Beware the Third Party Release in Chapter 11!

Until the Supreme Court weighs in, the permissibility of third party releases may depend on the scope of the release, the adequacy of the consideration, and the circuit in which the Chapter 11 bankruptcy case is pending.

MARC A. LIEBERMAN, ESQ | 7.22.2022

Can a corporation’s Chapter 11 plan release a non-debtor third-party from personal liability to creditors? The issue has been in the news recently, and the answer may surprise you.

Suppose your client Donny Developer is litigating a $10 million lawsuit against Slipshod Builders, Inc. based on poorly constructed shopping center and misrepresentations to Donny by Slipshod’s principal.

During discovery, you learn that Jack, Slipshod’s principal, has been diverting corporate funds to pay his personal expenses and those of his other company XYZ Corp. You amend your complaint to add alter-ego allegations against Jack and to allege XYZ and Slipshod constitute a “single enterprise.” Your strategy is to make Jack and XYZ liable for Donny’s damages.

Slipshod then files Chapter 11. Unsecured claims total $25 million. You seek relief from stay to continue your lawsuit, but the bankruptcy judge denies your motion and stays the lawsuit as to all defendants for the duration of the bankruptcy case. You file your proof of claim and tell Donny to sit tight.

Slipshod then files its Chapter 11 Plan and Disclosure Statement, which proposes to pay unsecured claims a pro-rata share of $1 million to be contributed by Jack and XYZ. If the Plan is confirmed, Donny will end up with pennies on the dollar from Slipshod. No big deal, you can always go after Jack and XYZ when bankruptcy is over, right?

Before advising Donny, you muscle your way through Slipshod’s 312 page Disclosure Statement and 137 page Plan. On page 103 of the Plan, you find this release language:

“Release of Insiders. Pursuant to the Debtor’s $1 million settlement with Insiders, all Insiders are released of all claims held by the Debtor and the Debtor’s estate, including, without limitation:
(i) all claims that may have been asserted by the Debtor or the Debtor’s estate;
(ii) all claims that may be asserted by anyone that are derivative of claims that could have been asserted by the Debtor or the Debtor’s estate; and
(iii) all claims against Insiders related to the operations of the Debtor.”

You flip back to page 29 of the Plan and note that “Insiders” means Slipshod’s officers, directors, and shareholders, and XYZ.

You vaguely recall something about the Purdue Pharma bankruptcy, the Sackler family, and something about third party releases not being permitted. So you’re good, right?

Well, maybe. Or maybe not.

Purdue Pharma was a privately-held company owned by Sackler family members. Most of the company’s $34 billion in annual revenue was derived through OxyContin sales.

The company pled guilty to falsely marketing its product and paid $600 million in fines. Civil suits mounted, and Sackler family members were being named as defendants. The Purdue bankruptcy judge found the Sacklers “distributed significant sums of Purdue money to themselves” at a time when they were “aware of the opioid crisis and the litigation risk.” The Sackler’s expert acknowledged that the withdrawals substantially reduced the company’s “solvency cushion.”

The bankruptcy court found that distributions to insiders would allow Purdue’s bankruptcy estate to assert more than $11 billion in avoidable transfers.

Purdue filed a chapter 11 petition, and the bankruptcy court promptly approved a temporary injunction barring suits against the Sacklers and the company’s officers, directors or employees. The injunction stopped thousands of suits against the company and about 400 against the Sacklers. The injunction was upheld on appeal and extended 18 times, until the plan was confirmed.

Through mediation, and in exchange for broad releases of both direct and derivative claims, the Sacklers agreed to pay $4.3 billion over 9 years through Purdue’s Chapter 11 Plan. While the Plan was approved by a supermajority of each class of creditors, the U.S. Trustee and several states attorneys general objected to the Plan on account of its broad third-party releases.

The Purdue bankruptcy judge fretted that that failure to confirm the Plan would lead to the company’s liquidation and no recovery for unsecured creditors, including personal injury plaintiffs. He held his nose and reluctantly confirmed Purdue’s Chapter 11 plan with the third party releases intact.

The District Court reversed. Sitting as a court of appeal, the District Court (within the Second Circuit) noted “a long-standing conflict among the Circuits,” with the Fifth, Ninth and Tenth Circuits “reject[ing] entirely the notion that a court can authorize non-debtor releases outside the asbestos context.” The court went on to hold that non-consensual releases of a creditor’s direct claims against non-debtors are impermissible:

“[T]he Bankruptcy Code does not authorize such non-consensual non-debtor releases; not in its express text . . .; not in its silence . . .; and not in any section or sections of the Bankruptcy Code . . ..”

Unsurprisingly, courts have found other grounds for denying (and upholding) third party releases.

What does this mean for Donny? It means that whether or not third party releases are permitted depends on, among other things, the circuit in which the bankruptcy case is pending. It also means that legality of a third-party release depends on whether the claims being released are “derivative” of claims that could have been asserted by the debtor itself (like claims based on allegations of alter-ego or breach of fiduciary duty) on the one hand as opposed to direct claims (like fraud or torts against certain creditors committed by a particular individual) on the other hand.

So what should you do if confronted with an insider release that might adversely impact your client?

First, determine whether or not the proposed release is limited to derivative claims (as opposed to direct claims) against insiders. If there is any ambiguity, object at the first possible opportunity.

Next, if the proposed release is in fact limited to derivative claims, determine whether or not the prospective releasees are providing adequate consideration. What amount is “adequate” will be a function of the releasees’ exposure, their ability to pay, and the expense and uncertainty of litigation against the releasees by the debtor (or a creditors’ committee or bankruptcy trustee.)

Finally, if there is any doubt about whether the proposed insider releases are appropriate, object. Negotiations to resolve Donny’s objection will typically occur between the filing of the opposition and hearing date. If the potential releasees are truly concerned about how the judge may rule on Donny’s objection, they may offer to buy his claim!

Marc A. Lieberman, Esq. is a partner in the FLP Law Group LLP, LLP and a Certified Specialist in Bankruptcy Law by the State Bar of California Board of Legal Specialization. Editorial assistance provided by Alan M. Forsley, Esq. FLP Law Group LLP holds the copyright to these materials.

Conclusion

In conclusion, the permissibility of third-party releases in Chapter 11 bankruptcy cases remains a hotly debated issue, and the answer may depend on various factors such as the scope of the release, the adequacy of the consideration, and the circuit in which the case is pending.

While some bankruptcy courts have allowed non-debtor third-party releases in exchange for adequate consideration, others have rejected the notion of non-consensual non-debtor releases, outside of the asbestos context. Therefore, it is important for individuals and businesses who are seeking bankruptcy protection to consult with a business bankruptcy law firm or a bankruptcy lawyer in Los Angeles to understand their rights and obligations under the Bankruptcy Code.