In a recent decision by the United States Bankruptcy Court for the District of Delaware, In re Hercules Offshore, Inc., et al., Judge Kevin J. Carey confirmed Hercules Offshore’s plan over objections by the Equity Committee—including an objection to allegedly impermissible plan releases and exculpations.
Hercules Offshore filed a joint prepackaged chapter 11 plan in its “chapter 22 case” approximately seven months after confirmation of the chapter 11 plan in its previous chapter 11 case.
Central to the deal culminating in the plan was a settlement agreement with the first lien lenders—approved by a special committee of independent directors—that, among other things, transferred all of the debtors’ assets to a wind down entity, permitted a 100% recovery to the general unsecured claimants, subordinated the first lien lenders’ claims to provide $15 million guaranteed payment to common stockholders, and reduced the amount of the first lien lenders’ claim by $32.5 million. The plan also provided lenders, directors and officers, and other third parties with releases from claims held by the debtors and releasing parties.
Notwithstanding a mediation, the Official Committee of Equity Security Holders, the “Equity Committee,” pursued several objections at the confirmation hearing, including an objection to the plan releases and exculpation provisions regarding claims held by debtors and other third parties. The court overruled these objections. Although this case does not offer anything new or unusual, it is a good reminder that proper corporate formalities and substantial supporting evidence are important factors in obtaining approval of releases.
Section 1123(b)(3)(A) of the Bankruptcy Code permits a plan of reorganization to provide for a settlement of a debtor’s claims and include debtor releases. Courts have identified five factors for determining whether a debtor’s release of a non-debtor is appropriate under a plan: (1) an identity of interest between the debtor and non-debtor such that a suit against the non-debtor will deplete the estate’s resources; (2) a substantial contribution to the plan by the non-debtor; (3) the necessity of the release to the reorganization; (4) the overwhelming acceptance of the plan and release by the creditors and interest holders; and (5) the payment of all or substantially all of the claims of the creditors and interest holders under the plan. These five factors are not exclusive or conjunctive requirements, but form the foundation for a court’s analysis in addition to any other relevant factors to the particular case.
Directors and Officers Releases
The plan released the debtors’ claims against the debtors’ current and former officers and directors, in addition to other related professionals. The Equity Committee asserted that the estate may have colorable claims against the debtors’ directors and officers for “engineering” a liquidation and for a failure to exercise fiduciary duties. However, after completing a viability analysis of the purported claims, the court concluded that the Equity Committee offered little support for its contentions.
The court first evaluated the decision by a special committee of independent directors to approve the settlement agreements with the first lien lenders under the business judgment rule. The standard only requires that a court determine that the debtors exercised sound business judgment in deciding to accept a settlement integral to the proposed plan. The decision must be made in good faith, with the reasonable belief that such decision is in the best interests of the corporation. This standard is satisfied when a board makes a decision on an “informed basis,” using its independent business judgment and considering the advice of attorneys and financial advisors.
The special committee pursued this settlement once it determined that bids received from a prepetition marketing process would not provide recoveries to unsecured creditors and equity holders. The court determined that the special committee satisfied the business judgment standard through evidence of frequent meetings to consider the debtors’ options, a lengthy and comprehensive marketing process, and the use of retained professionals to consider competing bids.
The court also considered the Equity Committee’s assertion that the board of directors failed to comply with its fiduciary duties and exercise sound business judgment in reacting to alleged defaults on a credit agreement’s leverage covenants. The court focused on evidence that the board met regularly to discuss and monitor the company’s financial position and discuss the details and implications of a potential default, finding that the board properly exercised its fiduciary duties in pursuing the chapter 11 plan, the option it believed would preserve the value of the estates and maximize recovery for all stakeholders.
The court further considered each of these potential claims in light of terms in the company’s certificate of incorporation, which exculpated the company’s officers and directors from liability so long as that person acted in good faith and in the best interests of the corporation. The court found that no credible allegations supported claims that would be excepted from the exculpation provisions in the certificate of incorporation and further found that because of the exculpation provisions that the directors and officers were further insulated from any claims against them.
The plan also included releases by the debtors of certain lender parties in exchange for those parties’ agreement to compromise their claims and allow for other claimholders to recover under the plan. The Equity Committee stated that the debtors had colorable claims against the released lender parties. The court evaluated and quickly dismissed the viability of the first two alleged claims of equitable subordination and equitable disallowance.
The court gave a more thorough review of the claim that the released lenders breached the covenant of good faith and fair dealing by (1) asserting baseless events of default; (2) declining to extend a deadline in a credit agreement; and (3) forcing entry into a forbearance agreement. The court dismissed the Equity Committee’s argument that the covenant defaults, which the debtors acknowledged, were immaterial as there was no materiality requirement in the credit agreements. The court stated that an implied covenant of good faith and fair dealing is breached when a party acts in a manner that would deprive the other party of the right to receive the benefits of their agreement and, further noting, that no obligation may be implied that would be inconsistent with other terms of the contractual relationship. With respect to the deadline extension and entrance into a forbearance agreement, the court found that the released lender parties did not overstep any boundaries of their contractual rights and that no implied covenant was breached. Not surprisingly, the court noted that the lenders being “aggressive,” “vocal,” “persistent,” and even “annoying” does not equate to wrongful conduct.
“Paramount” to the court’s decision was the evidence produced by first lien lenders of the substantial value provided to Hercules Offshore in the settlement agreements in exchange for these releases which most significantly included a reduction of the lenders’ claims, payment of unsecured creditors, and payment to shareholders.
The court approved the debtors’ releases based on the substantial and credible evidence put forth by the debtors and on the five factor analysis, although it did not include detailed examination of each factor.
Third Party Releases
The plan also included consensual third party releases. The Equity Committee objected to the third party releases on the basis that, with respect to the equity holders, these releases were not consensual and did not satisfy the requirements for approval of a non-consensual third party release through a jurisdictional and solicitation procedures argument. The court approved these releases after the debtors revised the plan so that common stockholders, other than restructuring support parties, did not provide the releases.
Release and exculpation provisions are frequently used and heavily negotiated provisions in a plan of reorganization. Although they are a popular tool for debtors, a court’s thorough review of a plan’s releases and exculpations is not uncommon. Proponents of such plan provisions should make every effort throughout the plan process to establish a record of an informed decision-making process. Courts in the Third Circuit often review plan release and exculpation provisions closely when faced with an objection. Hercules Offshore highlights some of the scrutiny that release and exculpation provisions may receive, particularly with respect to alleged colorable claims by those objecting to them. Proponents of these provisions should be prepared to defend these plan provisions before a court in light of those potential claims.