Contributed by Christopher Hopkins
The inclusion of third-party releases in plan of reorganization can be a particularly contentious aspect of the plan confirmation process. Debtors seeking such releases typically face opposition from affected creditors and scrutiny from bankruptcy courts that consider such releases prone to abuse. As the Fourth Circuit’s recent decision in National Heritage Foundation, Inc. v. Highbourne Foundation makes clear, courts will not simply “rubber stamp” third-party releases absent creditor consent unless the debtor is able to prove that the unique circumstances of the case justify the release. Even in jurisdictions where third-party releases may be enforced in appropriate circumstances, many courts only grant releases “cautiously and infrequently.”
National Heritage Foundation is a public non-profit charity that administers and maintains donor advised funds. In 2009, National filed for chapter 11 protection after a state court entered a multimillion dollar judgment against it. Following a contentious plan confirmation process, the bankruptcy court approved the debtor’s plan of reorganization. The plan included a third-party release releasing claims against the debtor, the creditor’s committee, and any officer, director, or employee of the debtor or the committee. Following confirmation of the debtor’s plan, certain creditors affected by the release challenged the bankruptcy court’s approval of the plan on the ground that the release provision was invalid. The creditor’s appeal was remanded back to the bankruptcy court by the Fourth Circuit after the district court affirmed the bankruptcy court’s confirmation of the plan on the ground that the bankruptcy court failed to make sufficient factual findings to support approval of the release. On remand, the bankruptcy court (with a new bankruptcy judge) reversed and declared the release unenforceable. This time, National appealed, and after the district court affirmed the bankruptcy court’s ruling, National found itself before the Fourth Circuit for the second time.
The Dow Factors: Justifying Third-Party Releases
The Fourth Circuit adopted the seven-factor test set out by the Sixth Circuit in Class Five Nevada Claimants v. Dow Corning Corp. (In re Dow Corning Corp.) (which is a test comprised of six substantive factors and one non-substantive factor) to determine whether National had adequately proved the appropriateness of the third-party release provision in the plan. The court applied the six substantive Dow factors to the facts of the case and concluded that National had failed to meet its burden. Because the court’s decision addressed the applicable standards related to each Dow factor and applied the facts of the case to each of this six substantive factors, National Heritage provides a useful road map for debtors seeking approval of third-party releases.
- Whether the debtor and the third-party share a unity of interest
Courts generally look to whether there is an indemnity or guarantee relationship between the debtor and the third-party. Where such relationships exist, courts reason that third-party releases may be appropriate because a suit against the third-party may operate in effect as a suit against the debtor by virtue of the indemnity or guaranty. Here, the court concluded that National had adequately proved this factor by demonstrating that, under its by-laws, it was obligated to advance legal expenses and indemnify its officers and directors. The court reasoned that such an expansive indemnity obligation was enough to satisfy the first Dow factor. This would be the only Dow factor that National successfully proved weighed in favor of the release.
- Whether the third-party has contributed substantial assets to the reorganization
This factor requires the debtor to prove that the released parties made a substantial, cognizable, and valid contribution of assets to the debtor as part of its reorganization. National attempted to meet its burden under this factor by asserting that its directors and officers had made a substantial contribution to the reorganization by promising to continue serving at National. The court rejected this argument, finding that National’s directors and officers continued serving National because they were either paid or had a fiduciary duty to do so. Further, National offered no evidence supporting its assertion that its officers and directors actually promised to stay. Accordingly, the court concluded that the released parties had not provided meaningful consideration to National in exchange for the release.
- Whether the release is essential to the debtor’s reorganization
National not only failed to prove that it met this factor, but it also included provisions in its plan that “cemented” the court’s belief that the release was not essential to its reorganization. The court stated that the relevant inquiry concerning this factor is whether the debtor’s reorganization “hinges on the debtor being free and clear from indirect suits against parties who would have indemnity or contribution claims against the debtor.” National failed to provide convincing evidence regarding the number of likely claims, the nature of such claims, and their potential merit, and other evidence provided by National was simply too vague to substantiate the risk of litigation. National’s plan also included severability provision that provided that National’s plan would remain in effect “should any provision in this Plan be determined to be unenforceable.” The court reasoned that if the release was truly essential to the debtor’s plan, National would not have made it subject to a severability provision.
- Whether the creditors affected by the release have overwhelmingly voted in favor of the plan
The releases in National’s plan primarily affected National’s donor-investors. The Fourth Circuit was faced with an interesting dilemma. Because National’s donors were not considered an impaired class under the plan, the donors were deemed to accept the plan without voting. National argued that the bankruptcy court was entitled to presume the donors’ support of the releases because their claims were unimpaired. The Fourth Circuit disagreed, reasoning that although there is “some uncertainty regarding whether an unimpaired class’s presumed support for a reorganization plan is sufficient to satisfy this Dow factor,” National could have implemented a procedure providing each creditor the right to vote on the release irrespective of the creditor’s class’s right to vote on the plan. Because the affected creditors had no opportunity to accept or reject the plan—and thereby the release—the court refused to find that the equities tipped in National’s favor.
- Whether the debtor’s plan of reorganization provides a mechanism to consider and pay substantially all claims of the affected creditors
National failed to establish that this factor justified the releases for two reasons: (i) National’s plan failed to provide any mechanism for the payment of untimely and other claims not resolved through National’s bankruptcy, and (ii) National failed to present evidence that the notice it provided to affected creditors adequately protected their interests. As a general matter, courts will usually find that a debtor has met its burden under this Dow factor where the debtor’s plan provides for the “channeling” of released claims to a settlement fund or some other mechanism that prevents the release from effectively extinguishing the affected creditors’ claims. The absence of such a mechanism from National’s plan weighed against the grant of the release because the plan lacked an important safeguard: “a second chance for even late claims to recover.”
Further, the court noted that National’s course of conduct in dealing with the affected creditors did not constitute a bona fide effort to ensure the consideration of nearly all of the affected creditor’s claims in the bankruptcy proceedings. National did not encourage the affected creditors to participate in the bankruptcy process. Instead, National’s disclosure statement told the affected creditors that National would object to any filed claims and that the affected creditors had no right to vote on or reject the debtor’s plan. Under such circumstances, the court refused to find that National had established that this factor weighed in favor of the release because National neither encouraged the affected creditors’ participation in the bankruptcy process nor provided a mechanism to ensure such their claims were not extinguished by the release.
- Whether the plan provides an opportunity for those who chose not to settle to recover in full
After noting that the proper analysis under this Dow factor largely overlaps with that of the fifth factor, the court reiterated the importance of National’s failure to provide any mechanism to pay the affected creditors’ claims outside of the bankruptcy proceedings. Further, noting National’s inability to prove five of the six Dow factors weighed in favor of the release, the court reiterated the bankruptcy court’s finding that the “very purpose of the Release Provision is to preclude any recovery from third party sources outside of the plan.”
The Fourth Circuit ultimately concluded that, although a debtor need not demonstrate that every Dow factor is met, National had failed to tip the scales in its favor. Importantly, the court also noted that its ruling was rooted in National’s “failure of proof rather than circumstances alone,” suggesting that if National had provided adequate factual support for its claims that the circumstances warranted the third-party release, the court might have approved the release.
National Heritage is an instructive case for debtors seeking third-party releases. Where the inclusion of a third-party release in a plan has been challenged, debtors should be prepared to present specific and substantial evidence establishing the necessity of the third-party release; unsubstantiated assertions are not enough to pass muster. In addition, debtors should be mindful of the reasons the court ruled against National, which included the severability provision in the plan, National’s failure to solicit the approval of the affected creditors with respect to the third-party release, and National’s failure to provide a mechanism to prevent the release from effectively extinguishing the affected creditors’ claims (especially given National’s lack of bona fide effort to deal with the affected creditors’ claims in the bankruptcy proceedings). Had any or all of these facts been different, then, perhaps, the releases may have been upheld.