In a recent decision, the United States Court of Appeals for the Eleventh Circuit reaffirmed its position sanctioning, under appropriate circumstances, nonconsensual third party release provisions in chapter 11 plans. In SE Prop. Holdings, LLC v. Seaside Eng’g & Surveying, Inc.(In re Seaside Eng’g & Surveying, Inc.), 780 F.3d 1070 (11th Cir. 2015), the Eleventh Circuit affirmed bankruptcy and district court decisions approving a debtor’s chapter 11 plan that released the debtor’s former principals over the objection of a noninsider equity holder. In so ruling, the Eleventh Circuit maintained its alignment with the majority position on the third party release issue, along with the Second, Third, Fourth, Sixth, and Seventh Circuits.
Validity of Nonconsensual Third Party Releases in a Chapter 11 Plan
The federal circuit courts of appeal are split as to whether a bankruptcy court has the authority to approve chapter 11 plan provisions that, over the objection of creditors or other stakeholders, release specified nondebtors from liability and/or enjoin dissenting stakeholders from asserting claims against such nondebtors. The minority view, held by the Fifth, Ninth, and Tenth Circuits, bans such nonconsensual releases on the basis that section 524(e) of the Bankruptcy Code, which provides generally that “discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt,” prohibits them. See Bank of N.Y. Trust Co. v. Official Unsecured Creditors’ Comm. (In re Pac. Lumber Co.), 584 F.3d 229 (5th Cir. 2009); In re Lowenschuss, 67 F.3d 1394 (9th Cir. 1995); In re W. Real Estate Fund, Inc., 922 F.2d 592 (10th Cir. 1990).
On the other hand, the majority of circuits to consider the issue—the Second, Third, Fourth, Sixth, and Seventh Circuits—have found such releases and injunctions permissible, under certain circumstances. See In re Drexel Burnham Lambert Group, Inc., 960 F.2d 285 (2d Cir. 1992); In re Continental Airlines, 203 F.3d 203 (3d Cir. 2000); In re A.H. Robins Co., Inc., 880 F.2d 694 (4th Cir. 1989); In re Dow Corning Corp., 280 F.3d 648 (6th Cir. 2002); In re Airadigm Communications, Inc., 519 F.3d 640 (7th Cir. 2008). For authority, these courts generally rely on section 105(a) of the Bankruptcy Code, which authorizes courts to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code].” Moreover, as the Seventh Circuit held in Airadigm, the majority view is that section 524(e) does not limit a bankruptcy court’s authority to grant such a release. The First and D.C. Circuits have indicated that they agree with the “pro-release” majority, as did the Eleventh Circuit in a decision that had long predated Seaside Engineering. See In re Monarch Life Ins. Co., 65 F.3d 973 (1st Cir. 1995); In re Munford, Inc., 97 F.3d 449 (11th Cir. 1996); In re AOV Industries, 792 F.2d 1140 (D.C. Cir. 1986).
In Dow Corning, the Sixth Circuit identified seven factors that bankruptcy courts should consider when evaluating the propriety of a nonconsensual release of claims against a nondebtor third party in a chapter 11 plan:
- An identity of interests between the debtor and the third party, usually an indemnity relationship, such that a suit against the nondebtor is, in essence, a suit against the debtor or will deplete the assets of the estate;
- Substantial contribution by the nondebtor of assets to the reorganization;
- The essential nature of the injunction to the reorganization, namely, the fact that the reorganization hinges on the debtor’s being free from indirect suits against parties who would have indemnity or contribution claims against the debtor;
- Overwhelming acceptance of the plan by the impacted class or classes;
- Provision in the plan for payment of all or substantially all of the claims of the class or classes affected by the injunction;
- Provision in the plan for an opportunity for claimants who chose not to settle to recover in full; and
- A record of specific factual findings by the bankruptcy court that supports its conclusions.
The list is nonexclusive, and not all of the factors need to be satisfied. Courts have the discretion and flexibility to determine which of the factors will be relevant in each case.
In In re Master Mortgage Invest. Fund, Inc., 168 B.R. 930 (Bankr. W.D. Mo. 1994), the bankruptcy court articulated a similar five-factor test that considers: (i) the identity of interests between the debtor and the third party, including any indemnity relationship; (ii) any value (monetary or otherwise) contributed by the third party to the chapter 11 case or plan; (iii) the need for the proposed release in terms of facilitating the plan or the debtor’s reorganization efforts; (iv) the level of creditor support for the plan; and (v) the payments and protections otherwise available to creditors affected by the release. Like the Dow Corning factors, the Master Mortgagetest has been cited with approval by many other courts. See, e.g., In re Charles St. African Methodist Episcopal Church of Bos., 499 B.R. 66 (Bankr. D. Mass. 2013); In re Riverbend Leasing, LLC, 458 B.R. 520 (Bankr. S.D. Iowa 2011); In re Wash. Mut., Inc., 442 B.R. 314 (Bankr. D. Del. 2011); In re Zenith Elecs. Corp., 241 B.R. 92 (Bankr. D. Del. 1999).
The Eleventh Circuit revisited the third party release issue in Seaside Engineering.
Seaside Engineering & Surveying, Inc. (“Seaside”) was a closely held civil engineering and surveying firm that conducted hydrographic surveying and navigational mapping. Seaside’s five principal shareholders were also its officers, directors, and key operating personnel.
Seaside’s principal shareholders also formed two wholly separate real estate companies. These companies borrowed money from Vision-Park Properties, LLC, and an affiliate (collectively, “Vision”). Seaside’s shareholders personally guaranteed the loans, but Seaside was neither a borrower nor a guarantor.
The real estate ventures ultimately defaulted on the loans, triggering a $4.5 million obligation under the personal guarantees. Three of Seaside’s principal shareholders then filed chapter 7 cases. The chapter 7 trustee in one of the cases auctioned the debtor’s Seaside shares, which Vision acquired for $100,000.
Seaside filed for chapter 11 protection in the Northern District of Florida on October 7, 2011 (after Vision acquired the Seaside shares). Seaside filed a chapter 11 plan (the “Plan”) under which Seaside proposed to reorganize and continue operating under a new name—Gulf Atlantic, LLC (“Gulf”). Gulf would be owned by irrevocable family trusts settled for Seaside’s principal shareholders, who would also manage the reorganized company. Under the Plan, nonmanager equity holders, including Vision, were to receive promissory notes with interest accruing at the rate of 4.25 percent annually in exchange for their interests in Seaside and would not receive an ownership interest in Gulf.
The Plan also included provisions releasing Seaside’s officers, directors, and members; Gulf; Gulf’s officers, directors, and members; and the representatives of each of these nondebtor entities. The releases covered liability for acts, omissions, transactions, and other occurrences related to Seaside’s chapter 11 case, except actions amounting to fraud, gross negligence, or willful misconduct.
Vision objected to various aspects of the Plan, including the releases. According to Vision, the releases were “inappropriate, unjust and unnecessary” and improperly sought to frustrate Vision’s efforts to collect from the principal shareholders and their respective bankruptcy estates.
The bankruptcy court approved the releases after Seaside amended the Plan provisions to remove subsidiaries and affiliates from the list of released parties and agreed to terminate litigation against Vision seeking sanctions. In doing so, the court applied the multifactor Dow Corning test.
The bankruptcy court confirmed the amended Plan over Vision’s objections. Vision appealed to the U.S. District Court for the Northern District of Florida, which affirmed the confirmation order. Vision then appealed to the Eleventh Circuit.
The Eleventh Circuit’s Ruling
A three-judge panel of the Eleventh Circuit affirmed.
At the outset of its ruling, the Eleventh Circuit noted that, in Munford, the court previously held that section 105(a) of the Bankruptcy Code provides bankruptcy courts with authority to approve nonconsensual third party releases. The court approved the release in Munford because: (i) it was “integral to settlement in an adversary proceeding,” and (ii) the released party was a settling defendant that would not have agreed to the settlement without the release. Despite the factual dissimilarities between the two cases, the Eleventh Circuit in Seaside Engineering wrote that “Munford is the controlling case here” and held that the Eleventh Circuit follows the “majority view” that nonconsensual third party releases are permissible under certain circumstances.
The Eleventh Circuit rejected the argument endorsed by the “minority circuits” that such releases are prohibited by section 524(e) of the Bankruptcy Code. In doing so, the court agreed with the Seventh Circuit’s rationale in Airadigm, where the court stated that “[t]he natural reading of this provision does not foreclose a third-party release from a creditor’s claims.” Moreover, the Eleventh Circuit explained, if Congress had intended to limit the power of bankruptcy courts in this respect, it would have done so unequivocally.
With this groundwork, the Eleventh Circuit ruled that the bankruptcy court’s application of Dow Corning was consistent with existing Eleventh Circuit precedent. In commending those factors to bankruptcy courts within the circuit, the Eleventh Circuit emphasized that bankruptcy courts have discretion to determine which of the factors will be relevant in each case and that the factors should be considered a nonexclusive list of considerations. Moreover, the Eleventh Circuit noted, the Dow Corning factors should be applied flexibly, always keeping in mind that such releases should be used “cautiously and infrequently” and only where essential, fair, and equitable.
The Eleventh Circuit determined that the bankruptcy court did not abuse its discretion in finding that, overall, application of the Dow Corning factors demonstrated that the Plan releases were appropriate. However, the Eleventh Circuit explained that, in accordance with Munford, bankruptcy courts should also consider whether a proposed release is “fair and equitable.” Although the bankruptcy court did not explicitly make such a finding in the case before it, the Eleventh Circuit was satisfied that the bankruptcy court, in discussing considerations relevant to such a finding and requiring Seaside to cease litigation against Vision, properly considered whether the releases had satisfied this requirement. Among other things, the Eleventh Circuit, noting that the bankruptcy court had described the chapter 11 case as a “death struggle,” stated that “the non-debtor releases are a valid tool to halt that fight.”
Impact of Seaside Engineering
Seaside Engineering confirms that the Eleventh Circuit is still firmly in the majority camp concerning the propriety of nonconsensual third party releases in a chapter 11 plan, depending on the circumstances. This can be viewed as a positive development for proponents of such releases as a tool for overcoming confirmation obstacles in complex, contested chapter 11 cases.
The final report issued on December 8, 2014, by the American Bankruptcy Institute’s Commission to Study the Reform of Chapter 11 highlights the circuit split on this controversial issue. Although the Commission endorsed the majority view in favor of plan releases under appropriate circumstances, it also examined which text better determines whether such circumstances exist: the Dow Corning test or the Master Mortgage test.
The two tests overlap significantly. However, unlike the Dow Corning factors, the Master Mortgage factors do not consider whether “[t]he bankruptcy court made a record of specific factual findings that supports its conclusions.” The Commission ultimately recommended that courts adopt a standard based on the factors articulated in Master Mortgage rather than those in Dow Corning. The Commission declined “to incorporate separate identification of unique or unusual circumstances,” stating that “the Master Mortgage factors adequately capture the careful review required in these cases.”