Contributed by Joshua Nemser
Sometimes, a well-worded release can really make your day. Take the case of In re Managed Storage International, Inc., where it saved one creditor over $5 million. The decision, recently handed down by the Judge Walrath of the United States Bankruptcy Court for the District of Delaware, holds that a release executed by a chapter 11 debtor in possession is generally binding on a subsequent chapter 7 trustee.
After filing a voluntary petition under chapter 11 of the Bankruptcy Code, the debtors sold their assets in a bankruptcy court-approved sale to a private fund, Laurus Master Fund, Ltd. Proceeds of the sale should have been set aside for Avnet, Inc., a secured creditor with a purchase money security interest in certain collateral. Unfortunately, the funds were never segregated, and Avnet filed a motion requesting a turnover of the collateral from Laurus. In response, the debtors, Laurus, and Avnet entered into a stipulation: Laurus paid Avnet $975,000, and the debtors executed releases in favor of both Laurus and Avnet, who reciprocally executed releases in favor of the debtors. The pertinent language of the release of Avnet by the debtors is as follows:
Debtors for themselves and their respective heirs, . . . successors and assigns hereby:
(a) release and discharge Avnet and each of its heirs, . . . predecessors, successors and assigns, from any and all actions, causes of action, . . . claims and demands relating to the Debtors and their Chapter 11 cases only, in law or equity, including but not limited to any claims relating to the Avnet PMSI collateral . . . .
After the stipulation, the debtors’ cases were converted to chapter 7 cases. The chapter 7 trustee filed preference actions against Avnet for approximately $5.5 million and Bell Microproducts, Inc. (and Avnet as Bell’s successor) for approximately $1 million. Avnet and Bell filed motions to dismiss, but only Avnet’s motion was granted. But why, you ask? Read on.
The Release Was Binding
The trustee argued that the parties did not have the requisite intent to make the release binding after the case was converted. In support of his argument that he was not bound, the trustee contrasted the release granted in favor of Laurus, which included specific language that makes the release binding on a chapter 7 trustee, with the Avnet release, which did not expressly bind a subsequent chapter 7 trustee. Judge Walrath rejected the trustee’s argument, finding that agreements executed by a debtor are generally enforceable against a subsequently appointed trustee. Further, relying on general principles of contract construction, the bankruptcy court noted that “the mere inconsistency between the releases granted to Avnet and to Laurus is insufficient evidence of an intent not to bind the Trustee.” The trustee was pressed to find another way to prove why he was not bound by the release, and he advanced three theories.
First, the trustee asserted that the estate would suffer “extreme prejudice” if it waived a $5 million preference claim. The court responded that, if barring pursuit of a large preference was enough to invalidate a release, “all releases would be invalid . . . .”
Second, the trustee averred that there was no consideration given for the release. The stipulation itself mentioned avoided costs related to litigating the underlying collateral segregation issue as possible consideration. Further, the stipulation included a reciprocal release executed by Avnet in favor of the debtors. Acknowledging these facts, the court found sufficient consideration, further noting that, although the deal might not have been a home run for the debtors, it was not “unconscionable.”
Third, the trustee argued that because there was insufficient notice of the stipulation provided to all creditors and interested parties, the release within it could not be binding. Rule 2002(a)(3) requires 21 days’ advance notice of a settlement hearing, but the court noted that it had the power to shorten this period, or even eliminate the notice requirement altogether, for “cause shown.” Because interested parties had notice that a relevant “stipulation was being circulated to resolve Avnet’s motion,” the court found no prejudice in doing away with the notice requirement.
Dismissing the trustee’s arguments, the court held that the release was binding on the trustee. The next issue was whether the release was broad enough in scope to include preference actions.
Preference Actions Included in Release
Relying again on general principles of contract formation, the court determined that the release included preference actions. In referencing a decision from the Supreme Court of Delaware, Hob Tea Room v. Miller, the bankruptcy court found that “[r]eleases do not need to include explicitly all causes of action which are covered.” Because the trustee was unable to provide any evidence that the general release intended to exclude preference actions, the court found that the preference claim fell within the scope of the release.
After undertaking this inquiry, the court dismissed the action against Avnet.
What About Bell?
Bell Microproducts, Inc. was merged into Avnet after the execution of the stipulation and release. Bell argued that because of the merger, the preference action against it also should be dismissed under the release. After discussing Delaware precedent, the court found “that the release of Avnet did not release any claims that the Trustee has against Bell which arose prior to its merger with Avnet.” (emphasis added)
As the great Austin Powers once said, “Whooptydoo. What does it all mean, Basil?” The court affirmed that agreements executed by chapter 11 debtors bind subsequent chapter 7 trustees. Additionally, unless preference actions are explicitly excluded from a postpetition release, courts may be hesitant to allow the pursuit of such actions. Nevertheless, Avnet might have avoided litigation altogether if it had, as Laurus did, expressly included chapter 7 trustees in the list of entities bound by the debtors’ release. Managed Storage provides us with yet another example of the power of careful drafting.