Circuit held in
Airadigm, the majority view is that section 524(e) does
not limit a bankruptcy court's authority to grant such a
release. The First and D.C. Circuits have indicated that they agree
with the "pro-release" majority, as did the Eleventh
Circuit in a decision that had long predated Seaside
Engineering. See In re Monarch Life Ins. Co., 65 F.3d
973 (1st Cir. 1995); In re Munford, Inc., 97 F.3d 449
(11th Cir. 1996); In re AOV Industries, 792 F.2d 1140
(D.C. Cir. 1986).
In Dow Corning, the Sixth Circuit identified seven factors
that bankruptcy courts should consider when evaluating the
propriety of a nonconsensual release of claims against a nondebtor
third party in a chapter 11 plan:
- An identity of interests between the debtor and the third party, usually an indemnity relationship, such that a suit against the nondebtor is, in essence, a suit against the debtor or will deplete the assets of the estate;
- Substantial contribution by the nondebtor of assets to the reorganization;
- The essential nature of the injunction to the reorganization, namely, the fact that the reorganization hinges on the debtor's being free from indirect suits against parties who would have indemnity or contribution claims against the debtor;
- Overwhelming acceptance of the plan by the impacted class or classes;
- Provision in the plan for payment of all or substantially all of the claims of the class or classes affected by the injunction;
- Provision in the plan for an opportunity for claimants who chose not to settle to recover in full; and
- A record of specific factual findings by the bankruptcy court that supports its conclusions.
The list is nonexclusive, and not all of the factors need to be
satisfied. Courts have the discretion and flexibility to determine
which of the factors will be relevant in each case.
In In re Master Mortgage Invest. Fund, Inc., 168 B.R. 930
(Bankr. W.D. Mo. 1994), the bankruptcy court articulated a similar
five-factor test that considers: (i) the identity of interests
between the debtor and the third party, including any indemnity
relationship; (ii) any value (monetary or otherwise) contributed by
the third party to the chapter 11 case or plan; (iii) the need for
the proposed release in terms of facilitating the plan or the
debtor's reorganization efforts; (iv) the level of creditor
support for the plan; and (v) the payments and protections
otherwise available to creditors affected by the release. Like the
Dow Corning factors, the Master Mortgage test has
been cited with approval by many other courts. See,
e.g., In re Charles St. African Methodist Episcopal
Church of Bos., 499 B.R. 66 (Bankr. D. Mass. 2013); In re
Riverbend Leasing, LLC, 458 B.R. 520 (Bankr. S.D. Iowa 2011);
In re Wash. Mut., Inc., 442 B.R. 314 (Bankr. D. Del.
2011); In re Zenith Elecs. Corp., 241 B.R. 92 (Bankr. D.
Del. 1999).
The Eleventh Circuit revisited the third party release issue in
Seaside Engineering.
Background
Seaside Engineering & Surveying, Inc. ("Seaside")
was a closely held civil engineering and surveying firm that
conducted hydrographic surveying and navigational mapping.
Seaside's five principal shareholders were also its officers,
directors, and key operating personnel.
Seaside's principal shareholders also formed two wholly
separate real estate companies. These companies borrowed money from
Vision-Park Properties, LLC, and an affiliate (collectively,
"Vision"). Seaside's shareholders personally
guaranteed the loans, but Seaside was neither a borrower nor a
guarantor.
The real estate ventures ultimately defaulted on the loans,
triggering a $4.5 million obligation under the personal guarantees.
Three of Seaside's principal shareholders then filed chapter 7
cases. The chapter 7 trustee in one of the cases auctioned the
debtor's Seaside shares, which Vision acquired for
$100,000.
Seaside filed for chapter 11 protection in the Northern District of
Florida on October 7, 2011 (after Vision acquired the Seaside
shares). Seaside filed a chapter 11 plan (the "Plan")
under which Seaside proposed to reorganize and continue operating
under a new name—Gulf Atlantic, LLC ("Gulf"). Gulf
would be owned by irrevocable family trusts settled for
Seaside's principal shareholders, who would also manage the
reorganized company. Under the Plan, nonmanager equity holders,
including Vision, were to receive promissory notes with interest
accruing at the rate of 4.25 percent annually in exchange for their
interests in Seaside and would not receive an ownership interest in
Gulf.
The Plan also included provisions releasing Seaside's officers,
directors, and members; Gulf; Gulf's officers, directors, and
members; and the representatives of each of these nondebtor
entities. The releases covered liability for acts, omissions,
transactions, and other occurrences related to Seaside's
chapter 11 case, except actions amounting to fraud, gross
negligence, or willful misconduct.
Vision objected to various aspects of the Plan, including the
releases. According to Vision, the releases were
"inappropriate, unjust and unnecessary" and improperly
sought to frustrate Vision's efforts to collect from the
principal shareholders and their respective bankruptcy
estates.
The bankruptcy court approved the releases after Seaside amended
the Plan provisions to remove subsidiaries and affiliates from the
list of released parties and agreed to terminate litigation against
Vision seeking sanctions. In doing so, the court applied the
multifactor Dow Corning test.
The bankruptcy court confirmed the amended Plan over Vision's
objections. Vision appealed to the U.S. District Court for the
Northern District of Florida, which affirmed the confirmation
order. Vision then appealed to the Eleventh Circuit.
The Eleventh Circuit's Ruling
A three-judge panel of the Eleventh Circuit affirmed.
At the outset of its ruling, the Eleventh Circuit noted that, in
Munford, the court previously held that section 105(a) of
the Bankruptcy Code provides bankruptcy courts with authority to
approve nonconsensual third party releases. The court approved the
release in Munford because: (i) it was "integral to
settlement in an adversary proceeding," and (ii) the released
party was a settling defendant that would not have agreed to the
settlement without the release. Despite the factual dissimilarities
between the two cases, the Eleventh Circuit in Seaside
Engineering wrote that "Munford is the
controlling case here" and held that the Eleventh Circuit
follows the "majority view" that nonconsensual third
party releases are permissible under certain circumstances.
The Eleventh Circuit rejected the argument endorsed by the
"minority circuits" that such releases are prohibited by
section 524(e) of the Bankruptcy Code. In doing so, the court
agreed with the Seventh Circuit's rationale in
Airadigm, where the court stated that "[t]he natural
reading of this provision does not foreclose a third-party release
from a creditor's claims." Moreover, the Eleventh Circuit
explained, if Congress had intended to limit the power of
bankruptcy courts in this respect, it would have done so
unequivocally.
With this groundwork, the Eleventh Circuit ruled that the
bankruptcy court's application of Dow Corning was
consistent with existing Eleventh Circuit precedent. In commending
those factors to bankruptcy courts within the circuit, the Eleventh
Circuit emphasized that bankruptcy courts have discretion to
determine which of the factors will be relevant in each case and
that the factors should be considered a nonexclusive list of
considerations. Moreover, the Eleventh Circuit noted, the Dow
Corning factors should be applied flexibly, always keeping in
mind that such releases should be used "cautiously and
infrequently" and only where essential, fair, and
equitable.
The Eleventh Circuit determined that the bankruptcy court did not
abuse its discretion in finding that, overall, application of the
Dow Corning factors demonstrated that the Plan releases
were appropriate. However, the Eleventh Circuit explained that, in
accordance with Munford, bankruptcy courts should also
consider whether a proposed release is "fair and
equitable." Although the bankruptcy court did not explicitly
make such a finding in the case before it, the Eleventh Circuit was
satisfied that the bankruptcy court, in discussing considerations
relevant to such a finding and requiring Seaside to cease
litigation against Vision, properly considered whether the releases
had satisfied this requirement. Among other things, the Eleventh
Circuit, noting that the bankruptcy court had described the chapter
11 case as a "death struggle," stated that "the
non-debtor releases are a valid tool to halt that fight."
Impact of Seaside Engineering
Seaside Engineering confirms that the Eleventh Circuit
is still firmly in the majority camp concerning the propriety of
nonconsensual third party releases in a chapter 11 plan, depending
on the circumstances. This can be viewed as a positive development
for proponents of such releases as a tool for overcoming
confirmation obstacles in complex, contested chapter 11
cases.
The final report issued on December 8, 2014, by the American
Bankruptcy Institute's Commission to Study the Reform of
Chapter 11 highlights the circuit split on this controversial
issue. Although the Commission endorsed the majority view in favor
of plan releases under appropriate circumstances, it also examined
which text better determines whether such circumstances exist: the
Dow Corning test or the Master Mortgage
test.
The two tests overlap significantly. However, unlike the Dow
Corning factors, the Master Mortgage factors do not
consider whether "[t]he bankruptcy court made a record of
specific factual findings that supports its conclusions." The
Commission ultimately recommended that courts adopt a standard
based on the factors articulated in Master Mortgage rather
than those in Dow Corning. The Commission declined
"to incorporate separate identification of unique or unusual
circumstances," stating that "the Master
Mortgage factors adequately capture[] the careful review
required in these cases."
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.