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The Eleventh Circuit Court of Appeals recently issued an opinion resolving any question as to whether or not a chapter 11 plan of reorganization may include enforceable releases of third parties who are not in bankruptcy.[1]  This ruling reinforces the importance of carefully reviewing proposed chapter 11 plans as these plans could impact a creditor’s rights against third parties that are not in bankruptcy such as guarantors and co-borrowers.

The Facts

Seaside Engineering & Surveying, Inc. (“Seaside”) was a civil engineering and surveying firm principally owned by five individuals.  Prior to Seaside filing bankruptcy, the principals branched out into real estate development and formed other entities to further those endeavors.  These entities borrowed money from a creditor that was secured by personal guaranties from the principals.  After the loans went into default, the creditor filed suit to collect under the personal guaranties. Three of the principals/guarantors filed chapter 7 bankruptcy and listed their ownership interest in Seaside as assets of the bankruptcy estate.  Through the bankruptcy case, one of the principal’s ownership interest in Seaside was sold to the creditor. Seaside then commenced its chapter 11 bankruptcy case.

Seaside proposed a chapter 11 plan of reorganization in which Seaside would continue operations as an entity named Gulf Atlantic, LLC (“Gulf”).  Some of the owners of Gulf were the same owners of Seaside.  The proposed chapter 11 plan provided that non-debtors (including officers, directors and members of Seaside and Gulf) would not be liable for claims related to the bankruptcy case except to the extent such liability is based on fraud, gross negligence or willful conduct.  The bankruptcy court confirmed the chapter 11 plan over the creditor’s objection and the district court affirmed the ruling.  The creditor then appealed to the Eleventh Circuit Court of Appeals.

The Court’s Ruling

In its analysis, the court recognized the split among circuits as to whether a chapter 11 plan can effectively release a non-debtor from claims.  The Court of Appeals for the Fifth, Ninth and Tenth Circuits prohibit such releases while the Second, Third, Fourth, Sixth and Seventh Circuits allow such releases under certain circumstances.  Citing the case of In re Munford, 97 F.3d 449 (11th Cir. 1996), the Court of Appeals for the Eleventh Circuit stated that its circuit was within the majority view.

The minority view looks to Section 524(e) of the Bankruptcy Code[2] as the reason why a chapter 11 plan cannot effectuate the release of a non-debtor third party.  The majority view interprets this statute as providing that while a discharge itself does not release a third party from liability, it does not limit a bankruptcy court’s equitable powers under Section 105 of the Bankruptcy Code to approve such a release.

While the Court of Appeals for the Eleventh Circuit finds itself in the majority view, it states that such releases “ought not to be issued lightly, and should be reserved for those unusual cases in which such an order is necessary for the success of the reorganization, and only in situations in which such an order is fair and equitable under all the facts and circumstances. The inquiry is fact intensive in the extreme.”[3]  The court set out seven factors adopted by the Sixth Circuit[4] to be considered when determining if a release of third parties should be approved:

  1. existence of an identity of interest 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 release is essential to the 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 all, or substantially all, of the class or classes affected by the release;
  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.[5]

While adopting these seven factors, the Eleventh Circuit cautioned that these factors should be viewed as a non-exclusive list to be applied flexibly and that bankruptcy courts should remember that releases of non-debtor third parties should be used “cautiously and infrequently.”[6]

In the Seaside bankruptcy, the court of appeals concluded that an analysis of the above-cited factors supported the non-debtor releases. The court stated that the releases “prevent claims against non-debtors that would undermine the operations of, and doom the possibility of success for, the reorganized entity, Gulf.”[7] The court based its conclusion on the fact that it was the principals who provided the services being sold by Gulf and that if required to defend such claims, the principals would be unable to devote proper time and resources to seeing that Gulf succeeds. In reaching its conclusion, the court also noted that the fact the plan provided for payment in full of the creditor “weighs heavily in favor of the releases.” [8]

Takeaways for Creditors

Creditors often take solace that they have personal guarantors or co-borrowers when a borrower files bankruptcy. Creditors may even go so far as to elect not to take an active role in the bankruptcy case on the assumption that they will be able to pursue the other obligors. However, rather than completely disregarding a borrower’s bankruptcy case and focusing solely upon those other obligors, it is critical that creditors stay engaged in the bankruptcy process. Otherwise, a chapter 11 plan of reorganization may be confirmed that prevents the creditor from pursuing co-obligors.

Footnotes:

[1] In re Seaside Engineering & Surveying, Inc., 2015 U.S. App. LEXIS 3831, at *1 (11th Cir. March 12, 2015).

[2] This statute provides in relevant part that the “discharge of a debt of the debtor does not affect the liability of another entity on . . . such debt.”  11 U.S.C. § 524(e).

[3] In re Seaside, 2015 U.S. App. LEXIS 3831 at *14.

[4] In re Dow Corning Corp., 280 F.3d 648, 658 (6th Cir. 2002).

[5] Id.

[6] In re Seaside, 2015 U.S. App. LEXIS 3831 at *15.

[7] Id. at *8.

[8] Id. at *19.