Contributed by Victoria Vron
As has been discussed in previous posts, nonconsensual third-party releases are controversial, and one can never be sure that a third-party release in a chapter 11 plan will be approved.  Some debtors may include third-party releases in a chapter 11 plan with the mindset that there is no harm asking for the third-party releases – if the court does not approve such releases, the court will just confirm the plan without them.  Saxby’s Coffee Worldwide, LLC, Case No. 09-15898 (ELF) (Bankr. E.D. Pa., Sept. 22, 2010, as amended Sept. 24, 2010), shows why such thinking may sometimes backfire, especially when the debtor attempts to link the releases to its emergence from chapter 11.

In Saxby’s, the debtor, a coffee shop franchisor, acquired the assets and assumed the liabilities of Saxby’s Coffee, Inc.  A dispute with a number of the acquiree’s minority shareholders and creditors in connection with the acquisition led to litigation in state court against the debtor, its two members, and its chief executive officer.  The debtor commenced its chapter 11 case, in part, to avoid the ongoing expenses of the state court litigation.
During the chapter 11 case, the bankruptcy court enjoined the continuation of the state court litigation as against the debtor’s two members and its chief executive officer until the completion of the confirmation hearing.  The bankruptcy court reasoned that such an injunction would “provide the Debtor’s key management personnel the freedom from personal distraction so that they can devote their unfettered efforts to the Debtor’s reorganization, thereby giving the Debtor an opportunity to formulate and attempt to confirm its plan of reorganization.”  Saxby’s at 3.  The debtor sought to turn this temporary injunction into a permanent injunction in its proposed chapter 11 plan, arguing that releasing its principals from the distraction of the state court litigation was necessary so they could devote their full efforts to running the debtor’s business (and thereby implementing the chapter 11 plan) after confirmation.  The debtor also included in its plan a release of third-party claims against one of its suppliers, Coffee Shops International, LLC, a company controlled by the debtor’s two members.  The debtor tried to justify this release on the ground that Coffee Shops would provide the debtor with financial contributions post-confirmation in the form of rebates, which would reduce the amount of the debtor’s cash obligations and formed an important component of the debtor’s post-confirmation cash management strategy.  In support of all the third-party releases, the debtor also argued that the chapter 11 plan was dependent upon exit financing, one of the conditions to which was the inclusion of the releases in the plan.
The debtor’s chapter 11 plan only proposed to make a modest distribution to general unsecured creditors and was in fact rejected by the two classes of unsecured creditors, one of which included the state court litigation plaintiffs.  The U.S. Trustee and the plaintiffs objected to confirmation of the plan, although it was the U.S. Trustee who argued, among other things, that the plan contained impermissible third-party releases.
In analyzing the U.S. Trustee’s objection to the third-party releases, the bankruptcy court acknowledged that there may be an exception in “extraordinary cases” to section 524(e)’s restriction that only the debtor receive a discharge, but noted that it is not clear under what conditions such exception may be granted.  Saxby’s at 7-8.  The court cited Gillman v. Continental Airlines (In re Continental Airlines), 203 F.3d 203 (3d Cir. 2000), in which the U.S. Court of Appeals for the Third Circuit never got the opportunity to establish the specific rules governing which third-party releases may be permitted because it found that the “hallmarks of permissible non-consensual releases – fairness, necessity to the reorganization, and specific factual findings to support these conclusions” were all absent from the third-party releases the debtor in that case sought to get approved.  As a result, lower courts in the Third Circuit have fashioned their own tests for determining which third-party releases satisfy the hallmarks of permissible releases as outlined by the Third Circuit in Continental Airlines.  To determine whether the third-party releases in the debtor’s plan would satisfy even the “most flexible” of these tests, the Saxby’s court used the following “most flexible” test:

(1) whether the third party who will be protected by the injunction or release has made an important contribution to the reorganization; (2) whether the requested injunctive relief or release is “essential” to the confirmation of the plan; (3) whether a large majority of the creditors in the case have approved the plan; (4) whether there is a close connection between the case against the third party and the case against the debtor; and (5) whether the plan provides for payment of substantially all of the claims affected by the injunction of release.

Id. at 8 (citing In re South Canaan Cellular Investments, Inc., 427 B.R. 44 (Bank. E.D. Pa. 2010)).  The court determined that the third-party releases in the debtor’s plan failed to meet at least two of the elements set forth above because (i) the plan was not supported by the majority of creditors who voted on the plan, and (ii) the plan did not pay substantially all of the claims affected by the releases.  As a result, the court did not even analyze any of the other factors.  Saxby’s at 8. The court cautioned that third-party releases cannot be approved simply because they are necessary to the reorganization.  Instead, “[c]ourts may approve third-party releases only when the reorganization plan is widely supported by the creditor constituency that includes the parties being restrained, accords significant benefits to that constituency and the court is satisfied that creditors being restrained also are being treated fairly.”  Id. at 11.  Because these factors were not met in this case, the court held that the third-party releases were impermissible.  Also, because the debtor put on evidence showing that its exit lender would not provide exit financing without these third-party releases and that it needed the exit financing to reorganize, the court found that the plan was not feasible and was thus unconfirmable.  The court did not rule on the other objections to the plan, finding that the impermissibility of third-party releases was fatal to the plan regardless of the outcome of the other objections.
It is not clear from Saxby’s why, or how strongly, the exit lender insisted upon the existence of the third-party releases in the plan.  Perhaps the exit lender legitimately was concerned about the possible distraction that continued litigation against the debtor’s senior management would have on the debtor’s post-confirmation business.  Nothing in the case suggests that the debtor attempted to negotiate away this requirement in order to save its plan.  The debtor may have concluded that the exit lender’s requirement was a convenient means of justifying the inclusion of releases of its members and senior management as “necessary” to the reorganization.  These nuances do not come through in the opinion.  Whether third-party releases are truly essential to a particular plan must be judged on a case by case basis.  Saxby’s demonstrates the tightrope a plan proponent may have to walk when it includes third-party releases in its plan – it must show the necessity of the releases to the reorganization effort, but if it overemphasizes the necessity of third-party releases to the successful reorganization of a debtor, the rejection of the third-party releases may lead to the denial of plan confirmation altogether.
It is unclear whether Saxby’s reflects that the permissibility of third-party releases may be narrowing in the Third Circuit.  The Saxby’s court appears to take a formulaic approach to determining whether the “most flexible” test set forth in South Canaan was met by looking at whether each of the five factors outlined above has been satisfied.  On the other hand, that the debtor tied the success of its plan to protection of the parties in control of the debtor without any meaningful support from unsecured creditors may have influenced the court’s decision.  Interestingly, on its face, the test set forth in South Canaan does not appear to be as formulaic as the Saxby’s court interprets it to be.  In fact, in South Canaan, the court cited the above five factors as just some of the factors that are important in deciding whether to issue third-party releases, but did not indicate that all five of the factors had to be met to approve third-party releases.  The standard the South Canaan court adopted in fact prefaced the above list of factors with a statement that “[t]he issuance of a third party injunction or release depends upon the contents of the plan and other attendant circumstances.”  See South Canaan, 427 B.R. at 71-72 (citations and quotations omitted).  Time will tell whether other courts in the Third Circuit will follow the apparently more formulaic interpretation in Saxby’s or the slightly more flexible approach that South Canaan outlined.