A recent decision of the United States Bankruptcy Court for the Southern District of New York provides important guidance on the limits of nonconsensual third-party releases in the Second Circuit.[1] SunEdison, Inc. sought confirmation of a plan for itself and its affiliated debtors. The plan included releases of claims against non-debtor third parties by any creditor that was entitled to but did not cast a vote on the plan.[2] No party objected to the release at the confirmation hearing, but Judge Bernstein asked sua sponte whether he had authority to bind non-voting creditors to broad releases of claims against third parties.[3]

In the Opinion issued this week, he concluded that he did not. Specifically, “the Debtors have failed to demonstrate that Non-Voting Releasors impliedly consented to the Release, that the Court has jurisdiction to release the Non-Voting Releasors’ third party claims to the extent set forth in the Release, or that approval of the nonconsensual Release is appropriate under the standards enunciated in In re Metromedia Fiber Network, Inc., 416 F.3d 136 (2d Cir. 2005).”[4]

Consent

The Court first considered whether the failure to vote on the plan by the Non-Voting Releasors could be construed as their consent to the release. The Debtors contended that a “conspicuous warning in the Disclosure Statement and the ballots regarding the possible effect of the Release on nonvoting creditors was sufficient” to find that they consented to the release.[5] Judge Bernstein disagreed.

The Debtors have failed [. . . ] to show that the Non-Voting Releasors’ silence [. . .] signified their consent to the Release. There are other plausible inferences that support the opposite inference. For example, the meager recoveries (here, less than 3% for the unsecured creditors) may explain their inaction without regard to the Release. Or the creditor could have failed to return a ballot because it supported the Plan but did not want to give the Release. “Charging all inactive creditors with full knowledge of the scope and implications of the proposed third party releases, and implying a ‘consent’ to the third party releases based on the creditors’ inaction, is simply not realistic or fair, and would stretch the meaning of ‘consent’ beyond the breaking point.”[6]

Jurisdiction

In the absence of consent, the Court next inquired “whether it has jurisdiction over the attempts to enjoin the creditors’ unasserted claims against the third party.”[7] The Debtors argued that the Court could base jurisdiction on the indemnification obligations owed to their existing directors as well as other third-party claims that could be triggered in the event of claims against the non-debtor releasees. The Court rejected this argument. The Court does have jurisdiction to enjoin a third-party claim that may give rise to a potential indemnification or contribution claim against the estate because such claim will have a “conceivable effect” on the estate. But, the release before the Court was “much broader than the indemnification obligations the Debtors contend support it, [and] the Release [is not] limited to the potential indemnified parties listed by the Debtors. [. . . ] The reference to certain indemnity obligations owed to a few parties does not prove that the outcome of the universe of claims the Debtors seek to enjoin will have a conceivable effect on the estate.”[8]

Metromedia

Finally, even if jurisdiction existed here, “third party releases are proper only in rare and unique circumstances.”[9] As instructed by the Second Circuit in Metromedia,

In deciding whether a third party release is appropriate, courts may consider whether the estate has received a substantial contribution, whether the enjoined claims are channeled to a settlement fund rather than extinguished, whether the enjoined claims would indirectly impact the debtor’s reorganization through claims of indemnity or contribution, whether the plan otherwise provides for payment in full of the enjoined claims and whether the creditor has consented. Nevertheless, the test is not ‘a matter of factors and prongs,’ and a third party release will not be tolerated ‘absent findings of circumstances that may be characterized as unique.’[10]

The proposed release did not withstand the scrutiny required by this standard. “The Non-Voting Releasors did not consent to the Release. The creditors are not being paid in full, and their third party claims will be extinguished rather than channeled to a fund that will pay them. Furthermore, as noted, the Debtors have not identified which third party claims will directly impact their reorganization, and given the broad scope of the Release, it is likely that many will not. Finally, while some of the proposed releasees undoubtedly made contributions for which they are not otherwise compensated, or compromised their rights as part of the global settlement that made confirmation possible, the broad definition of Released Parties includes persons that added nothing to the cases.”[11]

Importantly, however, the Court left open the possibility of approving a more narrowly-tailored third-party release that would bind the Non-Voting Releasors. Any such revised provision, the Court ordered, “must specify the releasee by name or readily identifiable group and the claims to be released, demonstrate how the outcome of the claims to be released might have a conceivable effect on the Debtors’ estates and show that this is one of the rare cases involving unique circumstances in which the release of the claims is appropriate under Metromedia.”[12]