The
Fifth Circuit is largely resistant to third party release provisions. The
Circuit will enforce a clearly defined third-party release that is not objected
to, Republic Supply Co. v. Shoaf, 815 F.2d 1046 (5th Cir. 1987),
but will not sustain such a provision if a timely objection is filed, Ad
Hoc Group of Vitro Noteholders v. Vitro SAB De CV (In re Vitro SAB De
CV), 701 F.3d 1031 (5th Cir. 2012). It is also resistant to bar
orders, Feld v. Zale Corp., (In re Zale Corp). 62 F.3d 746
(5th Cir. 1995) and most exculpation clauses, Bank of New York
Trust Co., NA v. Official Unsecured Creditors' Comm. (In re Pacific Lumber Co.),
584 F.3d 229 (5th Cir. 2009). (If you need more
background on these different types of third-party releases, I would be happy
to provide you with my paper from the last Western District Bench-Bar
Conference which discusses these issues at length).
The Court recently rebuffed
an attempt to distinguish its jurisprudence on exculpation clauses but offered
other limited relief. The case is Nexpoint Advisors, L.P. v. Highland Capital Mgmt., L.P. (In re Highland CapitalMgmt., L.P.), 2022 U.S. App. LEXIS 25107 (5th Cir. 9/7/22).
What Happened
This is the story of a billion-dollar investment fund and its break-up
with one of its founders. Highland Capital Management, LP was a Dallas-based
investment fund co-founded by James Dondero. In 2019, Highland filed bankruptcy
in the U.S. Bankruptcy Court for the District of Delaware. The case was
transferred to the Northern District of Texas.
The Fifth Circuit noted that the case “did not proceed under the
governance of a traditional chapter 11 trustee.” Of course, having a chapter 11
trustee is the exception rather than the rule. What the court meant was that
the parties fashioned a bespoke remedy for control of the Debtor. Dondero stepped down as control person of the
Debtor’s general partner and was replaced by three independent directors approved
by the court, including a former bankruptcy judge. The Court barred any claims
against the independent directors without prior court approval. The Court
subsequently appointed a Chief Restructuring Officer. Thus, the parties obtained a de facto trustee of their own choosing.
Dondero proposed several plans which were not confirmed. The Committee
and the Independent Directors negotiated their own plan. When Dondero couldn’t
get his plans confirmed, “he and other creditors began to frustrate the
proceedings by objecting to settlements, appealing orders, seeking writs of mandamus,
interfering with Highland Capital's management, threatening employees, and
canceling trades between Highland Capital and its clients.” Eventually the
Bankruptcy Court held him in civil contempt and fined him $100,000. Dondero and the U.S. Trustee objected to the
plan’s exculpation provisions.
The Bankruptcy Court confirmed the Plan and appeals followed. The
Fifth Circuit generally affirmed the plan but pared back the exculpation
clauses.
Exculpation
Exculpation clauses are a subspecies of third-party releases. They
preclude any party from suing various parties associated with the plan except
for gross negligence or willful misconduct. Their practical effect is to bar claims
for ordinary negligence in connection with the plan process.
Exculpation clauses have both a proper use and an improper one. The
improper use is to shield professionals from their own negligence. The proper
use is to encourage parties to work together to confirm consensual plans safe
in the knowledge that they won’t get sued if things don’t work out. A third
reason to include an exculpation clause is that it’s part of an attorneys’
boilerplate and no particular thought went into including the clause.
The plan in this case had two provisions which protected the plan
participants: the exculpation clause and
the gatekeeper clause. The parties protected included the Debtor, its
employees, the Chief Restructuring Officer, the independent directors, the
Unsecured Creditors’ Committee, the professionals and the "Related Parties.”
According to the Fifth Circuit:
The Plan exculpates the protected parties from claims based on any conduct "in connection with or arising out of" (1) the filing and administration of the case, (2) the negotiation and solicitation of votes preceding the Plan, (3) the consummation, implementation, and funding of the Plan, (4) the offer, issuance, and distribution of securities under the Plan before or after the filing of the bankruptcy, and (5) any related negotiations, transactions, and documentation. But it excludes "acts or omissions that constitute bad faith, fraud, gross negligence, criminal misconduct, or willful misconduct" and actions by Strand and its employees predating the appointment of the Independent Directors.
The Fifth Circuit also explained the gatekeeper clause as follows:
Under the Plan, bankruptcy participants are enjoined "from
taking any actions to interfere with the implementation or consummation of the
Plan" or filing any claim related to the Plan or proceeding. Should a
party seek to bring a claim against any of the protected parties, it must go to
the bankruptcy court to "first determin[e], after notice and a hearing,
that such claim or cause of action represents a colorable claim of any
kind." Only then may the bankruptcy court "specifically
authoriz[e]" the party to bring the claim. The Plan reserves for the
bankruptcy court the "sole and exclusive jurisdiction to determine
whether a claim or cause of action is colorable" and then to
adjudicate the claim if the court has jurisdiction over the merits.
The Court’s Ruling
The Court upheld the exculpation clause as to the Debtor, the
Unsecured Creditors’ Committee and the independent directors. Under Pacific
Lumber, a release may only be approved if provided elsewhere in the Code. The Debtor
receives a release because it is discharged under the Plan. The Court in
Pacific Lumber found that the Code provisions relating to members of the Unsecured
Creditors’ Committee allowed their exculpation.
The Court found that the independent directors were entitled to
exculpation because they were acting in the role of a trustee. The Court stated
that:
That leaves one remaining question: whether the bankruptcy court
can exculpate the Independent Directors under Pacific Lumber. We answer in the
affirmative. As the bankruptcy court's governance order clarified, nontraditional
as it may be, the Independent Directors were appointed to act together as the
bankruptcy trustee for Highland Capital. Like a debtor-in-possession, the
Independent Directors are entitled to all the rights and powers of a trustee. It
follows that the Independent Directors are entitled to the limited qualified
immunity for any actions short of gross negligence. Under this unique
governance structure, the bankruptcy court legally exculpated the Independent
Directors. (cleaned up).
Nevertheless, the Court found that outside of these three groups,
exculpation was improper and had to be reversed. This applied primarily to the
bankruptcy professionals, the CRO, the Debtor’s employees and the “Related
Parties.”
However, the Court did not leave then un-exculpated parties
without any protection. It upheld the gatekeeper provisions. The Court analogized
the gatekeeper provisions to the Barton Doctrine which protects Trustees from
being sued without prior court permission. The Court stated:
Courts have long recognized bankruptcy courts can perform a
gatekeeping function. Under the "Barton doctrine," the bankruptcy
court may require a party to "obtain leave of the bankruptcy court before
initiating an action in district court when the action is against the trustee
or other bankruptcy-court-appointed officer, for acts done in the actor's
official capacity." In Villegas, we held "that a party must continue to
file with the relevant bankruptcy court for permission to proceed with a claim
against the trustee." Relevant here, we left to the bankruptcy court,
faced with pre-approval of a claim, to determine whether it had subject matter
jurisdiction over that claim in the first instance. In other words, we need not
evaluate whether the bankruptcy court would have jurisdiction under every
conceivable claim falling under the widest interpretation of the gatekeeper
provision. We leave that to the bankruptcy court in the first instance. (cleaned
up).
What Does It Mean?
The Fifth Circuit remains resistant to broad exercises of power untethered
to the Code. However, it is willing to
consider pragmatic expansions of existing precedent. Here, the problem was that
one party had proven himself to be unduly litigious. This meant that the plan
proponents and related parties had a legitimate concern that they might be sued
over the plan in a forum unfamiliar with the bankruptcy case. While the Barton
Doctrine is an equitable doctrine specifically intended to protect trustees
from being sued without permission, the Fifth Circuit was willing to endorse
its extension to a broad class of plan-related parties. This partial measure
protects the parties from frivolous suits without granting blanket releases.
This suggests that the Fifth Circuit would also consider other
partial measures that stop short of outright releases. In particular, it seems
likely that the Fifth Circuit would allow temporary injunctions against
collection of debts from insiders during the period of plan performance as was
done by Judge Barbara Houser in In re Seatco, 257 B.R. 469 (Bankr. N.D.
Tex. 2001).
The message to plan drafters in the Fifth Circuit is that if you can’t get consensus, be modest, be practical, and find a hook in the Code or existing precedent.
