On June 27, 2014, in National Heritage Foundation, Inc. v. Highbourne Foundation, 1 the United States Court of Appeals for the Fourth Circuit, agreeing with decisions by the Bankruptcy Court for the Eastern District of Virginia and the District Court for the Eastern District of Virginia, which were issued upon remand from a prior appeal, held that the third-party non-debtor release provision in the chapter 11 plan of reorganization of National Heritage Foundation, Inc. was invalid. National Heritage claimed that the unique facts and circumstances surrounding its bankruptcy case justified the release. The Fourth Circuit found that there was insufficient evidence to support National Heritage’s contentions and affirmed the Bankruptcy Court’s decision.
In 2009, National Heritage, a non-profit public charity that administered and maintained Donor-Advised Funds, 2 filed a voluntary petition for relief under chapter 11 of the Bankruptcy Code after a state court entered a judgment of more than $6 million against the company in Texas. The Bankruptcy Court confirmed National Heritage’s Fourth Amended and Restated Plan of Reorganization, which included a non-debtor release provision (the “Release Provision”) that releases, among others, National Heritage, the Official Committee of Unsecured Creditors, and any officers, directors, and employees of National Heritage, the Committee, and their successors and assigns (the “Released Parties”). The Release Provision stated that the Released Parties
shall not have or incur, and are hereby released from, any claim, obligation, cause of action, or liability to any party in interest who has filed a claim or who was given notice of the Debtor’s Bankruptcy Case … for any act or omission before or after the Petition Date through and including the Effective Date in connection with, relating to, or arising out of the operation of the Debtor’s business, except to the extent relating to the Debtor’s failure to comply with its obligations under the Plan.
Certain of National Heritage’s donors challenged the Bankruptcy Court’s confirmation of the Plan, arguing that the Release Provision was invalid. The District Court affirmed the Bankruptcy Court’s confirmation of the Plan, including the Release Provision, and the donors appealed. The Fourth Circuit’s Remand to the Bankruptcy Court On the first appeal, after the District Court affirmed the confirmation of the Plan by the Bankruptcy Court, the Fourth Circuit held that the Bankruptcy Court had failed to make sufficient findings to conclude that the Release Provision was essential, reiterating that non-debtor releases “should only be approved ‘cautiously and infrequently.’” 3 The Court directed the Bankruptcy Court to consider the following six substantive factors set forth in the Sixth Circuit case of Class Five Nevada Claimants v. Dow Corning Corp. (In re Dow Corning Corp.): 1. whether there is an identity of interests between the debtor and the third party…such that a suit against the non-debtor, in essence, is a suit against the debtor or will deplete the assets of the bankruptcy estate; 2. whether the non-debtor has contributed substantial assets to the reorganization; 3. whether the injunction is essential to the reorganization; 4. whether the impacted class, or classes, overwhelmingly voted to accept the plan; 5. whether the plan provides a mechanism to pay for all, or substantially all, of the class or classes affected by the injunction; and 6. whether the plan provides an opportunity for those claimants who choose not to settle to recover in full. 4 On remand, a different bankruptcy court judge reviewed the then-existing record and made factual findings with respect to each of the factors set forth in Dow Corning. The Bankruptcy Court concluded that only the first Dow Corning factor—an identity of interests between National Heritage and the Released Parties—weighed in favor of the Release Provision. Therefore, the Bankruptcy Court held that the Release Provision was invalid and the District Court affirmed. National Heritage then appealed to the Fourth Circuit. The Fourth Circuit’s Analysis The Fourth Circuit affirmed, holding that National Heritage had failed to justify the Release Provision based on the facts and circumstances of the case. The Court considered each of the Dow Corning factors in turn. 3 Nat'l Heritage Found., Inc. v. Highbourne Found., 2014 U.S. App. LEXIS 12144, at *4 (citing Behrmann v. Nat'l Heritage Found., Inc., 663 F.3d 704, 712 (4th Cir. 2011) (hereinafter NHF I). 4 In re Dow Corning Corp..280 F.3d 648, 658 (6th Cir. 2002).Fried Frank Client Memorandum 3 Identity of Interests The first factor is whether there is an identity of interests between the debtor and the released party. In such circumstances, a suit against the non-debtor may have the same effect as a suit against the debtor in that it risks depleting the assets of the bankruptcy estate. The Fourth Circuit concluded that National Heritage had established an identity of interests between itself and the Released Parties because “[u]nder the terms of its bylaws [National Heritage] must advance legal expenses and indemnify its officers and directors for ‘any action … in which such person may be involved by reason of his being or having been a director or officer of’ [National Heritage].” 5 Furthermore, no security was required to ensure that any such covered individuals must repay National Heritage for any advanced expenses. Due to the expansiveness of this indemnity obligation, the Court stated that the first factor was satisfied. Substantial Contribution The second factor a court must consider when evaluating a non-debtor release is whether the non-debtor made a substantial contribution of assets to the debtor’s reorganization. This factor ensures that in order for a Released Party to achieve that status, it must have provided a “cognizable and valid contribution to the debtor as part of the debtor’s reorganization.” 6 The Fourth Circuit stated that none of the Released Parties made any financial contributions to the reorganization, nor did they provide any meaningful consideration for a release of their liability. The Court noted that National Heritage’s assertion that its officers and directors promised to continue serving National Heritage would not constitute a substantial contribution of assets in this case because the officers were paid to do so and the directors had a fiduciary obligation to do so. Essential to Reorganization The third factor a court must consider is whether the release is “essential” to the debtor’s reorganization, “such that ‘the reorganization hinges on the debtor being free from indirect suits against parties who would have indemnity or contribution claims against the debtor.’” 7 National Heritage contended that the risk of litigation from its thousands of donors renders the Release Provision essential because National Heritage would have to indemnify its officers and directors for their legal expenses should such suits arise. The Fourth Circuit rejected National Heritage’s contention, noting that National Heritage failed to provide evidence regarding the number, nature or potential merit of any donor claims. Without more to substantiate such claims, the risk of litigation was too uncertain. The Court also pointed out that the severability clause contained in the Plan, which provides that the Plan would remain in effect “should any provision in this Plan be determined to be unenforceable,” further suggests that the Release Provision is not essential to the debtor’s reorganization. 5 Nat'l Heritage Found., Inc. v. Highbourne Found., 2014 U.S. App. LEXIS 12144, at *7-8. 6 Id. at *8. 7 Id. at *10 (citing NHF I at 711–12).Fried Frank Client Memorandum 4 Affected Classes Vote in Favor of Release The fourth factor is whether the class or classes affected by the Release Provision voted overwhelmingly in favor of the debtor’s plan of reorganization. The Release Provision affected the individuals who donated money to National Heritage, whose acceptance of the plan was presumed without a vote because they were to receive full payment with interest and were considered unimpaired. 8 While the Fourth Circuit noted there was some uncertainty as to whether the presumed acceptance by an unimpaired class is the same as an overwhelming vote in favor of the plan for purposes of this factor, the Court reasoned that in this case, the equities would weigh against National Heritage because the class most affected by the Release Provision, the donors of National Heritage, was not given the opportunity to accept or reject the Plan. However, the Court said it need not address this factor because even if presumed acceptance weighed in favor of the validity of the Release Provision, it would not outweigh the other factors which weighed against its validity. Pay Substantially All Classes Affected by Release The fifth factor is whether the plan provides a mechanism to consider and pay all or substantially all of the classes affected by the release. The Fourth Circuit stated that this consideration was typically used to justify a release where there was a mechanism in place, such as a settlement fund, to pay the claims of those affected by an injunction. Noting that National Heritage had not provided any evidence that there was a process in place that would protect donor claims against it, the Court concluded that this factor weighed against the Release Provision. Opportunity for Those Not Settling to Recover in Full The sixth and final factor a court must consider when evaluating the validity of a release is whether the plan of reorganization provides an opportunity for those who choose not to settle to recover in full. The Fourth Circuit stated that their analysis of this factor largely overlapped with the previous one, in which National Heritage failed to provide any mechanism to pay donor claims either in or outside of the bankruptcy case. Based on the application of these factors, the Fourth Circuit held that there was not sufficient evidence to justify the Release Provisions. The Fourth Circuit emphasized that its decision was ultimately rooted in National Heritage’s failure to provide proof rather than the actual circumstances. Conclusion This decision serves as a reminder of the importance of carefully analyzing whether the circumstances of a particular case warrant broad third-party releases for non-debtor parties. When including such releases in chapter 11 plans, debtors should keep in mind the high level of scrutiny courts perform when determining whether such a release is warranted under the circumstances. * * * 8 Under § 1126(f) of the Bankruptcy Code, a class that is not impaired under a plan is conclusively presumed to have accepted the plan. Fried Frank Client Memorandum New York Washington, DC London Paris Frankfurt Hong Kong Shanghai friedfrank.com 5 This memorandum is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions about the contents of this memorandum, please call your regular Fried Frank contact or an attorney listed below: Authors & Contacts: New York Brad Eric Scheler +1.212.859.8019 firstname.lastname@example.org Gary L. Kaplan +1.212.859.8812 email@example.com Alan N. Resnick +1.212.859.8529 firstname.lastname@example.org Jennifer L. Rodburg +1.212.859.8520 email@example.com Kalman Ochs +1.212.859.8139 firstname.lastname@example.org