Recent splits within the Delaware courts: Are third-party releases consensual for nonvoting creditors and equity holders?

When a debtor confirms a chapter 11 plan, section 1141 of the Bankruptcy Code allows the debtor to discharge its liabilities. The discharge is limited to debtors, and section 524(e) of the Bankruptcy Code specifically provides that the discharge does not affect the pre-confirmation liability of non-debtor entities. To close the loop, chapter 11 plans typically contain releases for third parties from claims related to the debtor or the restructuring process. Although limited in scope, these releases have an effect similar to discharge and are often key to a plan’s success.

Essential plan participants, like DIP lenders and exit financing lenders, would be unlikely to participate in a chapter 11 case (i.e. provide essential post-petition funding) without a shield from certain third-party claims. Similarly, other non-debtor parties that provide a substantial contribution to a restructuring often seek releases in exchange for those contributions. In other words, without approval of these third-party releases, non-debtor parties who participate in a chapter 11 case would not receive the benefit of the bargain they struck for providing essential funding, exerting significant efforts, and making concessions during the chapter 11 process.

Given the number of non-debtor parties that contribute to a restructuring, and the substantial impact of a release on the rights of creditors and equity holders, bankruptcy courts place a great deal of emphasis on determining which parties are bound by third-party releases. Courts agree that third-party releases are binding on those creditors and equity holders that consent to such releases but diverge on what constitutes consent.

Delaware courts on third-party releases

Several Delaware bankruptcy judges have ruled that creditors and equity holders consent to third-party releases if they do not opt out of the releases contained in the plan solicitation materials, even where creditors and equity holders abstain by failing to vote or otherwise submit a ballot indicating whether they are opting out of the releases.¹

More specifically, procedurally, creditors and equity holders typically receive solicitation materials consisting of a ballot or a notice of nonvoting status which contains an opt-out selection box. Those who do not check the box and return the ballot or opt-out form are deemed to have consented to the third-party releases contained in the plan.

These courts have reasoned that clear and conspicuous instructions contained in the solicitation materials about how to opt out of granting third-party releases provide sufficient information and opportunity such that creditors and equity holders that fail to opt out (including through abstention) have manifested their consent to the release.

Other judges have looked at opt-out mechanisms more skeptically.² These courts have ruled that a third-party release is effective only with respect to those who affirmatively consent to it by voting in favor of a plan or returning a ballot or opt-out form and not opting out of the third-party releases; abstention by failure to return a ballot or opt-out form is not a sufficient manifestation of consent to a third-party release.

The law in Delaware therefore is unsettled. Although each case is fact-dependent, whether the court views third-party releases as consensual has a significant impact on the stakeholders participating in a chapter 11 case and advancing the chapter 11 goals of the debtor.

Recent Delaware decisions highlight opposing approaches

Two recent cases in Delaware highlight judges’ distinct views on this topic.

The debtors in In re Emerge Energy Services LP proposed a plan that included an opt-out mechanism for, among others, a class of equity interests that would receive no distribution and was therefore were deemed to reject the plan under section 1126(g) of the Bankruptcy Code and therefore not entitled to vote. In a 24-page opinion denying confirmation, The Honorable Karen B. Owens stated that the court could not be certain that those failing to return a ballot or opt-out notice understood the meaning and ramifications of such notice and, in failing to return the notice, did so intentionally to give the third-party release.³ For the court to infer consent from nonresponsive creditors and equity holders, the debtors would need to show under basic contract principles that the court could construe silence as acceptance.

Judge Owens noted the disparate positions within the District of Delaware, stating that the court held a minority position but “must respectfully disagree with its colleagues who have held differently as it has concluded that a waiver cannot be discerned through a party’s silence or inaction unless specific circumstances are present.”

Judge Owens later confirmed the debtors’ plan subject to revisions making clear that the releases were only being given by parties who “affirmatively consented” to the releases.

Shortly after Judge Owens denied confirmation in Emerge Energy Services, the debtors in In re Insys Therapeutics Inc. proposed a plan before The Honorable Kevin Gross that included an opt-out mechanism for, among others, a class of equity interests that would not receive any distribution and was therefore nonvoting and deemed to reject the plan.⁴ Under the release provisions of the plan, failure to return an opt-out form was deemed consent to the third-party release.

In an objection to the plan, the Securities and Exchange Commission (SEC) cited Emerge Energy Services and argued that the releases should be considered consensual only if the affected parties provide affirmative consent through an opt-in mechanism. The SEC further argued that because equity holders rely on brokers to receive beneficial holder ballots, the court should not assume that each class member that does not return a ballot opts to consensually relinquish its rights against third parties.

At the confirmation hearing, Judge Gross found that due to the debtors’ notoriety, creditors knew about the existence of the bankruptcy case and that they would have to act because of it. Moreover, Judge Gross stated that the proposed released parties were “very instrumental” to the settlement underlying the plan and, consequently, that the third-party releases were “essential to the plan” and would be approved over the SEC’s objection.

Uncertain future

While the majority of judges in the District of Delaware agree that opt-out mechanisms may be used to determine the deemed consent of nonresponsive creditors and equity holders, there remains a minority view that requires debtors to show that classes bound by third-party releases have affirmatively consented to provide such releases. As a result, there is likely to be continued uncertainty on this key issue, and it will affect debtors and potential plan participants whose contributions to a restructuring may be dependent on the assurance of third-party releases.