Last week, the Supreme Court issued its decision in Travelers Indemnity Co. v. Bailey,2 establishing an important precedent concerning the ability of bankruptcy courts to release claims against third party non-debtors in chapter 11 plans of reorganization. In the June 2009 issue of Cadwalader’s Restructuring Review newsletter, we introduced this case and considered the potential implications of a ruling on this important but unsettled topic. 3 This memorandum reviews the state of the law regarding non-debtor releases prior to the Supreme Court’s ruling in Travelers, and analyzes the continued viability of lower court decisions on this issue in light of the ruling.

In the much-anticipated decision, the Supreme Court avoided directly addressing whether third party releases may be included in plans of reorganization, leaving intact conflicting circuit law standards on this issue. Thus, the Second Circuit's decision in Deutsche Bank AG v. Metromedia Fiber Network, Inc. (In re Metromedia Fiber Network, Inc.) is still in effect, and in that jurisdiction third party releases may be granted where the released claims have a potential impact on the property of the bankruptcy estate, there are “unusual circumstances” justifying the release, and the release itself is “important” to the plan of reorganization.4 However, the Second Circuit's opinion in Travelers suggests that if the court were presented with another opportunity to rule on third party releases, it might limit Metromedia. Finally, although the Supreme Court did not resolve the differences among the circuits regarding the ability of bankruptcy courts to approve them, Travelers does reinforce certain guideposts for parties who may seek the benefit of third party releases in chapter 11 plans.

Importance of Third Party Releases

The ability of a chapter 11 debtor to provide in its plan of reorganization for the release by creditors of claims against third parties is often critical to its ability to reorganize. Debtors commonly must induce third parties, such as equity investors and insurance carriers, to provide contributions to fund the plan, or must often obtain exit financing from an existing lender that may be the debtor’s only available source of additional capital. These contributions or additional loans are often vital to the debtor’s ability to emerge from bankruptcy, but investors, insurers and lenders require the release of claims against them in connection with their agreement to participate in a plan. Similarly, releases of claims against officers, directors or other employees may be critical to a debtor’s successful continuation of business after confirmation of its plan.

Circuit Split

Notwithstanding the importance of third party releases in reorganization cases, the circuit courts of appeal are divided on whether third party releases in plans of reorganization are permitted under the Bankruptcy Code. The Fifth, Ninth and Tenth Circuits prohibit nondebtor releases in reorganization plans,5 holding that releases of claims against entities other than the debtor are prohibited under section 524(e) of the Bankruptcy Code, which provides that "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."6

Courts in the Eleventh and (until recently) Seventh Circuits have held that bankruptcy courts may discharge or release nondebtors from liability on claims if the affected creditors consent.7 By requiring consent, the third party release provision becomes enforceable under general contract principles because the parties giving the release have agreed to the terms. Generally, silence does not equal consent, and creditors must affirmatively vote to accept the plan or unambiguously assent to the release to become bound.8

The Second, Third, Fourth, Sixth and (most recently) Seventh Circuits have adopted more flexible approaches, and have held that bankruptcy courts have the power to force creditors to release their claims against nondebtors, regardless of creditor consent, when appropriate and depending on the factual circumstances of the case.9 Typically, there must be "unusual circumstances" and other validating factors,10 and the provisions must be fair and necessary to the successful reorganization of the debtor. Claims of a party that was not even a creditor of the debtor have been released under a plan where the party whose claim was extinguished received adequate notice and opportunity to object.11

The Second Circuit Standard

In SEC v. Drexel Burnham Lambert Group, Inc. (In re Drexel Burnham Lambert Group, Inc.),12 the court upheld a reorganization plan containing broad releases and permanent injunctions of claims against non-debtor third parties. The Second Circuit Court of Appeals stated that a third party release and injunction was proper, provided that it played "an important part in the debtor's reorganization plan."13 In Metromedia, the Second Circuit clarified that “such a release is proper only in rare cases.” 14 The court gave examples of cases in which third party releases were approved, including when the estate received substantial consideration; the enjoined claims were "channeled" to a settlement fund rather than extinguished; the enjoined claims would indirectly impact the debtor's reorganization "by way of indemnity or contribution"; the plan otherwise provided for the full payment of the enjoined claims; and the affected creditors consented.15 However, the court cautioned that “this is not a matter of factors and prongs,” and “[n]o case has tolerated nondebtor releases absent the finding of circumstances that may be characterized as unique.”16

Background of Travelers

In 1986, as part of the Johns-Manville chapter 11 reorganization plan, the United States Bankruptcy Court for the Southern District of New York issued an injunction barring “all persons” from commencing any action against the settling insurers “for the purpose of[] directly or indirectly” recovering on any asbestos-related claims. 17 Despite the broad wording of this injunction, over ten years after it was issued certain claimants commenced direct suits against various settling insurers, including Travelers. These suits asserted that the insurers were directly liable to the claimants for the insurers’ own alleged misconduct in intentionally misleading claimants about the dangers of asbestos and conspiring with Johns-Manville and others to conceal asbestos-related risks.

Travelers petitioned the bankruptcy court to enjoin the suits as having been commenced in violation of the confirmation order. Pursuant to a settlement agreement with certain claimants, in 2002 the bankruptcy court issued a clarifying order stating that the direct claims were barred by the 1986 injunction and had always been barred by that injunction. The district court affirmed the bankruptcy court’s clarifying order, but the Second Circuit reversed. The Second Circuit held that because the claims sought direct recovery from the insurers based on the insurers’ own conduct, and because the claims were unrelated to the insurers’ obligation to pay on the Johns-Manville insurance policies, the plan included an improper release of non-debtor third parties.18 Furthermore, the Second Circuit concluded that “the district court lacked subject matter jurisdiction to enjoin claims against Travelers that were predicated, as a matter of state law, on Travelers’ own alleged misconduct and were unrelated to Manville’s insurance policy proceeds and the res of the Manville estate.”19

The Second Circuit held that simply making a “financial contribution to the debtor’s estate,” such as the amounts Travelers contributed to the Johns-Manville settlement fund, is not enough to justify including a third party release in a plan of reorganization.20 The court cautioned that if financial contribution was the standard, nondebtor parties could easily and improperly manufacture jurisdiction to obtain a non-consensual release of the creditors’ direct claims.

Instead, the Second Circuit held that a bankruptcy court may only enjoin creditors’ claims against non-debtor third parties that directly affect the property of the bankruptcy estate. If the outcome of the third-party litigation does not have the potential to reduce the amounts available to the debtor’s creditors as a result of, for example, contribution or indemnification claims against the debtor, the Second Circuit concluded that the bankruptcy court lacks jurisdiction to issue the release or injunction. Notably, the Second Circuit observed that suits that relate to a third party’s independent wrongdoing that “make no claim against an asset of the bankruptcy estate, nor do [the plaintiff’s] actions affect the estate” cannot be enjoined by a bankruptcy court pursuant to a plan of reorganization.21

Although a bankruptcy court has continuing jurisdiction to interpret its own orders, the Second Circuit held further that the bankruptcy court could not, in enforcing the Johns-Manville confirmation order, “enjoin claims over which it had no jurisdiction.”22

Supreme Court Decision

The Supreme Court disagreed with the Second Circuit’s determination that the issue in Travelers was “primarily a question of jurisdiction.”23 For the Supreme Court, the key question was whether the direct claims against Travelers were barred by the precise language of the Johns-Manville confirmation order, even if the bankruptcy court lacked jurisdiction to issue the original injunction. Although the Second Circuit stated that “[a] court’s ability to provide finality to a third-party is defined by its jurisdiction, not its good intentions,”24 the Supreme Court concluded that even an erroneous jurisdictional analysis is binding on the parties once an order becomes final, noting that “[i]t is just as important that there should be a place to end as that there should be a place to begin litigation.”25

In reversing the Second Circuit’s decision, the Supreme Court held that the Second Circuit was wrong in considering whether the bankruptcy court had authority to issue the original 1986 injunction, as the issue was not properly before the court. Specifically, the Supreme Court stated that:

Once the 1986 Orders became final on direct review (whether or not proper exercises of bankruptcy court jurisdiction and power) they became res judicata as to the “parties and those in privity with them, not only as to every matter which was offered and received to sustain or defeat the claim or demand, but as to any other admissible matter which might have been offered for that purpose.”26

In other words, the Supreme Court determined that the lawsuits in question were barred by the original Johns-Manville confirmation order because that order was final and binding upon all parties who had notice of the injunction and an opportunity to participate in the proceedings. Whether the bankruptcy court had the authority to grant the releases in the confirmation order was no longer subject to challenge. Further, the Supreme Court held that even if the releases were beyond the bankruptcy court's jurisdiction to grant, because they were final the same court could now enforce them. The Supreme Court offered no opinion as to the propriety of third party releases in chapter 11 plans.27

Impact

The Supreme Court’s decision in Travelers was narrow. As stated by the Supreme Court, “We do not resolve whether a bankruptcy court . . . could properly enjoin claims against nondebtor insurers that are not derivative of the debtor’s wrongdoing. . . . Nor do we decide whether any particular respondent is bound” by the confirmation order.28 Even though the decision upholds the enforceability of a broad third party release, it did so because the time to challenge the jurisdiction of the bankruptcy court and the entry of the order had expired, and not on any conclusion that the release was proper. If a third party obtains a release and injunction that exceeds the court's jurisdiction under a plan with a final confirmation order, then that order will not be subject to collateral attack later. Although the ruling is helpful to a third party that has already obtained a broad release, it does not provide any guidance on whether such a release may be granted by a bankruptcy court.

The decision reinforces certain guideposts for nondebtor releases.

  • Metromedia standard remains intact for the Second Circuit.

The law in the Second Circuit on a bankruptcy court’s authority to issue third party releases, as outlined above, remains unchanged after the Supreme Court decision, at least for now. Accordingly, third party releases may be granted where the released claims have a potential impact on the property of the bankruptcy estate, there are “unusual circumstances” justifying the release, and the release itself is “important” to the plan of reorganization.29 The standards regarding third party releases in other circuits remain intact (and in conflict) as well.

The Second Circuit’s decision in Travelers raises the possibility that it might limit Drexel and Metromedia in the future. The decision contains strong language regarding the limits of a bankruptcy court’s jurisdiction to grant third party releases. Where release of a claim against a third party does not impact the estate, the Second Circuit held that the bankruptcy court does not have jurisdiction to release or enjoin such claim. Even though the Supreme Court reversed the Second Circuit’s ruling, it did so finding that the time to challenge the bankruptcy court’s jurisdiction had expired, not that the Second Circuit’s ruling regarding the limits of the bankruptcy court’s jurisdiction was incorrect. In light of this, the Second Circuit could apply the same reasoning in a direct appeal of a confirmation order in the future where the issue is properly before it. If it did, there is a risk that the Metromedia standard could change.

  • Notice.

In Travelers, the Supreme Court emphasized that the Johns-Manville confirmation order could not be collaterally attacked by parties who had notice of the injunction and opportunity to appeal. Specifically, the Supreme Court stated that “[s]o long as respondents or those in privity with them were parties to the Manvillle bankruptcy proceeding, and were given a fair chance to challenge the Bankruptcy Court’s subject-matter jurisdiction, they cannot now challenge it by resisting enforcement of the 1986 Orders.”30 Although in Travelers the Supreme Court does not discuss what would constitute sufficient notice, two previous Supreme Court decisions conclude that a party not provided with constitutionally sufficient notice of a court injunction cannot be bound by it.31

  • Finality.

For the Supreme Court, the crucial issue in Travelers was the need to provide finality and certainty to parties in a bankruptcy proceeding. A party released by a broadly-drafted injunction in a final confirmation order may rely on the release without concern about a later collateral attack, even if claimants proceed on legal grounds not contemplated by the parties when the confirmation order was originally issued. For the same reason, a party who objects to a release of its claim against a third party in a plan confirmation order must timely appeal the order.

Strategy

Because the Supreme Court’s decision did not settle the conflict in the circuit courts regarding the ability of a bankruptcy court to grant third party releases, the venue of a bankruptcy case will continue to be a factor in determining whether, and under what conditions, third party releases will be available. This factor, along with others, may influence the forum selected by a debtor in a case where obtaining third party releases may be important to its reorganization.

The Supreme Court’s Travelers decision upheld the enforceability of a broad third party release and shielded it from collateral attack after the order granting the release had become final. Thus, third parties that are contemplating lending to, investing in, or making a contribution to a debtor in connection with a plan may take comfort that release provided by final order will stand (provided that adequate notice was provided to affected claimants). To the extent a third party requires a release of claims against it, any contribution, investment or loan contemplated by the third party should be conditioned upon obtaining this release by final order. However, third parties seeking a release should carefully consider the extent of the release necessary, as a narrowly tailored release is more likely to be approved by the court. Although a party may insist on an extremely broad release as a condition to participation in a plan, doing so may place the plan, and the debtor’s reorganization, at risk.

Conclusion

Lenders, equity investors, and other third parties regularly make financial contributions to debtors’ estates pursuant to a plan of reorganization, and those plans regularly release such participants from liability to the debtor’s creditors. The Supreme Court’s ruling in Travelers leaves unresolved the conflict among the circuit courts of appeal regarding whether and to what extent nondebtor releases may be provided in a plan of reorganization. In the absence of guidance from the Supreme Court, parties in interest in a reorganization are forced to continue to operate under the disparate laws of the respective circuits until such guidance from the Supreme Court is provided.

However, based on the Supreme Court’s decision in Travelers, non-debtor parties participating in a chapter 11 plan of reorganization may obtain finality for both the debtor and for plan participants released from third-party liability. If participants, including investors, insurers, lenders, advisors, employees, officers, and directors, abide by the rules set out in Travelers, construct appropriate release language, and give proper notice to any parties affected by the proposed release, Travelers directs that any releases granted by final order will withstand future attack.