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Second and Seventh Circuits Issue Decisions on Third-Party Releases

For decades now, debtors in chapter 11 have proposed in their chapter 11 plans “third-party releases,” whereby creditors are deemed to have released certain nondebtor parties (such as officers, directors, or affiliates of the debtor) upon the confirmation and effectiveness of the plan. For an equally long period, such third-party releases have engendered controversy in the courts and elsewhere as to when, if ever, such releases are appropriate. Over the years, the issue has been considered by several courts of appeals, with somewhat differing results. Until recently, the Second Circuit Court of Appeals (covering New York, Connecticut, and Vermont) was widely thought to be one of the most favorable jurisdictions to debtors on the issue of the propriety of third-party releases in a chapter 11 plan.

On February 15, 2008, however, the Second Circuit struck down a third-party release in the long-running Johns-Manville Corporation chapter 11 case, In re Johns-Manville Corp., 517 F.3d 52 (2d Cir. 2008), and in so doing potentially signaled a shift in that Circuit’s position on the issue. Not long after, on March 12, 2008, the Seventh Circuit Court of Appeals (covering Illinois, Wisconsin, and Indiana) issued its own opinion on third-party releases in the case of In re Airadigm Communications, Inc., 2008 WL 649704 (7th Cir. Mar. 12, 2008). In approving the third-party release in that case, the Seventh Circuit now may be viewed as a relatively favorable jurisdiction for debtors on the issue. As such, the Circuit split on third-party releases continues.

Third-Party Releases Under a Chapter 11 Plan

In general, a chapter 11 plan may contain two different types of releases—an estate release and a third-party release. An estate release is a release by the debtor of claims that the debtor itself possesses. By contrast, a third-party release prevents a nondebtor (especially creditors) from prosecuting claims against another nondebtor. There are two types of third-party releases—voluntary and involuntary. Voluntary third-party releases are those to which a creditor has consented, for instance by agreeing to the release on its plan ballot. Most courts do not find voluntary third-party releases controversial, since they essentially represent an agreement between the creditor and the released nondebtor party.

By contrast, involuntary third-party releases compel a creditor or nondebtor to release another nondebtor without consent. These releases always have been controversial. In fact, the Ninth and Tenth Circuits essentially have found such releases to be prohibited by the Bankruptcy Code. See In re Lowenschuss, 67 F.3d 1394 (9th Cir. 1995); In re Western Real Estate Fund Inc., 922 F.2d 592, 600 (10th Cir. 1990). Similarly, the Fifth Circuit has held that a bankruptcy court lacks jurisdiction to grant an involuntary third-party release where the third-party claim is not sufficiently related to the bankruptcy. See In re Zale Corp., 62 F.3d 746 (5th Cir. 1995). The Fourth and Sixth Circuits, by contrast, have permitted third-party releases in certain mass-tort cases, but only where the nondebtor that is released makes a substantial contribution to the plan. See In re A.H. Robins, 972 F.2d 77 (4th Cir. 1992); In re Dow Corning Corp., 280 F.3d 648 (6th Cir. 2002). Previously, the Second Circuit also had permitted third-party releases (including in prior proceedings in the Manville case itself) where the court found that the release was important to the chapter 11 plan and where the parties covered by the release were necessary to the plan. See In re Drexel Burnham Lambert Group, Inc., 960 F.2d 285 (2d Cir. 1992); MacArthur Co. v. Johns-Manville Corp., 837 F.2d 89 (2d Cir. 1988). Prior to the Airadigm case, the Seventh Circuit had never ruled on the issue. Instead, it ruled in In re Specialty Equipment Co., 3 F.3d 1043 (7th Cir. 1993), that consensual third-party releases were permissible, although the language of its opinion potentially suggested a negative view of involuntary third-party releases.

The Second Circuit’s Opinion in Johns-Manville

The recent Second Circuit Manville case arose out of an attempt by various of Manville’s asbestos personal-injury claimants to bring conspiracy and breach-of-duty claims against Travelers Insurance Company. Travelers was Manville’s primary insurer from 1947 to 1976 and became a focal point of the Manville bankruptcy case once Manville filed for chapter 11 in 1982 as a result of spiraling asbestos personal-injury lawsuits against the company. A primary asset of the Manville bankruptcy available to pay asbestos creditors was the insurance coverage that Travelers had provided to Manville over the years. As is the case with insurers in essentially all asbestos-related bankruptcies, Travelers was unwilling to reach an agreement with Manville concerning the extent to which that insurance would be contributed to the bankruptcy estate without “global finality” with Manville and its asbestos creditors. Otherwise, Travelers might find itself contributing millions of dollars of insurance coverage to the Manville plan of reorganization, only to be later sued by Manville’s asbestos creditors directly for millions more.

As such, the order confirming Manville’s 1986 plan of reorganization, in exchange for Travelers’ contribution of nearly $80 million to the trust being funded under the plan, contained an injunction (the “1986 Plan Injunction”) that prohibited Manville’s asbestos creditors from ever suing Travelers on account of claims that were “based upon, arose out of, or related to” Manville’s insurance. Those claims instead were channeled to the asbestos trust created by the plan. The injunction was broadly worded in order to provide Travelers with the “global finality” it sought in connection with Manville.

Notwithstanding the 1986 Plan Injunction, various asbestos claimants later filed suit against Travelers in several states, alleging that Travelers was involved in a conspiracy with Manville in violation of state law to suppress the hazards of asbestos or that Travelers violated certain duties to disclose asbestos-related information it learned from Manville during its tenure as Manville’s insurer (the “Misconduct Claims”). The plaintiffs in these cases asserted that their claims involved independent misconduct by Travelers not prohibited by the 1986 Plan Injunction. Originally, Travelers moved the New York bankruptcy court that had issued the 1986 Plan Injunction to enjoin the Misconduct Claims as a result of the injunction. Ultimately, however, Travelers determined to settle certain classes of the Misconduct Claims in the bankruptcy court for the payment of nearly $500 million, but only on the condition that the bankruptcy court issue a new order finding that the 1986 Plan Injunction always had barred the Misconduct Claims. The bankruptcy court approved the settlements and had little difficulty finding that the 1986 Plan Injunction was broad enough to cover the Misconduct Claims.

The plaintiffs appealed the bankruptcy court’s decision. On appeal, the district court reached the same result and labeled the suits “creatively pleaded attempts to collect indirectly against the Manville insurance policies.” Both courts relied, in part, on the Second Circuit’s 1988 opinion in MacArthur upholding the validity of the 1986 Plan Injunction in connection with an attempt by a distributor of Manville (who had been sued for asbestos liability) to seek indemnity against Travelers under certain vendor endorsements in insurance policies that Travelers had issued to Manville.

Notwithstanding its prior decision in MacArthur, the Second Circuit reversed the lower courts and found that the bankruptcy court lacked jurisdiction to enjoin the Misconduct Claims. The court found that the Misconduct Claims differed significantly from the vendor endorsement claims in MacArthur. The court believed that the Misconduct Claims sought damages unrelated to the Travelers insurance and that these were based not on Manville’s alleged misconduct, but on Travelers’ own. Ultimately, the court held that “a bankruptcy court only has jurisdiction to enjoin third-party, non-debtor claims that directly affect the res of the bankruptcy estate” and that the Misconduct Claims did not directly affect the res at issue—i.e., the insurance policies that Travelers had issued to Manville.

While the Second Circuit may not have believed that it was effectuating a material change or clarification in the law on involuntary third-party releases, the Manville opinion certainly could be interpreted as having done so. Prior to the Manville decision, the Second Circuit had not issued an opinion on involuntary third-party releases that focused on the jurisdictional issue that lay at the heart of the Second Circuit’s ruling in Manville. In Deutsche Bank AG, London Branch v. Metromedia Fiber Network, Inc., 416 F.3d 136 (2d Cir. 2005), the Second Circuit did express concerns about the third-party involuntary release under the plan in that case, which was given for the benefit of the debtor’s insiders, and the court ultimately found only that the challenge to that release was equitably moot on appeal. Nonetheless, there is no discussion in Metromedia of possible jurisdictional limitations on the release based on an impact on estate property. Similarly, in Drexel the Second Circuit did not require any impact on estate property in order to issue the involuntary third-party releases for the benefit of the debtor’s directors and officers in that bankruptcy case (although the ruling was in the context of approval of a plan-related mandatory, non-opt-out class action rather than the plan itself).

The Manville ruling may be difficult for courts to apply in connection with third-party releases that may be proposed under future chapter 11 plans in that Circuit. As an initial matter, the decision should not affect voluntary third-party releases, which have generally not been controversial and which were not involved in Manville. What constitutes a sufficient impact on “the res of the bankruptcy estate” necessary to confer bankruptcy-court jurisdiction to approve an involuntary third-party release, however, likely will engender much debate. For instance, chapter 11 plans sometimes propose a third-party release of a debtor’s officers, directors, and affiliates by the debtor’s creditors. Any creditor that affirmatively accepts, or does not object to, such a release likely will be bound, notwithstanding the Manville decision. But as to any creditor that does object to the third-party release, Manville, unless limited to its facts, potentially suggests that the debtor will need to establish some impact on the “res of the bankruptcy estate” that will form the jurisdictional basis for the proposed release. In many cases, the objecting creditor likely will assert that there is no such impact and that therefore the bankruptcy court lacks jurisdiction to approve the release.

To the extent that courts accept this position, the result will have clear implications for certain types of chapter 11 cases. For instance, bankrupt professional-service firm partnerships often have funded their chapter 11 plans with contributions from current and former partners, which (like Travelers in the Manville case) will make such contributions only if they receive a release in their favor that is binding on all of the partnership’s creditors. If partnerships no longer can grant such third-party releases under their chapter 11 plans because no impact on the res of the debtor can be shown, then it may be difficult for such partnerships to marshal assets under their plans to repay creditors in a coordinated fashion. In addition, the res-based rule could cause difficulties for debtors wishing to release under a chapter 11 plan their officers and directors from actions that are in some sense “derivative” of the creditors’ claims against the debtor itself but do not have a clear impact on the bankruptcy estate. The Second Circuit, as well as other Circuits, previously has found that a bankruptcy court does have jurisdiction to approve a plan of reorganization that causes the involuntary release of such derivative claims, especially where such releases are essential to confirmation of the plan.

The Seventh Circuit’s Opinion in Airadigm

Airadigm involved an appeal of entry of a confirmation order in the second chapter 11 case of a cellular service provider that had bid for C-block licenses from the Federal Communications Commission (“FCC”) in the mid-1990s. Like several other C-block licensees that had financed their purchases from the FCC with debt, Airadigm filed for chapter 11 in the late 1990s, when the value of those licenses had dropped precipitously. At that time, the FCC took the position that the licenses were forfeited as a result of Airadigm’s failure to pay for the licenses in full, and Airadigm’s first chapter 11 case proceeded as if the licenses were no longer an asset of the company. In 2003, however, the Supreme Court concluded in NextWave Personal Communications, Inc. v. FCC, 537 U.S. 293 (2003), that the FCC could not cancel a C-block license simply because the licensee had filed for bankruptcy prior to payment for the license.

Accordingly, Airadigm subsequently refiled for chapter 11 in 2006 to, among other things, account for the Supreme Court’s decision. Airadigm’s chapter 11 plan was dependent upon financing provided to Airadigm by Telephone and Data Systems (“TDS”). The plan, in consideration for the financing, provided TDS with a third-party release for post-petition actions related to the debtor’s second bankruptcy filing. The plan stated:

Except as expressly provided ... [TDS shall not] have or incur any liability to ... any holder of any Claim ... for any act or omission
arising out of or in connection with the Case, the confirmation of this Plan, the consummation of this Plan, or the administration of
this Plan or property to be distributed under this Plan, except for willful misconduct.

The FCC argued that such an involuntary third-party release was not authorized by the Bankruptcy Code. The Seventh Circuit disagreed, holding that a bankruptcy court may grant an involuntary third-party release under appropriate circumstances.

The Seventh Circuit made no mention of the need for any res of the bankruptcy estate to be involved in order for a bankruptcy court to grant such a release. Instead, the Seventh Circuit found the power of a bankruptcy court to issue such a release to be inherent in its broad equity power, as well as authorized by sections 105(a) and 1123(b)(6) of the Bankruptcy Code. The former section authorizes a bankruptcy court to issue orders “necessary or appropriate” to carry out the Bankruptcy Code, and the latter section provides that a plan may include any provision “not inconsistent with” the Bankruptcy Code. Since TDS was providing significant financing to the plan, and since TDS’s release was limited in several respects, the Seventh Circuit found that the release was appropriate. In so doing, the court appears to have given bankruptcy courts in the Seventh Circuit wide discretion to grant involuntary third-party releases where appropriate and without a res-based limitation, thereby potentially establishing that Circuit as a relatively favorable jurisdiction to debtors on the issue.

Conclusion

Travelers has sought reconsideration of Manville by the Second Circuit en banc, so there could be further developments in that case or modifications of the decision of the Second Circuit. Given the new focus on jurisdiction in the Manville decision that does not appear in Airadigm, as well as the split in other Circuits on the issue of involuntary third-party releases, it is certainly possible that a certiorari petition to the U.S. Supreme Court could be filed in either case and that the Supreme Court might ultimately decide to address this important jurisdictional question in chapter 11 cases. Only time will tell.
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