ThinkstockPhotos-99188298Circuit courts are divided as to whether provisions of a bankruptcy plan of reorganization may release a non-debtor from creditors’ claims over the objection of a non-consenting creditor (i.e. non-consensual third-party releases). A majority of courts will permit non-consensual third-party releases under certain limited circumstances. This issue has been in the news recently with speculation that the treatment of non-consensual third-party releases was a contributing factor in the decision by the debtors in the Caesars bankruptcy cases to file for bankruptcy in the Bankruptcy Court for the Northern District of Illinois (which is located in the Seventh Circuit—a circuit that permits non-consensual third-party releases and applies a less stringent test).

In a March 12th decision, the Eleventh Circuit addressed the issue of non-consensual third-party releases in the case of SE Property Holdings, LLC v. Seaside Engineering & Surveying, Inc., (In re Seaside Engineering & Surveying, Inc.). In its decision affirming the approval of a plan of reorganization that provided for a non-consensual third-party release, the Eleventh Circuit provided a refresher on the circuit split and joined the majority of courts that permit these releases under limited circumstances.

The Circuit Split

The split among circuit courts regarding non-consensual third-party releases centers around the interpretation of section 524(e) of the Bankruptcy Code. This section provides in relevant part that “[D]ischarge 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.” A minority of courts consisting of the Fifth, Ninth, and Tenth Circuits interpret this provision to prohibit non-consensual third-party releases because such releases implicate the liability of an entity other than the debtor.

In contrast, a majority of courts consisting of the Second, Third, Fourth, Sixth, and Seventh Circuits have held that non-consensual third-party releases are permissible, under certain limited circumstances. Moreover, the First, Eleventh, and D.C. Circuits have indicated that they agree with the “pro-release” majority. As the Seventh Circuit held in In re Airadigm Communications, Inc., the majority view is that section 524(e) does not limit a bankruptcy court’s authority to grant such a release. Indeed, when Congress has desired to limit a bankruptcy court’s authority—as it did, for example, in section 1129(a)—the Bankruptcy Code includes specific limitations on a bankruptcy court’s authority in the text of the provision. Section 524(e), however, does not contain such a limitation. Additionally, in permitting non-consensual third-party releases in limited circumstances, the “pro-release” majority have turned to section 105(a) of the Bankruptcy Code, which permits a court to issue orders “necessary or appropriate to carry out the provisions of [the Bankruptcy Code].”

Prior to the decision in In re Seaside Engineering & Surveying, Inc., the Eleventh Circuit indicated its agreement with the “pro-release” majority when it approved a release of claims against a non-debtor in In re Munford. That case involved an instance where a non-debtor defendant offered to settle claims for breach of fiduciary duties conditioned on the issuance of a protective order that would enjoin non-settling defendants from pursuing claims against the settling defendant. There, the Eleventh Circuit held that section 105(a) of the Bankruptcy Code permitted the issuance of this protective order, which was in essence a non-debtor release, because the non-debtor release was integral to the settlement agreement. Although the Eleventh Circuit held in Munford that non-debtor releases are permitted under limited circumstances, the Eleventh Circuit had not ruled on the issue of non-consensual third party releases in the plan confirmation context.

Eleventh Circuit Joins the “Pro-Release” Majority

Before the Eleventh Circuit in In re Seaside Engineering & Surveying, Inc., was a reorganization plan that included non-consensual third-party releases of principal shareholders of the debtor, a civil engineering and surveying firm. Under the plan of reorganization, these principal shareholders would own and manage the reorganized entity. An outside equity holder objected to the plan of reorganization including the provisions of the plan providing for the non-consensual third-party releases.

The Eleventh Circuit held, in accordance with its decision in Munford, that it joins the majority view that section 524(e) of the Bankruptcy Code does not speak to a bankruptcy court’s authority to grant non-consensual third-party releases and that a bankruptcy court may do so under section 105(a) of the Bankruptcy Code. In joining the “pro-release” majority, the Eleventh Circuit also recognized that non-consensual third-party releases should not be issued lightly and should only be granted in instances where they are “necessary for the success of the reorganization, and only in situations in which [they are] fair and equitable under all the facts and circumstances.”

Accordingly, the Eleventh Circuit applied the seven-factor test established by the Sixth Circuit:

  1. There is an identity of interests between the debtor and the third party, usually an indemnity relationship, such that a suit against the non-debtor is, in essence, a suit against the debtor or will deplete the assets of the estate;
  2. The non-debtor has contributed substantial assets to the reorganization;
  3. The injunction is essential to reorganization, namely, the reorganization hinges on the debtor being free from indirect suits against parties who would have indemnity or contribution claims against the debtor;
  4. The impacted class, or classes, has overwhelmingly voted to accept the plan;
  5. The plan provides a mechanism to pay for all, or substantially all, of the class or classes affected by the injunction;
  6. The plan provides an opportunity for those claimants who choose not to settle to recover in full; and
  7. The bankruptcy court made a record of specific factual findings that support its conclusions.

Like the Sixth Circuit, and the Fourth Circuit which has also applied this seven-factor test, the Eleventh Circuit explained that a bankruptcy court has discretion when applying these seven factors and that the factors are a non-exclusive list which should be applied flexibly.

Applying the Sixth Circuit factors, the Eleventh Circuit held that the bankruptcy court did not abuse its discretion in approving the non-consensual third-party releases contained in the plan of reorganization because most of the factors (the sixth factor was inapplicable) weighed in favor of approval of the releases. For example, the Eleventh Circuit noted that the releases were essential to the reorganization because without the releases, the non-debtor owners would be distracted by on-going litigation which would interrupt the labor-intensive work of the principal shareholders for the reorganized entity. The Eleventh Circuit agreed with the bankruptcy court that this would result in a deterioration of the estate. Moreover, the Eleven Circuit agreed with the bankruptcy court’s determination that the objecting shareholder would be paid the full value of its interest under the reorganization plan. Finally, the Eleventh Circuit held that the bankruptcy court made thorough findings in reaching its decision and that “the bankruptcy court’s extensive consideration of this case weighs heavily against any abuse of discretion.”

The Lesson: Some Guidance for the Eleventh Circuit but No Single Rule for Non-Consensual Third-Party Releases

The Eleventh Circuit’s decision provides clarity as to the state of the law regarding non-consensual third-party releases in the Eleventh Circuit: the Eleventh Circuit is part of the “pro-release” majority. Moreover, the decision provides a refresher regarding the existing circuit split. However, it should be noted that there are subtle differences in the application of the majority rule among the “pro-release” majority. For example, the Delaware Bankruptcy Court (located in the Third Circuit) has applied a stringent standard when considering the approval on non-consensual third-party releases. In contrast, the Seventh Circuit (as explained in Airadigm) applies an arguably less stringent standard than the Delaware Bankruptcy Court. As observed by those following the Caesars bankruptcy cases, these differences in the application of the majority rule may have influenced the debtors’ choice of venue; the debtors filed a voluntary petition in the Northern District of Illinois as opposed to the Delaware Bankruptcy Court. Accordingly, it is essential to consult the relevant circuit’s precedent when addressing non-consensual third-party releases.