In re Seaside Engineering & Surveying, Inc: Eleventh Circuit Approves Non-consensual Third-party Releases in Chapter 11 Plan

Practical Law Legal Update 2-605-7287 (Approx. 5 pages)

In re Seaside Engineering & Surveying, Inc: Eleventh Circuit Approves Non-consensual Third-party Releases in Chapter 11 Plan

by Practical Law Bankruptcy & Restructuring and Practical Law Finance

Background

Seaside Engineering & Surveying, Inc. (Seaside), was a civil engineering firm that conducted forms of technical mapping. Seaside's success was entirely dependent on the professional skill and business relationships of its five principal shareholders, all of which were engineers (Engineers).

The Engineers formed two unrelated companies for the purpose of real estate development, both of which borrowed funds from Vision-Park Properties, LLC (Vision). The two unrelated companies subsequently defaulted on their loans, and, as a result, three of the five Engineers eventually entered Chapter 7 bankruptcy. Through the Chapter 7 process, one of the Engineers was required to sell its interest in Seaside to Vision for $100,000, over the objections of Seaside.

On October 7, 2011, Seaside entered Chapter 11 bankruptcy. Seaside proposed a plan of reorganization that would, among other things:

Allow Seaside to continue operations as the reorganized entity Gulf Atlantic, LLC (Gulf).
Place four of the five Engineers that previously owned Seaside in positions of management and divide the ownership of Gulf between those four individuals. The plan granted these parties a release, providing that:
"None 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 ... or the consummation of the Amended Plan ..., except and solely to the extent such liability is based on fraud, gross negligence or wilful misconduct."
Give to outside equity holders, including Vision, promissory notes with an interest rate of 4.25%, in exchange for their interest in Seaside.

The bankruptcy court confirmed the plan of reorganization and the district court affirmed. Vision appealed to the Eleventh Circuit.

Outcome

The Eleventh Circuit noted that the circuit courts are split on whether non-consensual third-party releases are permissible in bankruptcy. The minority view, endorsed by the Fifth, Ninth and Tenth Circuits, is that non-consensual non-debtor releases are not permissible, based on section 524(e) of the Bankruptcy Code, which 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 majority view, endorsed by the Second, Third, Fourth, Sixth and Seventh Circuits, is that non-consensual third-party releases are permissible in certain circumstances under section 105 of the Bankruptcy Code, which gives bankruptcy courts broad equitable powers to enter orders and judgments that are necessary to carry out the provisions of the Bankruptcy Code.

The Eleventh Circuit found that its own precedent fit within the majority view. In In re Munford, Inc., the Eleventh Circuit approved a third-party release under section 105(a) of the Bankruptcy Code, enjoining non-settling defendants from pursuing contribution or indemnity claims against a settling defendant because the settlement was necessary to fund the bankruptcy case and the defendant would not settle without the release (97 F.3d 449 (11th Cir. 1996)).

The Eleventh Circuit extended that precedent, and embraced the majority view that third-party releases are permissible in bankruptcy, but should not be "issued lightly." The Eleventh Circuit explained that third-party releases should be reserved for those "unusual" cases in which the release is necessary for the success of the reorganization and is fair and equitable under all the facts and circumstances, an inquiry which it described as "fact intensive in the extreme." To make this determination, the Eleventh Circuit applied the Sixth Circuit's seven-factor test from In re Dow Corning, which examines:

The identity of interests between the debtor and the third party, usually an indemnity relationship, such that a suit against the third party is, in essence, a suit against the debtor or will deplete the assets of the estate. Here, the release included the former principals of Seaside who would be the key employees of the reorganized entity, Gulf. In the absence of a release, these individuals would spend their time defending against lawsuits rather than on their professional duties for Gulf. According to the Eleventh Circuit, "[t]ime equates to money for engineers. The principals' preoccupation with additional lawsuits will interrupt the labor intensive surveying, leading to a deterioration of the estate as Gulf loses valuable relationship-based work contracts."
The contribution of assets to the reorganization by the non-debtor. Since the services contributed by the releasees to Gulf is the very "life blood of the reorganized debtor," the Eleventh Circuit found that this factor weighed in favor of a release.
The essential nature of the third-party release to the reorganization. The Bankruptcy Court found that "it would be doubtful that the engineers and surveyors would ever be able to perform their professional work, complete contracts and create receivables necessary for the life blood of the reorganized debtor" without the release.
Whether the impacted class, or classes, overwhelmingly voted to accept the plan. Here, most classes of creditors unanimously accepted the plan, and the equity holders rejecting the plan would be paid the full value of their interests under the plan.
Whether the plan provides a mechanism to pay all, or substantially all, of the class or classes affected by the injunction. Here, the Eleventh Circuit found the fact that Vision would be paid in full under the plan weighed heavily in favor of granting the releases.
Whether there is an opportunity for those claimants who do not settle to recover in full. Since Vision only vaguely identified claims other than for the value of its equity interest (which was to be paid in full), the Eleventh Circuit concluded that any other claims asserted by Vision were those it made in challenging confirmation of the plan and were rejected.
Whether there are specific factual findings supporting the bankruptcy court's conclusions. In this case the Eleventh Circuit found that the bankruptcy court made thorough factual findings in reaching its decision, which were "amply supported by the evidence."

In addition, the Eleventh Circuit noted that the releases were fair and equitable because:

According to the bankruptcy court, this case was a "death struggle" and Vision expended a disproportionate amount of time for what it claimed to be a company valued at $960,000.
The bankruptcy court required Seaside to voluntarily cease litigation of its claims for sanctions against Vision, which prevented an asymmetrical benefit for Seaside from the plan.
The releases were narrowly limited to claims arising out of the Chapter 11 case and excluded claims for fraud, gross negligence or willful misconduct.

Practical Implications

In this decision the Eleventh Circuit firms sides with the majority view that non-consensual third-party releases are permissible in bankruptcy in appropriate circumstances, while emphasizing that they should be granted sparingly and providing guidance about the factors that should be considered when they are evaluated.

For more information on third-party releases in Chapter 11 plans, see Practice Note, Third-party Releases in Bankruptcy Plans.

In re Seaside Engineering & Surveying, Inc: Eleventh Circuit Approves Non-consensual Third-party Releases in Chapter 11 Plan | Practical Law