The United States Bankruptcy Court recently denied confirmation of a bankruptcy plan even though it found that the plan's global settlement was "fair and reasonable."1 Why? Because the plan's releases were too broad and "unreasonable" for many of the constituents. The case provides a pointed lesson to creditors and debtors alike — pay attention to the releases; overdoing it may sink the whole ship.

The Plan incorporated a global settlement among WaMu; JPMorgan Chase Bank, N.A.; the Federal Deposit Insurance Corporation, in its corporate capacity and as receiver for Washington Mutual Bank (“WMB”); certain creditors; certain WMB senior noteholders; and the Official Committee of Unsecured Creditors (the “Committee”) appointed in WaMu’s Chapter 11 case. Although finding the global settlement contained in the Plan to be fair and reasonable, the Court ultimately denied confirmation of the Plan, citing broad “unreasonable” releases to all the constituents, including various noteholders (“Settlement Noteholders”), indenture trustees (“Indenture Trustees”), officers and directors and fiduciaries appointed under the Plan (the “Liquidating Trust” and the “Liquidating Trustee”), WaMu affiliates, and others.

WaMu filed for protection under Chapter 11 of the Bankruptcy Code on September 26, 2008. Prior to the commencement of WaMu’s Chapter 11 case, WMB, a non-debtor affiliate of WaMu, was placed into receivership by the FDIC. Soon after the commencement of WaMu’s Chapter 11 case, disputes arose among WaMu, Chase and the FDIC concerning ownership of certain assets. WaMu subsequently filed suit in the United States District Court of the District of Columbia against the FDIC for, among other things, wrongful dissipation of WMB’s assets, taking of WaMu’s stock interest in WMB without just compensation, and conversion. In addition, JPMorgan Chase filed an adversary proceeding against WaMu, seeking a declaratory judgment that it owned various assets as a result of its purchase of Washington Mutual Bank. WaMu, in turn, filed an adversary proceeding against JPMorgan Chase for the turnover of $3.8 billion held in deposit accounts in WaMu’s name at WMB.

The global settlement, which served as the foundation of WaMu’s Chapter 11 Plan, provided for the disposition of over $25 billion worth of disputed assets and liabilities. The proponents of the Plan projected that the global settlement would provide approximately $6.1 to $6.8 billion in value to WaMu and would provide 100% recovery to unsecured creditors and 70-80% recovery to subordinated unsecured creditors. Nonetheless, the Plan was opposed by the Office of United States Trustee (the bankruptcy arm of the Justice Department), the Official Committee of Equity Security Holders appointed in WaMu’s Chapter 11 case, certain WMB noteholders, and certain other shareholders and creditors. Although many of the objecting parties contested the reasonableness of the global settlement for a variety of reasons, the Court ultimately found the global settlement fair and reasonable.

However, the objecting parties opposed, among other things, the releases granted under the Plan, and the Court found certain of these arguments persuasive.

The Court first reviewed the releases of JPMorgan Chase, the FDIC and WMB. Applying the five-factor test articulated in In re Master Mortgage Investment Fund, Inc., 168 B.R. 930, 937 (Bankr. W.D. Mo. 1994) and applied by the Delaware Bankruptcy Court in In re Zenith Electronics Corporation, 241 B.R. 92, 110 (Bankr. D. Del. 1999), the Court held that any releases under the Plan needed to meet the following five-factor test and then found the releases granted to JPMorgan Chase, the FDIC and WMB appropriate because they met all five factors: (1) an identity of interest exists among WaMu, JPMorgan Chase, the FDIC and WMB; (2) JPMorgan Chase and the FDIC made a substantial contribution to the Plan by waiving claims against WaMu; (3) the releases are necessary to WaMu’s reorganization and Plan confirmation; (4) the Plan depends on the value conveyed by JPMorgan Chase and the FDIC; and (5) the global settlement and the Plan provide for the favorable distributions to be received by all or substantially all creditors.

Despite the Court’s conclusion that the global settlement and the releases of JPMorgan Chase, the FDIC and WMB under the Plan were fair and reasonable, the Court nonetheless denied confirmation because, after applying the aforementioned five-factor test, the Court concluded that the Plan contained unreasonable releases of other parties. Specifically, the Court found that the Plan provided inappropriate releases for the settling of WMB senior noteholders, the Committee and its members, the Indenture Trustees, the Liquidating Trust and the Liquidating Trustee, certain WaMu affiliates and, importantly, WaMu’s current and former directors, officers and professionals.

With respect to the Liquidating Trust and the Liquidating Trustee, both to be appointed under the Plan after confirmation to implement the settlement, the Court held that they, by definition, cannot meet the five-factor test as they have not yet been appointed and therefore have not yet provided any consideration, nor done anything for which they might need a release.

As to the Committee and its members, the Court noted that it is appropriate to provide exculpations for their role during the pendency of the bankruptcy cases for actions, other than for willful misconduct or gross negligence. Further, the Court confirmed that it observed nothing to indicate that the Committee or its members have done anything other than fulfill their fiduciary duties. However, the Court further found that they did not meet the fivefactor test required to qualify for a release from the Debtors, as they have no identity of interest with the Debtors, made no cash or other tangible contribution to the Plan, and did not provide any extraordinary service that would constitute a substantial contribution to the Plan or bankruptcy cases. While creditors are receiving a substantial recovery in the case, it is not coming from the Committee or its members. The Court applied the same analysis to the Indenture Trustees and further noted that since all the Indenture Trustees were Committee members, the separate release and exculpation language governing them was unnecessary.

The Court then applied the same five-factor test to deny the proposed releases of the Settlement Noteholders. The Court found further that the alleged contribution made by their participation in the settlement negotiations involved no action by them as fiduciaries but solely on their own behalf. The Settlement Noteholders held interests in various levels of debt, and the negotiations and settlement resulted in their receiving in full a recovery in all but the lowest level of debt. Further, it is important to note that one of the individual creditors objecting to the global settlement accused the Settlement Noteholders of using their position in the negotiations to gain nonpublic information about the Debtors that permitted them to trade in the Debtors’ debt. Even with this evidence not admitted as hearsay, the Court mentioned this as another factor militating against the approval of any releases of the Settlement Noteholders.2

Also important, the Court found that WaMu’s current or former directors, officers and professionals might have met the first factor of the five-factor test for releases as their charter or bylaws might provide for indemnification against claims brought by creditors or shareholders, which creates an identity of interest between the debtors and the directors and officers. However, the Court found no evidence of the other four factors. Specifically, the Court found no evidence of a “substantial contribution” made to the case by the directors, officers or professionals, and no evidence that any of the “legends” of directors, officers or professionals covered by the Debtors’ releases are necessary for the reorganization. With respect to the directors, officers or professionals of the Debtors who served during the pendency of the bankruptcy cases, the Court permitted them only the same exculpation as the Committee and its members, including the Indenture Trustees, again excluding willful misconduct and gross negligence.

This decision makes clear that the various parties that may choose to become engaged and active in the bankruptcy process should not take for granted that all their conduct during the case will be protected by sweeping releases once all the disputed issues are resolved. Even where parties propose a plan implementing a global settlement that includes those releases as an important component of the plan settlement itself, the Court may deny confirmation absent the removal of those protections.