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Can a Chapter 11 Plan Release a Third Party from Liability to Creditors?

In a Chapter 11 bankruptcy, the debtor (usually a business organization) reorganizes its existing debts and repays obligations over a period of years in accordance with a court approved plan. Longstanding bankruptcy law permits the courts to discharge certain obligations as to the debtor. Some Chapter 11 debtors propose reorganization plans that release third parties from a variety of liabilities. However, the law is unclear on whether the courts have authority to do so.

Debtors sometimes ask the court to release third parties — such as company officers/directors, lenders and affiliates — from present and/or future claims. Debtors assert that they require help from these parties, who often provide working capital, revenue or expertise the debtor needs to stay in business. Another reason for release is that these parties might refuse further engagement with the debtor if there are potential liabilities.

Some legal scholars assert that courts lack authority to release third parties in bankruptcy, pointing out that there is no express mention of these releases in the bankruptcy code. Other scholars argue that judicial authority is implied within one or more sections of the code. At present, the federal courts in different circuits are split on this fundamental question. Some courts allow third-party releases while others do not.

In the Third Circuit, where releasing parties have consented to a provision in a plan of reorganization that releases claims against non-debtors, such releases will be approved on the basis of general principles of contract law. See First Fid. Bank v. McAteer, 985 F.2d 114, 118 (3d Cir. 1993) (noting that a consensual third-party release is no different from any other settlement or contract and does not implicate section 524(e)). These consensual releases can be distinguished from nonconsensual third party releases.

On December 16, 2021, Judge McMahon of the United States District Court for the Southern District of New York (District Court) issued her decision in In re: Purdue Pharma LP[1], overturning the bankruptcy judge’s confirmation of Purdue Pharma’s Chapter 11 plan. The District Court ruled that the Bankruptcy Code does not permit the granting of non-consensual releases to non-debtor third-parties outside of the asbestos context. Chapter 11 plans ordinarily provide for voluntary releases whereby creditors are given an opportunity to consent to or opt out of such releases. However, when non-consensual third-party releases are sought to support a proposed plan (as in the Purdue Pharma bankruptcy), the debtor company requests that the bankruptcy court mandate releases for third parties by all claimants regardless of whether a subset of holdout creditors wants to preserve claims against the non-debtor parties.

In the Ninth Circuit, which includes California, the U.S. Court of Appeals for the Ninth Circuit in Blixseth v. Credit Suisse, 961 F.3d 1074 (2020), held that a Chapter 11 plan may contain a “narrow exculpation clause” that releases claims against non-debtor parties for actions relating to the plan approval process. Although the opinion does not endorse broad nonconsensual third party releases that are available in certain other circuits under limited circumstances, it nevertheless opens the door to additional protections for creditors that typically take an active role in Chapter 11 cases.

Some bankruptcy experts argue that third party releases should be used only to the extent required to allow the debtor to operate, without unjustly benefiting or unfairly burdening other parties involved in the case. A third-party release can unfairly protect people who have committed or allowed misconduct that contributed to the debtor’s bankruptcy. The debtor may try to absolve company insiders (i.e. officers and directors) from fraud or breach of duty claims raised by company stockholders or creditors. A third-party release might bar an otherwise valid claim from a person harmed after the bankruptcy plan is approved. These possibilities all support a strict limitation on granting such releases.

The law on third-party releases is still evolving. The U.S. Supreme Court might address the issue by taking a relevant case or Congress might pass a law that settles the issue. Until there is some further action, the split of authority among the federal courts will continue. A skilled Chapter 11 bankruptcy attorney will take whatever action is appropriate in a given jurisdiction.

The Law Offices of Michael Jay Berger in Beverly Hills is one of the largest bankruptcy practices in the Southern California region. If you are in a Chapter 11 case or facing creditor problems, feel free to contact us online or call 310-271-6223 to schedule an initial consultation.


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