In an opinion filed on July 3, 2014, in the case of In re Lower Bucks Hospital, et al., Case No. 10-10239 (ELF), the United States Court of Appeals for the Third Circuit (Third Circuit) affirmed a decision of the United States Bankruptcy Court for the Eastern District of Pennsylvania (Bankruptcy Court), which denied approval of third-party releases benefitting The Bank of New York Mellon Trust Company, N.A., in its capacity as indenture trustee (BNYM, or the Trustee). The Third Circuit agreed with the Bankruptcy Court’s finding that the proposed releases were not adequately disclosed to the bondholders as required by Bankruptcy Rule 3016(c), and therefore would not be approved.

Background

In 1992, Lower Bucks Hospital (LBH) entered into a multi-party municipal bond financing transaction in order to refinance certain outstanding obligations and pay for capital improvement projects (Bond Transaction). Pursuant to the relevant documents, the Trustee was responsible for filing certain financing statements to perfect the security interest granted to the Trustee by LBH. The relevant documents also provided that LBH would indemnify BNYM, as Trustee, against all liabilities which it may incur in the exercise and performance of its powers and duties under the respective Trust Indenture, provided that such liabilities were not caused by the gross negligence or willful misconduct of the Trustee.

On January 13, 2010, LBH, Lower Bucks Health Enterprises, Inc., and Advanced Primary Care Physicians (collectively, the Debtors) filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code. The timing of the bankruptcy filing was partially motivated by the Debtors’ desire to preserve their claim that certain actions taken by the Trustee could be set aside as a preferential transfer, which claim was documented in an adversary proceeding (Adversary Proceeding) in which the Debtors sought to avoid the Trustee’s continued perfection of its security interest.

The Settlement

On August 12, 2011, after negotiations with the Trustee, the Debtors filed a Stipulation Resolving Adversary Proceeding (Settlement) and a motion to approve the same (Settlement Motion). The Settlement provided, among other things, that the Debtors’ plan of reorganization (Plan) would provide for a release of all claims and causes of action in any matter related to the trust documents against the Trustee by any and all parties including, without limitation, the bondholders, to the extent permitted by applicable law (Third Party Releases). In addition, the settlement agreement itself contained releases of actions that the bondholders could commence against the Trustee.  The Settlement Motion, however, did not contain any significant or conspicuous discussion of the proposed releases.

No objections were filed to the Settlement Motion. At the hearing on the Settlement Motion, the Debtors’ counsel provided a cursory summary of the Settlement terms but did not mention the Third Party Releases. The Court approved the Settlement, but emphasized that the intended consequences of the order approving the Settlement were narrow.

The Plan and Disclosure Statement

The Debtors filed the Plan, which, pursuant to the Settlement, provided for the Third Party Releases and the related Disclosure Statement on July 8, 2011. The Third Party Releases were not mentioned in either part of the Disclosure Statement discussing the Adversary Proceeding and Settlement. Thus, like the disclosures in the Settlement Motion, the disclosure of the Third Party Releases set forth in the Disclosure Statement was not conspicuous and contained no emphasis. Nevertheless, on September 28, 2011, the Court entered an order approving the Disclosure Statement.

The Bondholder’s Motion for Reconsideration of Order Approving Settlement and Resulting Order

After approval of the Disclosure Statement, on September 29, 2011, a bondholder filed a motion for reconsideration of the order approving the Settlement (Reconsideration Motion). In that motion, the bondholder argued that the parties lacked authority to provide for a release of the bondholders’ claims against the Trustee. This was especially the case, the bondholder argued, because the Trustee had a conflict of interest and the bondholders were not otherwise properly represented in the matter.

As a result of the filing of the Reconsideration Motion, the Bankruptcy Judge sua sponte entered an order modifying the order approving the Settlement with respect to the Third Party Releases. The revised order specifically provided that nothing in the Settlement or the revised order shall waive, release, discharge, or impair any claims that the bondholders may have against the Trustee.

The Bankruptcy Court’s Decision to Disallow the Third Party Releases

At the hearing to consider confirmation of the Plan, which was held on December 2, 2011, the parties agreed to sever the consideration of the Third Party Releases from the other confirmation issues so that the Bankruptcy Court could confirm the Plan. Thereafter, on March 2, 2012, the Bankruptcy Court held a hearing to consider the issues with respect to the Third Party Releases. At that hearing, the Trustee argued that its willingness to participate in the settlement negotiations on behalf of the bondholders justified demanding protection of its own interests in the negotiations, as any agreement releasing LBH’s indemnification obligations exposed the Trustee to what could be substantial losses without any right to look to LBH for indemnification. Therefore, the Trustee argued, the Third Party Releases were key terms that enabled the parties to reach the Settlement and to propose the Plan. The Trustee also argued that the Third Party Releases maximized the bondholders’ return under the Plan because, absent these releases, the Trustee would have been forced to exercise its rights under the Trust Indenture to assert a charging lien against the proceeds of the Settlement to pay for the Adversary Proceeding.

On May 10, 2012, the Bankruptcy Court issued an opinion denying the Third Party Releases. While the Bankruptcy Court agreed that without a resolution satisfactory to the Trustee, there could not have been a true global consensual settlement, it did not agree that, as a result, the Plan could not be confirmed without the Trustee being a party to the Settlement. For example, settlement negotiations could have gone forward without the Trustee but instead with a different bondholder representative, or the Trustee could have had separate representation in its capacity as indemnitee. But here, the Trustee was serving in two capacities.  On one hand, pursuant to the contractual authority provided for in the Trust Indenture, the Trustee served as the bondholders’ authorized representative in settlement negotiations designed to resolve the Adversary Proceeding and the bondholders’ claims in the bankruptcy cases. On the other hand, the Trustee took positions in the negotiations that were designed to protect its “personal” interests, such as increased exposure due to the fact that its indemnification rights against LBH (rights that belonged to the Trustee, not the bondholders) were being negotiated. Once the Trustee chose to act as the bondholders’ representative and participate in the settlement negotiations on its behalf, it was obligated to fully and faithfully represent the interests of the bondholders. The Bankruptcy Court found that the Trustee did not properly act in both capacities and, the negotiated result — the Third Party Releases — which releases were inadequately disclosed to bondholders — were improper.

The Bankruptcy Court found that a critical factor in assessing the confirmability of a plan that includes a third party release is whether the adversely affected class of creditors (here, the bondholders) have manifested their strong support for the plan through the voting process. For the bondholders to be able to make an informed decision, they needed to have adequate information. The Bankruptcy Court was firmly convinced that the bondholders did notreceive adequate information, either from the Disclosure Statement or the notices provided by the Trustee, before they voted to accept the Plan.

Specifically, the Bankruptcy Court found that neither the Disclosure Statement nor the notices sent by the Trustee complied with Bankruptcy Rule 3016(c), which provides that if a plan provides for an injunction against conduct not otherwise enjoined by the Bankruptcy Code, the plan and disclosure statement shall describe in specific and conspicuous language (bold, italic or underlined text) all acts to be enjoined and identify the entities that would be subject to the injunction. Not only did the Disclosure Statement obscure the significance of the Third Party Releases by placing the disclosure, without any emphasis, among the disclosure of other routine, and perhaps even superfluous, releases that would result from confirmation of the Plan, but the Disclosure Statement also failed to mention the Third Party Releases in several places where it would have been more than appropriate to do so. The Trustee compounded this issue by failing to highlight the releases in its own notices.  Therefore, the Court held that such actions violated Bankruptcy Rule 3016(c).

Ultimately, the Bankruptcy Court concluded that “[i]n order for the system to function efficiently and with integrity, chapter 11 practice and culture imposes on counsel an affirmative obligation to flag the key issues for the court to consider.” The Bankruptcy Court ruled that proponents of a plan that includes third party releases must adhere to all of the procedural requirements of the Bankruptcy Code and the rules of the Bankruptcy Court, especially the pre-solicitation disclosure requirements such as Bankruptcy Rule 3016(c).  Because this did not occur, the Bankruptcy Court did not approve the Third Party Releases. The District Court affirmed the Bankruptcy Court.

The Third Circuit Opinion

On July 3, 2014, the Third Circuit affirmed the order of the Bankruptcy Court. The Third Circuit pointed to Section 1125 of the Bankruptcy Code, which requires that a court approve a disclosure statement as containing “adequate information,” which is information of a kind, and in sufficient detail, that would enable a hypothetical investor of the relevant class to make an informed judgment about the plan. Further, the Court of Appeals noted that Bankruptcy Rule 3016 requires that if a plan provides for an injunction (such as the Third Party Releases), the plan and disclosure statement must describe in specific and conspicuous language (bold, italics or underlined texts) all acts to be enjoined and identify the entities that would be subject to the injunction. The Third Circuit stated that the Third Party Release is an injunction for all practical purposes, as it bars the bondholders from suing the Trustee, and stated that for the reasons found in the Bankruptcy Court’s “candid and comprehensive opinion” accompanying the order denying the third party release, it found no abuse of discretion in the Bankruptcy Court’s determination that the release of the Trustee was not adequately disclosed.

The Third Circuit also rejected the Trustee’s argument that because the Bankruptcy Court initially approved the disclosure statement, it could not revisit or reconsider that decision. Bankruptcy Rule 9024, which incorporates Federal Rule of Civil Procedure 60(b), allows bankruptcy courts to reconsider earlier orders in the case of mistake, inadvertence, surprise, excusable neglect, newly discovered evidence, or any other reason that justifies relief. The Third Circuit found that due to the parties’ failure to adequately disclose or otherwise draw the Bankruptcy Court’s attention to the Third Party Release provisions, the Bankruptcy Court was unaware of the third party releases when it reviewed the Disclosure Statement and Settlement and that once the Bankruptcy Court became aware of the release, it was within the Bankruptcy Court’s discretion to revisit its approval of the disclosure statement; “[a]ny other rule would encourage debtors to obscure information in their disclosure statements.” Therefore, the Third Circuit, after de novo review, affirmed the Bankruptcy Court’s decision with respect to this issue.

Finally, the Third Circuit agreed with the Bankruptcy Court that this was not an appropriate case for approval of a non-consensual third party release, as in the absence of adequate disclosure, it was impossible to conclude that “a large majority of the bondholders supported the Plan and acquiesced to the release of their potential claims against BNYM” (quoting the Bankruptcy Court opinion). The Third Circuit could not conclude that the release was exchanged for adequate consideration or was otherwise fair to the bondholders. Therefore, the Court of Appeals affirmed the decision of the Bankruptcy Court.

Practice Points

The Bankruptcy Court in Lower Bucks noted that had counsel for the Trustee flagged the Third Party Releases, the need for additional disclosures would have been mandated in a timely manner, at the time of the hearing on the Settlement Motion or even at the hearing on the Disclosure Statement. Instead, this issue did not come up until shortly before the confirmation hearing. Parties representing indenture trustees who are seeking such releases should ensure that the plan and disclosure statement describe, in specific and conspicuous language (bold, italic or underlined text) these releases, all acts to be enjoined and identify the entities that would be subject to the injunction so as to provide bondholders with adequate notice and information regarding such releases. Moreover, such parties should emphasize these provisions to the court at hearings related to the releases, as it was clear that the Bankruptcy Court did not take kindly to the fact that the relevant language was buried in dense, voluminous pleadings and documents. Further, indenture trustees should also emphasize such release provisions in any of the notices to bondholders that they prepare so as to ensure the information is clear and conspicuous and provided to bondholders in several different forms.

The Lower Bucks Hospital case does not appear to stand for the proposition that third party releases of indenture trustees will never be approved. Indeed, this case stands in contrast to a 2007 decision by the Bankruptcy Court for the Southern District of New York in the Delta Air Lines, Inc. bankruptcy case, wherein that court approved the releases at issue because the indenture trustee “developed an exceptionally full and open process of communication with all of the [bondholders].” Rather, Lower Bucks Hospital is a cautionary tale that provides guidance to indenture trustees and their counsel regarding what is necessary in the Third Circuit for such releases to be approved.