In a recent decision, the United States Court of Appeals for the Eleventh Circuit confirmed its previous adoption of the “majority view” that non-consensual, third-party releases are permissible under certain circumstances.  

Background

Seaside Engineering & Surveying, Inc. is a closely-held civil engineering and surveying firm located in Florida.  Certain of Seaside’s principal shareholders, who were also its directors and officers, were engaged in real estate development ventures, which were wholly separate from Seaside.  In connection with these ventures, the Seaside principals issued personal guaranties of loans extended by Vision Bank.  When the real estate ventures defaulted, Vision Bank sought to recover under the personal guaranties.  Several of the Seaside principals then commenced cases under chapter 7 of the Bankruptcy Code.  The trustee in one of those chapter 7 cases held an auction for the guarantor-principal’s Seaside equity and Vision Bank won the auction.  The bankruptcy court approved the sale over Seaside’s objection.  Shortly thereafter, Seaside filed for protection under chapter 11 of the Bankruptcy Code.

Seaside’s plan of reorganization proposed to continue operations as Gulf Atlantic, LLC, which would be managed by the same parties as Seaside and owned by each manager’s irrevocable family trust.  In in exchange for its equity interest, Vision Bank would receive a promissory note, but no continued ownership in Gulf Atlantic.  The plan also included the following third-party release:

[N]one of the Debtor, . . . Reorganized Debtor, Gulf Atlantic . . . (and any officer or directors or members of the aforementioned [entities]) and any of their respective Representatives (the “Releasees”) shall have or incur any liability to any Holder of a Claim against or Interest in Debtor, or any other party-in-interest … for any act, omission, transaction or other occurrence in connection with, relating to, or arising out of the Chapter 11 Case, the pursuit of confirmation of the Amended Plan as modified by the Technical Amendment, or the consummation of the Amended Plan as modified by this Technical Amendment, except and solely to the extent such liability is based on fraud, gross negligence or willful misconduct.

Vision Bank objected to confirmation of the Seaside plan on a number of grounds, including that the third-party release was inappropriate, unjust, and unnecessary.  Vision Bank argued in its objection that the “obvious purpose” of the third-party release was to frustrate Vision Bank’s claims against Seaside’s principals, to further Seaside’s efforts to block the transfer of shares from the Seaside principals that filed for chapter 7, and to ensure that all of the Seaside principals “continue to personally receive all of the wages, benefits and distributions which they were receiving pre-petition from this solvent business at the expense of their fellow shareholders, [Vision Bank] and the Chapter 7 trustees.”

The bankruptcy court overruled Vision Bank’s objection and confirmed Seaside’s plan including the third-party release.  Vision Bank appealed, but the district court upheld the propriety of the release and the Eleventh Circuit affirmed, stating that its decision would “provide guidance to the Circuit’s bankruptcy courts with respect to a significant issue: i.e. the authority of bankruptcy courts to issue non-consensual, non-debtor releases … and the circumstances under which such bar orders might be appropriate.”

Eleventh Circuit Confirms That It Follows the Majority View

The Eleventh Circuit turned first to its decision from In re Munford, in which it held that section 105(a) of the Bankruptcy Code provides bankruptcy courts with authority to approve non-consensual, third-party releases and upheld such a release where (i) the release was “integral to settlement in an adversary proceeding,” and (ii) the released party was a settling defendant that would not have entered into the settlement without the release.  As described below, the facts in Seaside were different:  Instead of facilitating settlement, “the releases prevent claims against non-debtors that would undermine the operations of, and doom the possibility of success for the reorganized entity.”  Still, the court determined that “Munford is the controlling case here” and held that the Eleventh Circuit follows the “majority view” that non-consensual, third-party releases are permissible under certain circumstances.

The court expressly rejected the argument, endorsed by the “minority circuits,” that non-consensual, third-party releases are prohibited by section 524(e) of the Bankruptcy Code, which provides, in relevant part, that the “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.”  More specifically, the Eleventh Circuit agreed with the Seventh Circuit, which stated that “[t]he natural reading of this provision does not foreclose a third-party release from a creditor’s claims,” and added that, if Congress intended to limit the bankruptcy courts’ power in this respect, it would have done so clearly.  The court also included a footnote in which it expressly rejected the Fifth Circuit’s recent assertion that another, older Eleventh Circuit decision had adopted the minority view.

The Eleventh Circuit was careful to note that, even though non-consensual, third-party releases were permissible, such releases “ought not to be issued lightly, and should be reserved for those unusual cases in which … 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.”  Consequently, the Eleventh Circuit commended for consideration the seven factors set forth by the Sixth Circuit in Dow Corning, noting that the list should be considered non-exhaustive, to be applied flexibly, while “always keeping in mind” that non-consensual, third-party releases should be used “cautiously and infrequently” and “only where essential, fair, and equitable.”

Eleventh Circuit’s Application of the Dow Corning Factors

The Eleventh Circuit next applied the standard it had just articulated to the facts in Seaside:

Click here to view table.

In addition, the Eleventh Circuit also considered (i) the bankruptcy court’s observation that the time and money expended by Vision Bank was “apparently disproportionate” to that party’s stated valuation of the company, (ii) the debtor’s agreement to drop claims for sanctions against Vision Bank, avoiding an asymmetrical benefit for the debtor, and (iii) the scope of the release, which was limited to claims arising from the chapter 11 case and expressly excluded claims arising out of fraud, gross negligence, or willful misconduct.  On balance, the Eleventh Circuit concluded that the bankruptcy court’s findings supported a conclusion that the third-party releases in the Seaside plan would “prevent claims against non-debtors that would undermine the operations of, and doom the possibility of success for the reorganized entity,” and were appropriate under the circumstances.

Takeaway

The Eleventh Circuit now clearly falls within the majority rule with respect to non-consensual, third-party releases.  Actually obtaining such a release, however, will remain challenging as the debtor must demonstrate that the release is essential to the success of the reorganization and is fair and equitable under all the facts and circumstances.