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Washington District Court Overturns Approval of Third-Party Releases in a Settlement Agreement and Related Free-and-Clear Sale

For nearly 25 years, courts in the Ninth Circuit have consistently refused to sanction nonconsensual third-party releases as part of chapter 11 plans. A ruling recently handed down by the U.S. District Court for the District of Washington reaffirms and extends that proposition. In In re Fraser’s Boiler Serv., Inc., 2019 WL 1099713 (D. Wash. Mar. 18, 2019), the court reversed a bankruptcy court order approving settlement agreements providing for the sale of certain of the debtor’s asbestos insurance policies back to the settling insurers free and clear of the claims of nonsettling insurers. The district court made the ruling on the basis that the settlement agreements’ third-party releases and injunctions were not permissible under Ninth Circuit case law.

Validity of Nonconsensual Third-Party Releases in Chapter 11 Plans

The circuit courts of appeals 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 they are prohibited by 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." 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 the circuits that have considered the issue—the Second, Fourth, Sixth, Seventh, and Eleventh Circuits—have found such releases and injunctions permissible under certain circumstances. See In re Drexel Burnham Lambert Grp., Inc., 960 F.2d 285 (2d Cir. 1992); 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 Commc’ns, Inc., 519 F.3d 640 (7th Cir. 2008); SE Prop. Holdings, LLC v. Seaside Eng’g & Surveying, Inc. (In re Seaside Eng’g & Surveying, Inc.), 780 F.3d 1070 (11th Cir. 2015). 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 releases.

The First and D.C. Circuits have suggested that they agree with the "pro-release" majority. See In re Monarch Life Ins. Co., 65 F.3d 973 (1st Cir. 1995) (a debtor’s subsidiary was collaterally estopped by a plan confirmation order from belatedly challenging the jurisdiction of the bankruptcy court to permanently enjoin lawsuits against the debtor’s attorneys and other nondebtors not contributing to the debtor’s reorganization); In re AOV Indus., 792 F.2d 1140 (D.C. Cir. 1986) (a plan provision releasing liabilities of nondebtors was unfair because the plan did not provide additional compensation to a creditor whose claim against the nondebtor was being released; adequate consideration must be provided to a creditor forced to release claims against nondebtors). The Third Circuit declined to decide the issue in In re Continental Airlines, 203 F.3d 203 (3d Cir. 2000), ruling that a plan release provision did not pass muster under even the most flexible tests for the validity of nondebtor releases.

Majority-view courts employ various tests to determine whether such releases are appropriate. Factors generally considered by courts evaluating third-party plan releases or injunctions include whether they are essential to the reorganization, whether the parties being released have made or are making a substantial financial contribution to the reorganization, and whether affected creditors overwhelmingly support the plan. See Dow Corning Corp., 280 F.3d at 658 (listing factors).

Special Rules in Asbestos Cases

 Section 524(g) of the Bankruptcy Code establishes a procedure for dealing with future personal-injury asbestos claims against a chapter 11 debtor. The provision contemplates the creation of a trust to pay future claims and the issuance of an injunction—sometimes referred to as a "channeling injunction"—to prevent future claimants from suing the debtor and certain related parties. All claims based upon asbestos-related injuries are channeled to the trust.

Section 524(g) creates an exception to the general rule in section 524(e) that the liability of other parties is not affected by a debtor’s discharge. In particular, a section 524(g) injunction may preclude actions against third parties having certain connections with the debtor, including financial interests in the debtor or its affiliates, involvement in the debtor’s management, or involvement in a transaction affecting the corporate structure or financial condition of the debtor or its affiliates. See 11 U.S.C. § 524(g)(4)(A)(ii) ("such an injunction may bar any action directed against a third party who is identifiable from the terms of the injunction (by name or as part of an identifiable group) and is alleged to be directly or indirectly liable" for the claims against the debtor by reason of specified relationships).

Because section 524(g) trusts typically are funded at least in part by the proceeds of insurance policies that the debtors have in effect to cover asbestos or other personal-injury claims, third parties protected by channeling injunctions commonly include the debtors’ insurers. See 11 U.S.C. § 524(g)(4)(A)(ii)(III). Protecting insurers and other third parties against actions alleging derivative liability "provides[s] them with an incentive … to contribute to the trust." In re Quigley Co., Inc., 676 F.3d 45, 59 (2d Cir. 2012).

It is generally recognized, however, that section 524(g) is available only if the debtor has an ongoing business or some other means to fund "evergreen" distributions under an asbestos trust. See In re Combustion Eng’g, Inc., 391 F.3d 190, 248 (3d Cir. 2005); In re Flintkote Co., 486 B.R. 99, 130 (Bankr. D. Del. 2012), aff’d, 526 B.R. 515 (D. Del. 2014); In re Quigley Co., 437 B.R. 102, 141 (Bankr. S.D.N.Y. 2010).

Free-and-Clear Sales

Section 363(f) of the Bankruptcy Code authorizes a trustee or chapter 11 debtor-in-possession ("DIP") to sell property "free and clear of any interest in such property of an entity other than the estate" under any one of five specified conditions. These include, among other things, if applicable non-bankruptcy law permits such a free-and-clear sale, if the sale price exceeds the aggregate value of all liens encumbering the property, or if the interest is in bona fide dispute.

Section 363(e) of the Bankruptcy Code provides that, upon the request of an entity that has an "interest" in property proposed to be sold by the trustee or DIP, the court "shall prohibit or condition" the sale "as is necessary to provide adequate protection of such interest." Section 361 in turn provides that "adequate protection may be provided" by periodic cash payments to protect against any decrease in value of the interest; an additional or replacement lien (if the interest is a lien); or other relief, such as an administrative expense claim, "as will result in the realization by such entity of the indubitable equivalent of such entity’s interest in such property."

"Any Interest" Broadly Construed

Section 363(f) has been applied to a wide range of interests. See generally Collier on Bankruptcy ¶ 363.06 (16th ed. 2018). Courts, however, have sometimes struggled to identify the outer limits of the term "interest," which is not defined in the Bankruptcy Code or its accompanying legislative history. Most courts reject the narrow approach under which the reach of section 363(f) is limited to in rem property interests or only those claims that have already been asserted at the time the property is sold. Instead, the majority have construed the term broadly to encompass other obligations that may flow from ownership of property, including, for example, successor liability claims (see, e.g., Ind. State Police Pension Trust v. Chrysler LLC (In re Chrysler LLC), 576 F.3d 108 (2d Cir. 2009), cert. granted and judgment vacated on other grounds, 558 U.S. 1087 (2009); In re Trans World Airlines, Inc., 322 F.3d 283 (3d Cir. 2003)) or even leasehold interests. See, e.g., Pinnacle Rest. at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holding II, LLC), 872 F.3d 892 (9th Cir. 2017) (notwithstanding the tenant protections set forth in section 365(h)(1), real property can be sold free and clear of a leasehold interest under section 363(f)).

Fraser’s Boiler Service

Fraser’s Boiler Service, Inc. ("FBS") manufactured and installed industrial boilers. FBS ceased operating in 2014 and sold all of its business assets.

FBS’s boilers contained asbestos. In January 2018, FBS and certain of its insurance companies entered into settlement agreements (the "Settlement Agreements") under which, in exchange for approximately $12 million, the settling insurers would be released from all future liability for asbestos claims against FBS, and actions against the settling insurers would be enjoined. In April 2018, FBS filed for chapter 11 protection in the Western District of Washington to seek approval of the Settlement Agreements, including the releases and the sale of the insurance policies—the company’s only remaining assets—back to the settling insurers under section 363(f). The proceeds of the sale were to be contributed to a trust under FBS’s proposed liquidating chapter 11 plan. However, because FBS was no longer operating, it did not seek approval of the trust mechanism under section 524(g).

Prior to the bankruptcy filing, FBS’s insurers had entered into a cost-sharing agreement (the "CSA") that contained various remedies in the event of a signatory insurer’s default, including breach of contract and equitable contribution claims (the "CSA Claims"). FBS was not a signatory to the CSA.

The nonsettling insurers objected to FBS’s motion seeking bankruptcy court approval of the Settlement Agreements and the sale of the insurance policies free and clear of the CSA Claims. They argued, among other things, that: (i) under Ninth Circuit precedent, the bankruptcy court could not enjoin third-party claims under section 105(a) when the requirements of section 524(g) are not satisfied; and (ii) the sale could not be approved under section 363(f) because the CSA Claims were not an "interest" in FBS’s property.

The bankruptcy court approved the Settlement Agreements as being reasonable under the standard applied to settlements in accordance with Rule 9019 of the Federal Rules of Bankruptcy Procedure. The court also enjoined the CSA Claims and released the settling insurers. Concluding that the CSA claims were "derivative" of the repurchased insurance policies, the bankruptcy court issued a permanent injunction pursuant to section 105(a). In doing so, the court relied upon In re A.H. Robins Co., Inc., 880 F.2d 694 (4th Cir. 1989) (section 524(e) did not prohibit injunctions against third-party claims where a discharge is essential to an "overwhelmingly approved" plan of reorganization), and MacArthur v. Johns-Manville Corp., 837 F.2d 89 (2d Cir. 1988) (because an insured vendor’s rights under product liability insurance policies were "completely derivative" of the debtor’s rights as the primary insured, the bankruptcy court had jurisdiction over the insurance policies as well as the authority to approve settlements with the insurers and to channel claims arising under the policies to the proceeds of the settlement). The bankruptcy court also relied upon the Ninth Circuit’s ruling in In re American Hardwoods, Inc., 885 F.2d 621 (9th Cir. 1989), where the court suggested in dicta that third-party claim injunctions might be permitted in a case with "unusual facts," such as A.H. Robins.

The bankruptcy court distinguished between enjoining the CSA Claims, on the one hand, and global third-party releases prohibited in the Ninth Circuit, on the other. According to the bankruptcy court, "[T]he crux of the difference is that, unlike releases of all claims against a third party, the supplemental injunction is narrowly tailored to only apply to derivative claims." The court reasoned that the CSA Claims are "derived from the insurance policies being sold back to the [Settling] Insurers free and clear pursuant to the Settlement Agreement[s]" and are therefore "inseparable from the debtor’s own insurance policies." The court concluded that, because the injunction affects only derivative claims, it is "not the equivalent of a discharge of a third party." The court also noted that the "injunction does not provide for retention of the asset by the debtor or a purchasing third party, but rather the payment of the cash value of those assets into a liquidating trust that is essential to [FBS’s chapter 11 plan]."

The bankruptcy court also approved the sale of the insurance policies free and clear of the CSA Claims. The court determined that the sale satisfied: (i) section 363(f)(1) because it was permissible under Washington state law; (ii) section 363(f)(2) because "holders of asbestos claims have given the equivalent of their consent by submitting ballots" in favor of a plan of liquidation solicited prior to the petition date and by the support of the official creditors’ committee for the motion seeking approval of the Settlement Agreements; and (iii) section 363(f)(5) because "asbestos-related tort claimants could be compelled to accept a money satisfaction of their interests in the policies in a legal or equitable proceeding."

Finally, the court ruled that the nonsettling insurers’ interests were adequately protected, as required by section 363(e). According to the court, "Combined with the benefits received from avoiding the risks of policy exhaustion as well as the costs and risks associated with processing certain claims, the Court finds that the non-settling insurers’ interests are adequately protected."

The nonsettling insurers appealed the order.

The District Court’s Ruling 

No Third-Party Releases or Injunctions

The district court reversed. Initially, the court noted, "any door left open" by American Hardwoods to the validity of third-party injunctions issued in connection with a chapter 11 plan in the Ninth Circuit "was definitively slammed shut" by Lowenschuss. In Lowenschuss, the district court explained, the Ninth Circuit held, "without exception, that § 524(e) precludes bankruptcy courts from discharging the liabilities of non-debtors." The Ninth Circuit also emphasized that American Hardwoods "expressly declined to adopt the approach set forth in A.H. Robins." Finally, according to the district court, the Ninth Circuit reasoned that its position in Lowenschuss was buttressed by the then recently created section 524(g), which was the single "narrow exception" to the general prohibition on discharging third-party claims—a position it reaffirmed in Deocampo v. Potts, 836 F.3d 1134, 1143 (9th Cir. 2016).

These rulings, the district court wrote in Fraser’s Boiler Service, amount to "a rejection of all exceptions to § 524(e)’s prohibition of enjoining third party claims … [including] the ‘derivative’ claims exception from [Manville] that the Bankruptcy Court relied on." Moreover, the district court noted that "the Ninth Circuit’s interpretation of § 524(e) prohibits not just ‘global third-party releases’ but all third-party releases." According to the district court, more recent bankruptcy court rulings from within the Ninth Circuit are not persuasive or distinguishable and do not "run afoul of the broad rule established in American Hardwoods and Lowenschuss" (discussing In re Yellowstone Mountain Club, LLC, 460 B.R. 254 (Bankr. D. Mont. 2011), and In re Pac. Gas & Electric Co., 304 B.R. 395 (Bankr. N.D. Cal. 2004)). Therefore, the district court ruled that the bankruptcy court could have properly exercised its section 105(a) powers to enjoin the nonsettling insurers only if the requirements of section 524(g) had been satisfied.

No Sale Free and Clear of Third-Party Claims

The district court also held that the bankruptcy court erred in authorizing the sale of the insurance policies under section 363(f). Explaining that the application of section 363(f) is "murk[y]" in cases involving claims between third parties, the district court concluded that: (i) the CSA Claims did not "fit within any existing definition or application of the term ‘interest’"; and (ii) allowing a sale free and clear of claims between third parties "would be inconsistent with existing Ninth Circuit precedent regarding bankruptcy courts’ power over third-party claims."

According to the district court, relevant case law indicates that a third-party claim can be an "interest" for purposes of section 363(f) in one of two ways: (i) the claim is "truly ‘derivative’" because the third party is asserting the debtor’s rights as a way of collecting against an insured; or (ii) the claim seeks compensation directly from policy proceeds owned by the debtor. The court found that neither situation existed in this case.

The court explained that the CSA was a separate contract that could not be equated with FBS’s rights under the insurance policies and that the CSA Claims belonged to each insurer individually rather than being "equivalent to standing in the shoes of the insured." The court further noted that the CSA Claims would be paid from the settling insurers’ general assets and "would only indirectly erode the limits of the Repurchased Policies."

Returning to American Hardwoods and Lowenschuss, the district court also explained that those decisions "rejected lenient approaches to bankruptcy courts’ authority to interfere with third-party claims" and were thus instructive with respect to application of section 363(f), even though they did not discuss that provision. Accepting that ordering a sale free and clear of third-party claims is not identical to enjoining such claims, the court wrote, "FBS has not explained how any differences between them excuse the inconsistency of allowing only one." Because Ninth Circuit precedent, "viewed holistically," sanctions releasing or enjoining third-party claims only in the context of section 524(g), the district court ruled that the bankruptcy court erred in approving the sale.

Finally, the district court ruled that, even if the CSA Claims were an "interest" within the meaning of section 363(f), the free-and-clear sale was not permitted under Washington law, as required by section 363(f)(1). Under Washington law, the court explained, although courts have the equitable power to enter an order precluding contribution claims by nonsettling parties, exercising that power is appropriate only if a proposed settlement is reasonable and the interests of the nonsettling defendants are protected. In this case, the district court determined, even if the Settlement Agreements were reasonable, they did not adequately protect the interests of the nonsettling insurers because the judgment reduction clause in the agreements provided "almost no protection" to nonsettling insurers to offset costs incurred in successfully litigating or settling asbestos claims.

The district court did not address the bankruptcy court’s findings that the sale also satisfied sections 363(f)(2) and 363(f)(5).

Outlook

Fraser’s Boiler Service reaffirms the Ninth Circuit’s prohibition of nonconsensual third-party releases and injunctions but extends the rationale beyond its more customary application to chapter 11 plans to encompass bankruptcy sales. The court’s message is clear: Other than the "narrow exception" carved out by section 524(g) in asbestos cases, nonconsensual third-party releases in whatever form are not permitted. The district court’s conclusion regarding the meaning of the term "interest" in section 363(f) is also noteworthy because it suggests that claims between third parties would rarely qualify for that designation.

The settling insurers appealed the district court’s ruling to the Ninth Circuit on April 18, 2019.

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