Highlights

• The Nondebtor Release Prohibition Act was submitted to the House for a full vote on November 3, 2021.
• The Bill seeks to end the discharge of liabilities for non-debtors in bankruptcy and stop the use of “divisive mergers” as a means of assigning away massive liabilities. 
• If passed, the bill would outlaw plans containing non-consensual third-party release of non-debtors and limit companies from utilizing bankruptcy in concert with the assignment of mass liabilities to newly formed subsidiaries.

Introduction

Last week, the House Judiciary Committee voted to send the Nondebtor Release Prohibition Act of 2021 to the floor of the house for vote. If passed, the bill would introduce two major amendments to the Bankruptcy Code. As foreshadowed by its title, the bill seeks to end the ability of non-debtor parties from obtaining a release in a Chapter 11 case of their affiliated entity. The bill would also terminate the use of “divisive mergers” in Chapter 11, a corporate reorganization tool made available by Texas and Delaware that allows companies to assign liabilities to a subsidiary that can then seek the protective auspices of bankruptcy.

Third-Party Release

Third-party releases, and especially nonconsensual third-party releases in Chapter 11 plans, have been a sticking point for at least a decade. In almost every large (and even not so large) case, the debtors include some version of a third-party release provision which garners objections from affected creditors and the office of the United States Trustee. The U.S. Trustee has been consistently objecting to these provisions in cases across the country, arguing that they violate the Bankruptcy Code (and the Constitution). Nonetheless the majority of lower courts approve them as does the majority of the Circuit courts. 

The bill would introduce section 113 to Chapter 1, Title 11 of the United States Code. The new section provides three major changes to the Bankruptcy Code. First, § 113(a) would restrict a court from approving any provision in a “plan of reorganization or otherwise” that discharges or modifies the liability of a non-debtor entity. Second, § 113(b)(5) includes would produce a carve-out to subsection (a), whereby the court is reserved the power to approve the “disposition of a claim or cause of action” of a non-debtor to the extent that each non-debtor affected by a proposed release consents in writing to the release and the consent or lack thereof does not affect its treatment under the plan. 

Finally, § 113(c) limits the effect of any order or decree under Chapter 11 temporarily staying the commencement or continuation of a proceeding against a non-debtor to 90 days except on the affected creditors’ consent.

Texas Two Step

In the last year or so, several companies created newly formed subsidiaries, to absorb mass litigation liabilities and filed for bankruptcy. The internal restructuring named “Texas Two Step” gets its name thanks to the Texas divisive merger statute which permits an entity to split itself into one or more entities and assign certain assets and liabilities to one of these newly created entities. A divisive merger is similar to a traditional merger in a sense that the agreement and plan of merger must clearly identify the assets and liabilities allocated to each entity involved and no actual assignment document is required. Subsequently, the entity holding such liabilities files Chapter 11 in an effort to achieve a global resolution of the claims, including a stay of litigation and a non-consensual third-party release of all claims against, its non-debtor affiliates. 

Under the proposed amendment to 11 U.S.C. § 1112, a court should dismiss a Chapter 11 case if the debtor or its “predecessor” was subject to, “formed[,] or organized in connection with a divisional merger or equivalent transaction” which “had the intent or foreseeable effect of separating material assets from material liabilities” and “assigning or allocating all or a substantial portion of those liabilities to the debtor” during the ten year period before the date of filing the petition.

Conclusion  

While there is a lot of wood to chop before the bill or any of its provisions become law, one should take note of Congress’s awareness of developments in bankruptcy practice and the tools being utilized by the bankruptcy process to accomplish the successful reorganization of financially troubled companies. While Congress is focusing on practices some of its members view as unacceptable, Congress will be well advised to proceed with caution. Troubled companies, including those with mass tort liabilities and other claims giving rise to crushing litigation costs and seemingly endless assault on the judiciary’s time and resources, should be able to avail themselves of the flexible tools required to accomplish a successful reorganization, with the bankruptcy court serving as a gatekeeper protecting all interests at play. Congress should be careful to not throw out the baby with the bath water.  

Read the proposed bill >>