Contributions

Discharging the Debt of a Third-Party Non-Debtor is Within the Authority of the Bankruptcy Courts

By Chelsea Ireland1

Everybody loses in bankruptcy, but the purpose of the Bankruptcy Code is to apportion that loss fairly and systematically.2 Filing for bankruptcy is a course of action available to an entity that is insolvent, meaning that the entity’s liabilities (debts) outweigh its assets. By way of example, suppose that the insolvent Debtor Company, a manufacturer of blenders, has $100 in assets. If Debtor Co. owes $50 each to Creditors A, B, and C, it is not possible for all three creditors to be paid in full. The Creditors are now in competition with each other over the limited pot of assets. Rather than a system of ‘first come, first served,’ the Code lays out the rules for how much, and in what order, different types of creditors are to be paid.3

The most basic type of corporate bankruptcy is liquidation under Chapter 7 of the Code, and it calls for an appointed “trustee” to take control of and sell off the debtor’s assets.4 The trustee is then entrusted to distribute proceeds from the sale of those assets to the creditors.5 The purpose of a liquidation is “to distribute any assets equitably among existing creditors before laying the defunct corporation to rest.”6 A corporation that does not want to be “laid to rest” may instead opt for a reorganization under Chapter 11 of the Code.7 Rather than forfeit its assets to a trustee to be sold off, the debtor corporation acts as its own trustee, becoming a “debtor in possession.”8 A debtor in possession maintains control of its assets, subject to the authority of the bankruptcy court.9 The debtor in possession will negotiate with creditors and third-parties in order to reorganize itself in such a way that it can emerge as a “profitable and productive member of its economic community.”10 The idea behind a Chapter 11 reorganization is that the debtor and creditors may be better served if creditors postponed demands for payment, and instead gave the debtor corporation the opportunity to increase its value by merger, acquisition, restructuring of contracts, or through other methods of financial restructuring.11

During Chapter 11 reorganization, the debtor in possession continues to operate the business, while a committee of creditors may begin to formulate a reorganization plan to restore the entity to financial health.12 If there is an opportunity for a merger with or acquisition by some third-party entity, the reorganization plan will provide for that merger and lay out how the different classes of creditors will be treated as a result of the merger.13 The terms of the merger, included in the reorganization plan, must ultimately be confirmed by the bankruptcy court.14 If the plan is confirmed, the merger is executed, along with all the provisions laid out in the plan.15

A bankruptcy court has broad (but not unlimited) discretion to confirm a wide range of reorganization plans which affect the relationship between the debtor and its creditors. Suppose that Debtor Co. files for Chapter 11 bankruptcy after a design flaw in the blenders’ blades causes a number of serious injuries and subjects Debtor Co. to a products liability class action. Debtor Co. then manages to convince Acquiring Company to acquire Debtor Co. Acquiring Co. manufactures some of the parts that Debtor Co. used in its blenders, and it is unclear whether Acquiring Co. has any liability to the injured parties. To limit its own potential liability, Acquiring Co. insists that in the reorganization plan, there must be a term which permanently enjoins all victims of Debtor Co.’s malfunction blender from seeking relief from Acquiring Co. Even if the majority of the blender victims vote to approve the reorganization plan, there is some debate as to whether a bankruptcy court has the authority to approve it.

The Code confers upon bankruptcy courts the “broad authority to modify creditor-debtor relationships,”16 but by confirming Debtor Co.’s reorganization plan, the bankruptcy court will have essentially discharged the liability of the third-party Acquiring Co., which is neither a creditor nor a debtor. Additionally, there are due process concerns relating to blender victims who voted against the reorganization plan: in general, classes of creditors vote on whether or not to accept a certain reorganization plan,17 and a majority of creditors in a class have the power to bind a minority.18 But when a reorganization plan includes the discharge of a third-party’s liability, and a majority of a creditor class votes in favor, the minority has effectively been stripped of their claims against their consent.

While reorganization plans commonly limit an acquiring company’s liability to the debtor’s creditors,19 a number of circuit courts of appeals have confirmed reorganization plans that discharge an acquirer’s liability to a class of creditors, even where that liability is unrelated to the debtor’s bankruptcy. The Second, Third, Fourth, Sixth, Seventh, and Eleventh Circuits have all allowed bankruptcy courts to confirm a third-party discharge,20 though some of the discharges have been controversial. For example, in a recent Eleventh Circuit case, the court confirmed a reorganization plan that contained a provision that insulated from liability the four individuals responsible for driving the company into bankruptcy.21 The Fifth, Ninth, and Tenth Circuits have opined that the bankruptcy court has no authority to discharge of the liability of a third-party non-debtor.22 The Fifth Circuit specifically has rejected the bankruptcy court’s authority to confirm a third-party discharge because such would result in consequences never intended by the legislature.23

This Contribution will argue that the discretion to discharge the liability of a third-party non-debtor is within the authority bankruptcy courts. The Bankruptcy Code is explicit about the breadth of discretion granted to the bankruptcy courts.24 That breadth is indicative of Congress’s confidence that the bankruptcy courts are in the best position to determine whether any specific course of action, including the discharge of a third-party debt, is necessary or appropriate for any particular reorganization plan.

* * * * *

The Bankruptcy Code does not prohibit the bankruptcy courts from discharging the debt of a third-party, and therefore it is within the authority of the courts to do so. The broad discretion of the bankruptcy courts is laid out in § 105 of the Code, which allows a bankruptcy court to “issue any order, process, or judgment” that is “necessary or appropriate to carry out the provisions of [the Code].”25 This discretion is not unlimited, and a court has no authority to confirm a reorganization plan that is “inconsistent with the applicable provisions” of the Code. 26 Therefore, if not otherwise forbidden by the Code, a court may discharge the liability of a third-party if doing so is “necessary or appropriate” in that instance.

Because the bankruptcy courts are capable of confirming any reorganization plan that is not inconsistent with the Code, objections to the use of the third-party discharge have been grounded mainly in overly literal readings of the Code itself. The Ninth and Tenth Circuits cite § 524(e) of the Code as the provision which forbids the third-party discharge.27 Section 524(e) states 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.”28 In the Ninth Circuit case of In re Lowenschuss, the court read the language of 524(e) to explicitly preclude bankruptcy courts from discharging third-party debts.29 In contrast, in In re Airadigm Communications., Inc., the Seventh Circuit held that, rather than a limit on discretion, § 524(e) is more naturally read as a “savings clause” which “preserves rights that might otherwise be construed as lost.”30

Section 524(e) is more naturally read to mean that the “discharge of a debt of the debtor does not affect the liability of any other entity” unless otherwise provided for. Given that Congress chose the phrase “does not”, rather than “may not” or “must not”, it would be strange to read § 524(e) as a restriction on the bankruptcy court’s authority.31 Additionally, where Congress has intended to limit the authority of the bankruptcy court, it has done so explicitly.32 For example, in § 1129, the Code states that a bankruptcy court “may not confirm a plan if the principal purpose of the plan is the avoidance of taxes.”33 Section 524(e) is not so explicit, and therefore cannot be read as a limit on the court’s authority. The Second, Third, Fourth, Sixth, and Eleventh Circuits have all agreed with or followed the Seventh Circuit, holding that the use of a third-party discharge is not precluded by the Code.34

Additionally, the Ninth Circuit has read § 524(e) of the Code to prohibit the use of the third-party discharge based on the theory that, because the Code specifically provides for the use of a third-party discharge in asbestos cases, Congress intended asbestos cases to provide the only circumstances where such a discharge can be used.35 Section 524(g) of the Code lays out a step-by-step process for the administration of asbestos cases, provides that the court may permanently enjoin plaintiffs from filing claims against that defendant debtor or a third-party.36 Asbestos litigation imposed an unparalleled burden upon the courts, and § 524(g) lays out the step-by-step process for the oversight of bankruptcy administration was necessary in order to efficiently wade through the ocean of asbestos-related claims.37 The specificity of the requirements laid out in § 524(g) are indicative of the need for a clear and specific process for organizing and overseeing asbestos cases, rather than of Congress’s intention to drastically narrow the circumstances under which a third-party discharge could be used.38 The inclusion of a third-party discharge as an available option under § 524(g) was therefore not meant to impose any additional restrictions on the bankruptcy courts outside of § 524(g).

While the Ninth Circuit focuses intently on specific statutory text, the Fifth Circuit looks to the broader purposes of the Code. The Fifth Circuit also “broadly [] foreclose[s] [the confirmation of] non-consensual non-debtor releases and permanent injunctions,” but it supports this conclusion on the idea that equity and the burden-benefit trade-off inherent in the bankruptcy process as defined by the code.39 The Fifth Circuit, in In re Pacific Lumber Co., opined that there was “little equitable about protecting the released non-debtors.”40 The Fifth Circuit has stressed the “policy that bankruptcy should benefit only the debtor,”41 and the Tenth Circuit has similarly suggested that a permanent injunction of a claim against a third-party affords that party the benefits of the bankruptcy process without requiring that party to submit itself to the burdens of the bankruptcy process.42 This concern is derived from the possibility that entities might “push the failing enterprise into bankruptcy not for the debtor’s sake, but for [its] own interests,”43 which could turn bankruptcies into a commodity as a potential extinguisher of extrinsic liability.44

The policy concerns asserted by the Fifth and Tenth Circuits drastically underestimate the aptitude of the bankruptcy courts to exercise discretion in the inclusion of a third-party discharge in a reorganization plan. The Code restricts the bankruptcy court’s discretion to those courses of action which are “necessary or appropriate” in any given circumstance, and so bankruptcy courts are already required by the Code to evaluate whether a third-party discharge meets this criteria.45 Several circuits have explicitly determined that such a discharge is unacceptable where the liability to be discharged arose as a result of “willful misconduct.”46 Additionally, the Sixth Circuit has developed a multi-factor test for determining whether a third-party discharge is appropriate, and this test (or some version of it) has been adopted by several circuits.47 Courts are already combing through the facts in each relevant case to determine whether the use of a third-party discharge is appropriate and are completely capable of ascertaining whether some third-party is attempting to take advantage of the bankruptcy process. For example, should a bankruptcy court find that some third-party is exploiting the bankruptcy process solely to insulate itself from liability, the court may refuse to allow the discharge and point to precedential language in the Code as justification.48 The Code already prohibits the confirmation of reorganization plans that have the principal purpose of avoiding tax liability,49 and so courts may be justified in finding that Congress never intended to allow sophisticated parties to employ gamesmanship to use the bankruptcy process solely as a liability shield.

Therefore, because the Code does not prohibit the use of a third-party discharge, and because the bankruptcy courts are qualified to exercise discretion concerning whether a discharge would be necessary or appropriate in any given situation, third-party discharges should be permitted.

Notes:

1. Chelsea Ireland is a 3L at New York University School of Law. This piece is a commentary on the 2017 Problem at the Duberstein Moot Court Competition held in Queens, New York at St. John’s University School of Law. There were two issues presented in the Duberstein Problem. This piece is restricted to the issue concerning whether bankruptcy courts have the authority to discharge the liability of a non-debtor to a non-consenting creditor. The views expressed in this article do not necessarily represent the views of the author on this point of law. Rather, this article is a distillation of one side of an argument assigned to the team that the author represented in the competition.
2. See Midlantic Nat’l Bank v. N.J. Dept. of Envtl. Prot., 474 U.S. 494, 508 (1986) (“the overriding purpose of bankruptcy liquidation [is] the expeditious reduction of the debtor’s property to money, for equitable distribution to creditors”).
3. See generally 11 U.S.C. §§ 701-84.
4. See 11 U.S.C. §§ 701-84; Collier on Bankruptcy ¶ 1.07(1) (Alan N. Resnick & Henry J. Sommer eds., 16th ed.).
5. See 11 U.S.C. §§ 701-84; Collier on Bankruptcy ¶ 1.07(1) (Alan N. Resnick & Henry J. Sommer eds., 16th ed.).
6. In re Blanton, 105 B.R. 811, 824 (Bankr. W.D. Tex. 1989).
7. See 11 U.S.C. §§ 1101-74.
8. See 11 U.S.C. § 1101(1).
9. See Collier on Bankruptcy ¶ 1.07(3) (Alan N. Resnick & Henry J. Sommer eds., 16th ed.).
10. Id.
11. See Michael A. Gerber & George W. Kuney, Business Reorganizations 6-7 (3d ed. 2013) (“[T]he risk of loss to all parties is reduced when a salvageable business is rescued rather than liquidated and sold piecemeal.”).
12. See 11 U.S.C. § 1103(c).
13. 11 U.S.C. § 1123(a)(5)(C).
14. See generally 11 U.S.C. § 1129.
15. Id.
16. United States v. Energy Res. Co., 495 U.S. 545, 549 (1990) (noting the traditional role of bankruptcy courts as courts of equity).
17. See 11 U.S.C. § 1129(a)(8).
18. See 11 U.S.C. § 1126(c) (“A class of claims has accepted a plan if such plan has been accepted by creditors, …that hold at least two-thirds in amount and more than one-half in number of the allowed claims of such class held by creditors…that have accepted or rejected such plan.”).
19. See 11 U.S.C. § 363(f).
20. See In re Metromedia Fiber Network, Inc., 416 F.3d 136, 142 (2d Cir. 2005) (“The Bankruptcy Code does not explicitly prohibit or authorize a bankruptcy court to enjoin a non-consenting creditor’s claims against a non-debtor.” (quoting In re Dow Corning Corp., 280 F.3d 648, 656 (6th Cir. 2002)); In re Continental Airlines, 203 F.3d 203, 213-14 (3d Cir. 2000) (declining to adopt a rule prohibiting the use of third-party discharges); In re A.H. Robins Co., 880 F.2d 694, 702 (4th Cir. 1989) (opining that § 524(e) does not have to be “literally applied in every case as a prohibition on the power of the bankruptcy courts.”); In re Dow Corning Corp., 280 F.3d at  656  (“The Bankruptcy Code does not explicitly prohibit or authorize a bankruptcy court to enjoin a non-consenting creditor’s claims against a non-debtor.”); In re Airadigm Commc’ns, Inc., 519 F.3d 640, 656 (7th Cir. 2008) (“The natural reading of [11 U.S.C. § 524(e)] does not foreclose a third-party release from a creditor’s claims.”); In re Seaside Eng’g & Surveying, 780 F.3d. 1070, 1078 (11th Cir. 2015) (adopting the reading of the Seventh Circuit).
21. See In re Seaside Eng’g & Surveying, 780 F.3d at 1075-81. In Seaside, a closely held civil engineering firm, Seaside, filed for Chapter 11 bankruptcy. The firm proposed to reorganize and continue operating as a new entity, Gulf, which would be managed by four of the five original shareholders of Seaside. The bankruptcy court, and later the Eleventh Circuit, confirmed a reorganization plan that included a provision effectively insulating the managers from any liability arising out of the reorganization process.
22. See In re Zale Corp., 62 F.3d 746, 757 n.28 (5th Cir. 1995); In re Lowenschuss, 67 F.3d 1394, 1401 (9th Cir. 1995) (“[Section] 524(e) precludes bankruptcy courts from discharging the liabilities of non-debtors.”); In re W. Real Estate Fund, 922 F.2d 592, 600 (10th Cir. 1990) (interpreting § 524(e) to mean that “it is the debtor, who has invoked and submitted to the bankruptcy process, that is entitled to its protections” and that “Congress did not intend to extend such benefits to third-party bystanders.”).
23. See In re Zale Corp., 62 F.3d at 757 n.28 (explaining that such authority would incentivize creditors to push debtors into bankruptcy for creditors’ own sake).
24. See 11 U.S.C. § 105(a). The Bankruptcy Code, in laying out the powers of the court during bankruptcy proceedings, allows a court to issue “any order, process, or judgment that is necessary or appropriate to carrying out” the bankruptcy proceedings.
25. Id.
26. 11 U.S.C. § 1123(b)(6).
27. See In re Lowenschuss, 67 F.3d at 1401 (“Section 524(e) precludes bankruptcy courts from discharging the liabilities of non-debtors.”); In re W. Real Estate Fund, 922 F.2d at 600 (interpreting § 524(e) to mean that “it is the debtor, who has invoked and submitted to the bankruptcy process, that is entitled to its protections” and that “Congress did not intend to extend such benefits to third-party bystanders.”).
28. 11 U.S.C. § 524(e). A number of circuit courts refer to the third party discharge as a “non-debtor release.” See, e.g., In re Metromedia Fiber Network, Inc., 416 F.3d 136, 142 (2d Cir. 2005); In re Seaside Eng’g & Surveying, 780 F.3d 1070, 1077 (11th Cir. 2015). Calling the discharge a release distances this activity from the language of 11 U.S.C. § 524(e), which refers specifically to a discharge, not a release. Such classification is an unpersuasive misnomer.. A release indicates consent by the creditor, see, e.g., Release, Black’s Law Dictionary (10th ed. 2014) (“The relinquishment or concession of a right, title, or claim.”), whereas the third-party discharge is controversial because it is involuntary.
29. See In re Lowenschuss, 67 F.3d at 1401 (“Section 524(e) precludes bankruptcy courts from discharging the liabilities of non-debtors.”).
30. 519 F.3d 640, 656 (7th Cir. 2008).
31. See id. (“The natural reading of this provision does not foreclose a third-party release from a creditor’s claims.”).
32. See, e.g., 11 U.S.C. § 1112(b)(2) (“The court may not convert a case under this chapter to a case under chapter 7” if certain criteria are met.); 11 U.S.C. § 1172(b) (If . . . transfer of . . . any of the debtor’s rail lines by an entity other than the debtor . . . would require approval by the Board . . . , then a plan may not propose such a transfer [unless certain conditions are met].”); 11 U.S.C. § 1116(3) (imposing express limits on the court’s ability to grant extensions in certain circumstances by stating that the court “shall not extend such time period to a date later than 30 days after the date of the order of relief.”).
33. 11 U.S.C. § 1129(d).
34. See In re Metromedia Fiber Network, Inc., 416 F.3d 136, 142 (2d Cir. 2005) (“The Bankruptcy Code does not explicitly prohibit or authorize a bankruptcy court to enjoin a non-consenting creditor’s claims against a nondebtor.”) (citing In re Dow Corning Corp., 280 F.3d 648, 656 (6th Cir. 2002)); In re Continental Airlines, 203 F.3d 203, 211 & n.6 (3d Cir. 2000) (declining to adopt a rule prohibiting the use of third-party discharges); In re A.H. Robins Co., 880 F.2d 694, 702 (4th Cir. 1989) (opining that § 524(e) does not have to be “literally applied in every case as a prohibition on the power of the bankruptcy courts.”); In re Seaside Eng’g & Surveying, 780 F.3d. 1070, 1078 (11th Cir. 2015) (adopting the reading of the Seventh Circuit).
35. See In re Lowenschuss, 67 F.3d 1394, 1402 n.6 (9th Cir. 1995) (asserting that a third-party discharge was “specifically designed to apply in asbestos cases only.”).
36. See 11 U.S.C. § 524(g)(4)(A).
37. See 140 Cong. Rec. H10,752 (daily ed. Oct. 4, 1994) (“The procedure is modeled on the trust/injunction in the Johns-Manville case, which pioneered the approach a decade ago in response to the flood of asbestos lawsuits, it was facing.”); Andrew W. Caine & Thomsen Young, Need Post-Confirmation Injunctive Relief? Get Some Class, 14 Am. Bankr. Inst. J. 30, 31 (Nov. 1995) (explaining § 524(g) codified the trust-injunction approach from MacArthur v. Johns Manville Corp., 837 F.2d 89 (2d Cir. 1988)).
38. Section 524(g) necessitates that a number of requirements be met before an asbestos defendant can take advantage of the benefits of § 524(g). Some of these requirements include the establishment of a trust that assumes the liability of the debtor and is funded by the debtor, that the debtor is likely to be subject to substantial future litigation, and that the actual amounts and timing of future claims cannot be determined. 11 U.S.C. § 524(g)(1)(B).
39. See In re Pacific Lumber Co., 584 F.3d 229, 252 (5th Cir. 2009).
40. Id.
41. In re Zale Corp., 62 F.3d 746, 757 n.28 (5th Cir. 1995).
42. See In re W. Real Estate Fund, 922 F.2d 592, 600 (10th Cir. 1990) (“the debtor, who has invoked and submitted to the bankruptcy process . . . is entitled to its protections; Congress did not intend to extend such benefits to third-party bystanders.”).
43. In re Zale Corp., 62 F.3d at 757 n.28.
44. See id. (citing Zerand-Bernal Group, Inc. v. Cox, 23 F.3d 159, 163 (7th Cir.1994)).
45. See 11 U.S.C. § 105(a).
46 See e.g., In re Airadigm Commc’ns., Inc., 519 F.3d 640, 657 (7th Cir. 2008); In re Seaside Eng’g & Surveying, 780 F.3d 1070, 1081 (11th Cir. 2015).
47. See generally Nat’l Heritage Found., Inc. v. Highbourne Found., 760 F.3d 344, 347 (4th Cir. 2014); In re Seaside Eng’g & Surveying, 780 F.3d at 1079.
48. See 11 U.S.C. § 1129(b)(1) (explaining that a court “shall confirm the plan . . . if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.”).
49. See 11 U.S.C. 1129(d).