by Chelsea Ireland*

Everybody loses in bankruptcy, but the purpose of the Bankruptcy Code is to apportion the loss in a systematic manner. When an insolvent entity files for bankruptcy, there are several routes open to it. This discussion will be restricted to liquidation under Chapter 7 and reorganization under Chapter 11. Chapter 7 liquidation is the most basic course of action allowed under the Bankruptcy Code and requires that an appointed trustee take control of and sell the debtor’s property and distribute the assets.2 Chapter 11 reorganization provides an alternative to liquidation.3 Rather than forfeit its assets, the debtor acts as its own trustee and becomes a debtor in possession.4 Subject to the authority of the bankruptcy court, 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.”5

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In 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.6 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.7 The terms of the merger, included in the reorganization plan, must ultimately be confirmed by the bankruptcy court.8

Concern arises, however, when a potential acquirer seeks to include provisions in the reorganization plan that insulate itself from liability to some class of creditors. While reorganization plans commonly limit an acquiring company’s liability to the debtor’s creditors,9 a number of Circuit Courts of Appeals have confirmed reorganization plans that discharge an acquirer’s liability to a class of creditors, where that liability is unrelated to the debtor’s bankruptcy. For example, in a recent Eleventh Circuit case, a closely held civil engineering firm, Seaside, filed for Chapter 11 bankruptcy.10 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.11 The bankruptcy court confirmed and the Eleventh Circuit affirmed a reorganization plan that included a provision that effectively insulated the managers from any liability arising out of the reorganization process.12 Put simply, by confirming the reorganization plan, the Eleventh Circuit allowed the four people who drove Seaside into bankruptcy to be protected from claims by Seaside’s creditors, which could arise out of the bankruptcy process.13

Classes of creditors vote on whether or not to accept a certain reorganization plan,14 and a majority of creditors in a class have the power to bind a minority.15 When a third party discharge of liability is included in a reorganization plan, and a majority of a creditor class votes in favor, the minority is effectively stripped of their claims without their consent.

Despite a bankruptcy court’s “broad authority to modify creditor-debtor relationships,”16 the Code is ambiguous as to whether, and under what circumstances, a bankruptcy court can discharge the liability of an entity that is not a party to the bankruptcy proceedings such as an acquirer. Federal circuits disagree as to whether a bankruptcy court can discharge the liability of a third party non-debtor. The Fifth Circuit specifically has opined that recognizing such authority would result in consequences never intended by the legislature.17 That court’s jurisprudence, however, tends to disregard the general language of the Bankruptcy Code.

The discretion that the Bankruptcy Code grants to bankruptcy courts indicates Congress’s confidence that the bankruptcy courts are in the best position to determine whether a third party discharge (or any non-prohibited course of action) is necessary or appropriate in any specific instance. This contribution will argue that not only does a bankruptcy court have the authority to discharge the liability of a third party, but that the ability of courts to do so is in the best interest of creditors in general.

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While on its face, the third party discharge seems inequitable, balancing interests can justify its use. A bankruptcy court has broad discretion when confirming a proffered reorganization plan.18 Yet discretion is cabined in two ways. First, a court has no authority to confirm a reorganization plan that is “inconsistent with the applicable provisions” of the Bankruptcy Code.19 Second, the Code limits discretion granted to the bankruptcy court to “issue any order process or judgment” to those that are “necessary or appropriate to carry out the provisions of [the Bankruptcy Code].”20 Therefore, if not otherwise forbidden by the Bankruptcy Code, a court may discharge the liability of a third party if doing so is “necessary or appropriate” in that instance.

Because the Bankruptcy Code leaves the bankruptcy courts open to confirm any reorganization plan that is not inconsistent with the Bankruptcy Code, objections to the use of the third party discharge have been grounded mainly in textual interpretations of the relevant statutory provisions. Section 524(e) of the Code 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.”21 Both the Ninth and Tenth Circuits have read section 524(e) of the Bankruptcy Code to prohibit the use of the third party discharge.22 However, 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.23 When the Bankruptcy Code is limiting the power of the bankruptcy courts, it does so explicitly and with more definite language.24 The Seventh Circuit, in In re Airadigm Communs., Inc., opined that section 524(e) is more naturally read as a “savings clause” which “preserves rights that might otherwise be construed as lost.”25 Based on the use of the phrase “does not,” the Seventh Circuit’s interpretation is highly persuasive, and section 524(e) is most naturally read to include the phrase “unless otherwise provided for.”26 Importantly, the Second, Third, Fourth, Sixth, and Eleventh Circuits have all joined in Seventh Circuit in indicating that the use of a third-party discharge is not precluded by the Bankruptcy Code.27

The Ninth Circuit relies on an expressio unius argument for prohibiting the general use of a third party discharge. In the case of In re Lowenschuss, the Ninth Circuit asserted that because the Bankruptcy 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.28 Section 524(g) of the Bankruptcy 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.29 This is the only place in the Bankruptcy Code where a third party discharge is explicitly authorized.

This expressio unius argument does not pack its usual punch. Asbestos litigation imposed an unparalleled burden upon the courts, and a step-by-step process for the oversight of bankruptcy administration was necessary in order to efficiently wade through the ocean of asbestos-related claims. The specificity of the requirements laid out in section 524(g) therefore indicate the need for a clear and specific process for organizing and overseeing asbestos cases, rather than Congress’s intention to drastically narrow the circumstances under which a third party discharge could be used.30 The inclusion of a third party discharge as an available option under section 524(g) was therefore not meant to impose any additional restrictions on the bankruptcy courts outside of section 524(g).

The Fifth Circuit’s jurisprudence, which also “broadly foreclose[s] non-consensual non-debtor releases and permanent injunctions,” rests on the broad purposes of the Bankruptcy Code, specifically equity and the burden-benefit trade-off inherent in the bankruptcy process.31 The Fifth Circuit, in In re Pacific Lumber Co., opined that there was “little equitable about protecting the released non-debtors.”32 Discharging the liability of a non-debtor in order to facilitate a reorganization could potentially result in the creditors of the debtor being prioritized to the detriment of the creditors of the unrelated non-debtor. This system might reward an entity for being the first to file for bankruptcy. The Fifth Circuit has also stressed the “policy that bankruptcy should benefit only the debtor,”33 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.34 This concern is derived from the possibility that entities might “push a failing enterprise into bankruptcy not for the debtor’s sake, but for their own interests,”35 which could turn bankruptcies into a commodity and potentially extinguish extrinsic liability.36 These 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 bankruptcy code restricts the bankruptcy court’s discretion to those courses of action which are “necessary or appropriate” in any given circumstance.37 Within the adversarial environment of confirmation hearings, a bankruptcy court will be able to entertain and challenge the arguments for or against any provision within a reorganization plan. A third party discharge may be inappropriate where it is clear that some third party is solely seeking to insulate itself from liability, and the court may refuse to allow the discharge in such an instance. Likewise, several circuits have determined that such a discharge is unacceptable where the liability to be discharged arose as a result of “willful misconduct.”38 The Sixth Circuit has developed a multi-factor test for determining whether a third party discharge is appropriate, and several circuits have adopted this test or some version of it.39 The test requires that a court determine, among other things, that “the non-debtor has contributed substantial assets to the reorganization,” and that “[t]he injunction is essential to reorganization, namely, the reorganization hinges on the debtor being free from indirect suits against parties who would have indemnity or contribution claims against the debtor,” and that “[t]he impacted class, or classes, has overwhelmingly voted to accept the plan.”40 The court goes on to list other factors which it requires for approval, but the point is that courts are already combing through the facts in each relevant case to determine whether the use of a third party discharge is appropriate.

If properly evaluated for appropriateness, a third party discharge provides a useful incentive to would-be financiers, which provides a benefit to creditors as a whole. In some situations “absent [the third party]’s involvement, the reorganization simply would not have occurred.”41 If discharging the liability of a non-debtor is enough to prevent the failing of a reorganization plan, then it is generally beneficial to creditors that such a discharge be implemented. Under a Chapter 11 reorganization, creditors must be treated at least as well as they would have been treated in a Chapter 7 liquidation,42 and so a Chapter 11 reorganization is financially preferable. A creditor prevented from filing a claim against a third party non-debtor is still benefiting from a system that aims to facilitate Chapter 11 bankruptcies in general. If a majority of the class of creditors affected by the third party discharge has voted in favor of the discharge, it would be inequitable to allow one portion of one creditor class to hold out and cause the entire reorganization to fail.

Therefore, because the Bankruptcy 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, the law should permit third party discharges.

* Chelsea Ireland is a 2L 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. Cyrus Kornfeld, also a 2L at New York University School of Law, briefed the second issue, which concerned the application of the equitable mootness doctrine.

2. See 11 U.S.C. §§ 701-84; Collier on Bankruptcy ¶ 1.07(1) (Alan N. Resnick & Henry J. Sommer eds., 16th ed.).

3. See 11 U.S.C. §§ 1101-74.

4. See 11 U.S.C. § 1101(1).

5. 1-1 Collier on Bankruptcy ¶ 1.07(3) (Alan N. Resnick & Henry J. Sommer eds., 16th ed. 2017).

6. See 11 U.S.C. § 1103(c).

7. See 11 U.S.C. § 1123(a)(5)(C).

8. See 11 U.S.C. § 1129.

9. See 11 U.S.C. § 363(f).

10. See In re Seaside Eng’g & Surveying, 780 F.3d 1070, 1075 (11th Cir. 2015).

11. Id.

12. Id. at 1076 (“[N]one of the Debtor, … Reorganized Debtor, Gulf Atlantic … (and any officer or directors or members of the aforementioned [entities]) and any of their respective Representatives (the “Releasees”) shall have or incur any liability to any Holder of a Claim against or Interest in Debtor, or any other party-in-interest … for any act, omission, transaction or other occurrence in connection with, relating to, or arising out of the Chapter 11 Case, the pursuit of confirmation of the Amended Plan as modified by the Technical Amendment, or the consummation of the Amended Plan as modified by this Technical Amendment, except and solely to the extent such liability is based on fraud, gross negligence or willful misconduct.”).

13. Id. at 1081 (“We conclude that the bankruptcy court did not abuse its discretion in approving the non-debtor releases. The releases are fair and equitable, and wholly necessary to ensure that Gulf may continue to operate as an entity. This case has been a death struggle, and the non-debtor releases are a valid tool to halt the fight.”).

14. See 11 U.S.C. § 1129(a)(8).

15. See 11 U.S.C. § 1126(c).

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 In re Zale Corp., 62 F.3d 746, 757 n.28 (5th Cir. 1995) (explaining that such authority would incentivize creditors to push debtors into bankruptcy for creditors’ own sake).

18. 11 U.S.C. § 105(a) authorizes a bankruptcy court to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.” A bankruptcy court bears the responsibility of confirming a reorganization plan, and under 11 U.S.C. § 1123(b)(6), the court may confirm a plan that includes “any other appropriate provision not inconsistent with the provisions of this title.”

19. 11 U.S.C. § 1123(b)(6).

20. 11 U.S.C. § 105(a).

21. 11 U.S.C. § 524(e); A number of Circuits refer to 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 a misnomer, and unpersuasive. A release indicates consent by the creditor, whereas the third party discharge is controversial because it is involuntary.

22. See In re Lowenschuss, 67 F.3d 1394, 1402 (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 section 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 Airadigm Communs., Inc., 519 F.3d 640, 656 (7th Cir. 2008) (“The natural reading of this provision does not foreclose a third-party release from a creditor’s claims.”).

24. See e.g., 11 U.S.C. § 105(b) (“[A] court may not appoint a receiver in a case under this title.”) (emphasis added).

25. In re Airadigm Communs., Inc., 519 F.3d at 656.

26. Id.

27. 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.”) (citing In re Dow Corning Corp., 280 F.3d 648, 656 (6th Cir. 2002)); In re Continental Airlines, 203 F.3d 203 (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 section 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 (11th Cir. 2015) (adopting the reading of the Seventh Circuit).

28. 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.”).

29. See 11 U.S.C. § 524(g)(4)(A).

30. 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. See 11 U.S.C. § 524(g)(1)(B).

31. See In re Pacific Lumber Co., 584 F.3d 229, 252 (5th Cir. 2009).

32. Id.

33. In re Zale Corp., 62 F.3d 746, 757 n.28 (5th Cir. 1995).

34. 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.”).

35. In re Zale Corp., 62 F.3d at 757 n.28.

36. See id., (citing Zerand-Bernal Group, Inc. v. Cox, 23 F.3d 159, 163 (7th Cir.1994)).

37. 11 U.S.C. § 105(a).

38. See e.g., In re Airadigm Communs., Inc., 519 F.3d 640, 657 (7th Cir. 2008); In re Seaside Eng’g & Surveying, 780 F.3d 1070, 1081 (11th Cir. 2015).

39. 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.

40. In re Dow Corning Corp., 280 F.3d 648, 658 (6th Cir. 2002).

41. In re Airadigm Communs., Inc., 519 F.3d at 657.

42. See 11 U.S.C. § 1129(a)(7).