We’ve focused a lot on third-party releases lately, as bankruptcy courts across the country continue to evaluate whether and under what circumstances they are permissible. But, as a recent opinion of the United States Court of Appeals for the Fifth Circuit demonstrates, bankruptcy courts are not the only courts grappling with this issue.
The case arises out of the failure of the Stanford Financial Group, which was revealed in 2009 to be a “massive Ponzi scheme [that] defrauded more than 18,000 investors who collectively lost over $5 billion.” After years of litigation and a lengthy mediation, the parties eventually achieved a settlement pursuant to which the Stanford receivership estate would receive $65 million from various insurance underwriters in exchange for not only releases from the estate but also a “bar order” enjoining an array of third-party claims against the underwriters.
The District Court approved the settlement over several objections, including from a group of former employees who were not released under the settlement. This allowed the receiver to continue to pursue claims against them even though they were subject to the bar order and therefore could not seek contribution or reimbursement from the underwriters. In addition to their policy claims, the former employees asserted “extra-contractual claims against the Underwriters, including for bad faith and statutory violations of the Texas Insurance Code,” which were also subject to a nonconsensual release.
In June, the Fifth Circuit overturned the District Court’s approval of the settlement for two reasons. First, the bar order, which was an integral component of the settlement, enjoined claims of coinsured parties (like the former employees) to policy proceeds without a “making any provision for them to access the proceeds through the Receiver's claims process.” Second, the nonconsenaul release of the former employees’ claims outside of the policy constituted an impermissible third-party release of direct (i.e., non-derivative) claims of third-parties that did not belong to the receivership estate.
There is a lot to unpack in this decision, but this a bankruptcy blog, so I am going to focus on a handful of issues that are most salient to the consideration of third-party releases in Chapter 11 cases.
First and foremost, the prohibition on third-party releases is alive and well in the Fifth Circuit, which encompasses very active bankruptcy courts in the Northern and Southern Districts of Texas (including Houston and Dallas/Fort Worth). Relying on its prior decisions in Zale and Vitek, the Fifth Circuit reaffirmed that a bankruptcy court cannot enjoin independent third-party claims against insurers.
The reasoning behind the decision, however, raises some interesting questions. For one thing, after noting the impermissibility of third-party releases in bankruptcy cases, the Court added that “[t]he prohibition on enjoining unrelated, third-party claims without the third parties’ consent does not depend on the Bankruptcy Code, but is a maxim of law not abrogated by the district court's equitable power to fashion ancillary relief measures.” This statement is at odds with the Fifth Circuit’s rationale in Zale, that third-party releases in a plan are impermissible because Section 524(e) of the Bankruptcy Code “prohibits the discharge of debts of nondebtors.” Of course, since this was not a bankruptcy case, the Fifth Circuit did not have the option of basing its decision on the Bankruptcy Code. Instead, the Court made broader pronouncements regarding the receiver’s standing to settle disputes to which it is not a party, the jurisdiction of the federal courts, and the limits of equity. But, in our view, this alternative basis for rejecting third-party releases outside of bankruptcy does not alter or limit prior Fifth Circuit precedent that third-party releases are prohibited in bankruptcy cases by Section 524 of the Bankruptcy Code.
Second, the opinion offered a roadmap for the parties to cure one of the two problems with the bar order: the exclusion of the coinsured former employees from pursuing policy proceeds. “Rather than extinguish the Appellants’ contractual claims, the court could have authorized them to be filed against the Receivership in tandem with the Stanford investors’ claims. Such ‘channeling orders’ are often employed to afford alternative satisfaction to competing claimants to receivership assets while limiting their rights of legal recourse against the assets.” Whether and to what extent a channeling order would cure an otherwise impermissible third-party release in the bankruptcy context remains an open question. In any event, the injunction against claims other than for payment out of the policy proceeds (i.e., the “extracontractual claims”) appears to remain well outside the scope of what Fifth Circuit law will tolerate.
Finally, the Court accepted that the insurance proceeds were property of the receivership estate without much analysis. But that question merits a lot more scrutiny when similar issues arise in bankruptcy cases and, in fact, there is considerable authority to the contrary within the Fifth Circuit. If in fact the policy proceeds are not property of the estate in a bankruptcy case, then a bankruptcy court’s authority to enjoin claims by coinsured non-debtors to seek payment of such policy proceeds – even if those parties are given the right to file a claim against the bankruptcy estate – would likely be diminished.