For some time, there has been a split among the circuit courts as to whether the Bankruptcy Code permits non-consensual releases of non-debtor entities under a plan of reorganization.

While a minority of circuits, such as the Ninth Circuit (see, e.g., In re Lowenschuss, 67 F.3d 1394 (9th Cir. 1995), have reasoned that bankruptcy courts lack the authority to approve non-debtor releases based on the language of section 524(e) of the Code (which specifies that the “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”), a majority of circuits recognize that courts can, in limited circumstances, approve non-consensual non-debtor releases using the broad equitable powers granted to bankruptcy judges in section 105 of the Code.  The Fourth Circuit is in the majority, and its recent decision in National Heritage Foundation, Inc. v. Highbourne Foundation, 2014 U.S. App. LEXIS 12144 (June 27, 2014), underscores the strict scrutiny that non-debtor releases face and the high evidentiary burden that must be met before they can be approved.

In National Heritage, the debtor, a non-profit, submitted a plan of reorganization that sought approval of broad releases of both prepetition and postpetition claims against, among others, the debtor’s officers, directors and employees. The release was challenged by a number of the debtor’s disgruntled donors, who believed claims might exist against these parties and were receiving nothing from the estate in exchange for the release.  In considering whether the proposed release passed muster, the Fourth Circuit noted that non-debtor releases “should only be approved cautiously and infrequently” based on an assessment of the following six factors:

• whether the proposed released parties made a substantial contribution to the debtor’s reorganization;
• whether the released parties are owed an indemnity obligation by the debtor such that they share an identity of interest with the debtor;
• whether a release is essential to the debtor’s reorganization;
• whether the class or classes affected by the proposed release overwhelmingly voted in favor of the plan;
• whether the debtor’s plan provides a mechanism, such as a dedicated settlement fund, to consider and pay substantially all of the class or classes affected by the non-release; and
• whether the debtor’s plan provides any mechanism to pay the class or classes affected by the non-debtor release outside of the bankruptcy.

The debtor submitted evidence in support of only one of these factors, demonstrating that the non-debtor released parties possessed indemnity claims against the debtor that, in essence, turned claims against the directors and officers into claims against the debtor itself.  No other evidence in support of the proposed releases was provided, and none of the other factors were satisfied. The Fourth Circuit deemed this record to be insufficient and struck down the release, noting that while a debtor is not required to establish that every relevant factor weighs in favor of approving a non-debtor release, it still must provide an “adequate factual basis to show that the circumstances warrant such exceptional relief.”  The court found that the thin evidentiary record established by the debtor did not support a finding that the proposed third party releases were appropriate.

As this ruling makes clear, courts continue to closely scrutinize all third-party releases in a plan, and debtors must present substantial evidence to support this extraordinary relief to overcome opposition from creditors. As hinted in National Heritage, however, the standard is not impossible to overcome. For example, a recent bankruptcy decision applying a standard similar to that utilized by the Fourth Circuit approved certain non-debtor releases in a plan of reorganization (though disapproving of others) where evidence established that (i) the parties being released had made critical financial contributions to the debtor which were necessary to the debtor’s reorganization and would not have been provided in the absence of the releases, (ii) the non-consenting creditors at issue were given reasonable consideration in exchange for the releases under the proposed plan, and (iii) there was an indemnity obligation supporting a finding of a shared identity of interest. In re 710 Long Ridge Road Operating Co., 2014 WL 886433 (Bankr. D.N.J. Mar. 5, 2014).  Indeed, courts are far more likely to approve non-debtor releases if the plan provides a mechanism for affected creditors to receive some value in exchange for the released claims so that the proposed release does not entirely extinguish creditors’ ability to collect from the released third parties.  In the absence of a settlement fund for affected creditors and/or a compelling justification (supported by evidence) as to why third party releases are necessary to the debtor’s reorganization, non-consensual non-debtor releases are likely to be rejected.