Release of Chapter 11 Plan Proponent Overbroad and Impermissible

Chapter 11 plans in complex restructurings routinely contain provisions either releasing, or enjoining litigation against, various stakeholders involved in the case, particularly where the plan contemplates an infusion of cash from an existing creditor or insurance company to fund distributions, or is predicated in part on the settlement of a major dispute between the debtor and a significant creditor or shareholder. The validity of such releases or injunctions, however, has often been disputed in the courts. Two areas that continue to be a magnet for controversy concern: (i) a provision in a chapter 11 plan purporting to enjoin actions against or release entities other than the debtor; and (ii) the scope of the release or injunction. Both of these were the subject of a ruling recently handed down by the First Circuit bankruptcy appellate panel. In Whispering Pines Estates, Inc. v. Flash Island, Inc. (In re Whispering Pines Estates, Inc.), the court reversed an order confirming a creditor-proposed chapter 11 plan, ruling that a release provision in the plan that insulated the plan proponent from a breach of its obligations to implement the plan was overbroad.

Effect of Plan Confirmation on Third Party Obligations

With certain exceptions, the provisions of a confirmed chapter 11 plan of reorganization are binding upon all creditors, whether or not they vote to accept the plan. In addition, confirmation of a plan acts to discharge the debtor from any debt that arose prior to the confirmation date, even if a creditor failed to file a proof of claim evidencing its debt or voted to reject the plan. Although the Bankruptcy Code precludes actions against the reorganized debtor or its property to collect on pre-bankruptcy debts, the same cannot be said with respect to litigation against non-debtor third parties who share liability for the same debts. Thus, section 524(e) of the Bankruptcy Code provides 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."

The Bankruptcy Code explicitly authorizes non-debtor releases only in cases involving companies with asbestos-related liabilities. Section 524(g) was added to the Bankruptcy Code in 1994. It establishes a procedure for dealing with future personal injury asbestos claims against a chapter 11 debtor. The procedure entails the creation of a trust to pay future claims and the issuance of an injunction to prevent future claimants from suing the debtor. All claims based upon asbestos-related injuries are channeled to the trust. Section 524(g) was enacted in response to lawmakers' concerns that future claimants ? i.e, persons who have been exposed to asbestos but have not yet manifested any signs of illness ? are protected and recognizes that these claimants would be ill-served if asbestos companies are forced into liquidation. The statute contains detailed requirements governing the nature and scope of any injunction issued under section 524(g) in connection with the confirmation of a chapter 11 plan under which a trust is established to deal with asbestos claims.

Nevertheless, under certain circumstances, courts have approved chapter 11 plans that release or enjoin litigation against non-debtors in non-asbestos cases. Examples include situations where the estate receives substantial consideration in exchange for the release or injunction, where the enjoined claims are "channeled" to a settlement fund rather than extinguished or where the enjoined or released claims would indirectly impact the debtor's reorganization by way of indemnity or contribution and the plan...