Can Non-Debtors Be Discharged Through a Debtor’s Bankruptcy Reorganization Plan?

by Andrew K. Alper November/December 2009
This article arises because of a very recent case entitled The Pacific Lumber Co, 2009 West Law 3082766; 2009 U.S. App. LEXIS 21749 filed in the Fifth Circuit. Among many other issues, it revisits the issue as to whether a plan of reorganization can release non-debtors from liability. Before getting to this case, a discussion of the law regarding non-debtor releases is appropriate.

Section 11 U.S.C. §105(a) of the U.S. Bankruptcy Code has been used by debtors over the years for a variety of purposes to accomplish a debtor’s goal during a bankruptcy case. This section states in relevant part: “The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.” In this regard, bankruptcy courts have, from time to time, enjoined actions against non-debtors when necessary or appropriate to enforce or implement court orders. Courts have also used this section of the Bankruptcy Code to discharge non-debtors.

On the other hand, 11 U.S.C. §524(e) of the Bankruptcy Code makes it clear that the bankruptcy discharge of a debtor, by itself, does not operate to relieve non-debtors of their liabilities. A discharge in bankruptcy operates to make a debt unenforceable as a personal liability of the debtor through the voiding of judgments and debts and the injunction against acts to collect the debt. The Bankruptcy Code does not explicitly authorize the release and permanent injunction of claims against non-debtors, except in asbestos cases pursuant to 11 U.S.C. §524(g). Subsection (e) of §524 makes it clear that except for certain debts in community property states, a discharge in no way affects the liability of any other person or entity or property of any other entity. Therefore, the use of §105(a) of the Bankruptcy Code should not be used to do something that the Bankruptcy Code does not allow, has a limited scope, and does not create substantive rights that would otherwise be unavailable under the Bankruptcy Code.

Despite the foregoing, some courts have disagreed over whether §524(a) may be overridden by a provision of a confirmed plan of reorganization under Chapter 11 or under any of the other rehabilitation chapters. However, the great weight of cases throughout the country hold that a plan cannot discharge a debt or enjoin a third party.

See for example In re Lowenshuss, 67 F.3d 139, 1401 (9th Cir. 1995); Underhill v. Royal Oak, 769 F.2d 1426 (9th Cir. 1985); In re Continental Airlines, 203 F.3d 203, 212-214 (3rd Cir. 2000); American Hardwoods Inc. v. Deutsche Credit Corp., 885 F.2d 621, 626 (9th Cir. 1989); In re Western Real Estate Fund Inc., 922 F.2d 592, 601 (10th Cir. 1990); In re Gray Davis Broadcasting, Inc., 176 B.R. 290, 292 (N.D. Ga. 1994); In re A.J. MacKay Co., 50 B.R. 756, 764 (D. Utah 1985); In re Future Energy Corp., 83 B.R. 470, 486 (Bankr. S.D. Ohio 1988); In re L.B.G. Properties, Inc., 72 B.R. 65, 66 (Bankr. S.D. Fla. 1987); In re Barnett Paper Corp., 68 B.R. 518, 520 (Bankr. E.D. Mo. 1986); In re Keller, 157 B.R. 680, 686 (Bankr. E.D. Wash. 1993); In re Digital Impact, Inc., 223 B.R. 1, 14 (Bankr. N.D. Okla. 1998).

There has been a more permissive view in the Second and Fourth Circuit in which the discharge of non-debtors arose out of unusual circumstances in major cases. See In re Drexel Bernham Lambert Group, Inc., 960 F.2d 285, 293 (2nd Cir. 1992) and In re A.H. Robins Co., 880 F.2d 694, 702 (4th Cir. 1989) where there were global settlements of massive liabilities against the debtor and co-liable parties or involving mass tort claims and the court as part of the settlement allowed for non-debtor releases and injunctions. However, these cases should be the exception, not the rule.

With the foregoing as background, we now turn to the recently decided Pacific Lumber case. In Pacific Lumber, a plan of reorganization was confirmed that contained a release of various non-debtors other than for their conduct arising out of their willful misconduct or gross negligence related to proposing, implementing and administering the plan. Among the provisions of the plan that were on appeal was a non-debtor exculpation and release clause. Although there was an appeal with respect to many aspects of the confirmation of the plan, there was no stay of the plan and therefore plan proponents and current owners of the reorganized debtors and/or property of the reorganized debtors requested that the appellate court dismiss the appeal as being “equitably moot” due to intervening actions. This is because after the plan was confirmed, the debts and property were transferred to the debtor’s successors and plan distributions were made.

In addition, during the 60 days following the confirmation order, certain of the debtors were dissolved; the new entities raised $325 million in exit financing secured by assets transferred to them; there was new management, a change in management structure, business consultants, new office space, a new distribution center were completed; and the new reorganized debtor had successfully navigated the regulatory labyrinth and secured unanimous approval to operate with state and federal agencies. Therefore, it was argued that even if the plan should not have been confirmed, the bell could not be unrung and, if the appeal was granted, it would cause major calamity.

Although the court agreed that the equitable mootness doctrine was appropriate to bar the appeal as to most of the provisions up on appeal, it did not agree that equitable mootness should bar the appeal as to the non-debtor exculpation and release clause. This is because the court did not believe that the non-debtor release and exculpation clause was part of the benefit of their bargain. More importantly, from a substantive view, the court did not allow the non-debtor release clause because it violated §524(e), which only allows the release of the debtor, and not co-liable third parties in the Fifth Circuit. See e.g., Coho Resources, Inc., 345 F.3d 338, 342 (5th Cir. 2003); Zale Corporation v. Feld, 62 F.3d 746 (5th Cir. 1995). Therefore, except for the Unsecured Creditors Committee, the court would not allow third-party non-debtor releases and despite the confirmation of the plan and the equitable mootness doctrine.

In many cases where a debtor files bankruptcy and its principals are guarantors and the creditor is still proceeding against the non-debtor guarantors, it is not unusual for the debtor’s counsel to either attempt to enjoin any state court or other action against the non-debtor guarantors or against property of non-debtors because of the alleged effect it will have on a debtor’s bankruptcy. The great weight of the law will not allow injunctions to be issued especially since there is no likelihood that a plan can be confirmed when a non-debtor release or injunction is included in the plan except in the most unusual circumstances. Although there may be business reasons why a creditor may not want to proceed against the guarantor such as the guarantor agreeing to put new value into the plan for the creditor to get paid with money or resources the creditor cannot reach, the law with respect to injunctions and releases against creditors from proceeding against non-debtors generally favors the creditor.

Andrew K. Alper is a partner with the law firm of Frandzel Robins Bloom & Csato, LC in Los Angeles. Alper has been representing equipment lessors, funding sources and other financial institutions since 1978. Alper obtained his Bachelor of Arts degree in Political Science, magna cum laude, from the University of California at Santa Barbara, and received his Juris Doctor from Loyola Marymount University School of Law making the Dean’s List. Alper’s practice emphasizes the representation of equipment lessors and funding sources in all aspects of equipment leasing including litigation, documentation, bankruptcy and transactional matters. Besides representing equipment lessors and funding sources, Alper represents banks and other financial institutions in the area of commercial litigation, insolvency, secured transactions, banking law, real estate and business litigation.

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