Exculpatory Clauses in Chapter 11 Plans of Reorganization

Knowing that the Ninth Circuit gives wide latitude to exculpatory language contained in Chapter 11 plans, Arizona bankruptcy practitioners should not be hesitant to navigate the waters of § 1125(e).

Chapter 11 plans of reorganization often contain provisions that limit the liability of persons involved in the plan and disclosure statement process. Authority for such immunity is found in Bankruptcy Code § 1125(e). Known as the so-called "safe harbor" provision, this section of the Bankruptcy Code is generally understood to protect any person who solicits acceptances of a plan of reorganization with a bankruptcy court-approved disclosure statement.

Section 1125(e) provides:

A person that solicits acceptance or rejection of a plan, in good faith and in compliance with the applicable provisions of this title, or that participates, in good faith and in compliance with the applicable provisions of this title, in the offer, issuance, sale or purchase of a security, offered or sold under the plan, of the debtor, of an officer participating in a joint plan with the debtor, or of a newly organized successor to the debtor under the plan, is not liable, on account of such solicitation or participation, for violation of any applicable law, rule, or regulation governing solicitation of acceptance or rejection of a plan or the offer, issuance, sale or purchase of securities.

11 U.S.C. § 1125(e). The legislative history of § 1125(e) provides limited insight into the breadth of its protections, and divergent lines of authority have developed regarding its contours. For example, in Jacobson v. AEG Capital Corp., 50 F.3d 1493, 1496 (9th Cir. 1995), the court held that "the plain language of section 1125(e) and its location in the section which outlines the procedures and requirements of disclosure and solicitation, both suggest that section 1125(e) only provides a safe harbor for the disclosure and solicitation process of a bankruptcy." Id. (emphasis added). The court additionally noted that although § 1125(e) provides a safe harbor, by its very terms, it does not protect acts carried out in bad faith. Id.

Similarly, in SEC v. Universal Express, Inc., 475 F. Supp. 2d 412, 425 (S.D.N.Y. 2007), the court noted that the purpose of § 1125(e) is to "shield from liability under the federal securities laws those individuals participating in the reorganization of an entity in bankruptcy; the purpose of protecting such activity is to encourage satisfaction of debts or other existing interests in the debtor." Id. (citing Collier on Bankruptcy, ¶ 1145.02[1][a] (15 ed. 2006); S. Rep. No. 95-989 at 122 (1978) (explaining that "exoneration" from liability under § 1125(e) is "coordinate with the exemption from . . . registration . . . requirements provided by Section 1145 of this title")).

The court further stated:

[T]he liability shield of § 1125(e) specifically applies to the disclosure and solicitation period prior to approval of a reorganization plan, when 'the investment-type decision by those called upon to accept a plan to modify their claims or interests . . . typically will involve acceptance of new securities or . . . a cash payment in lieu thereof.'

Id. (citing S. Rep. No. 95-989 at 121) (emphasis added). Therefore, "the § 1125(e) liability shield is intended to protect actors soliciting acceptance of a reorganization plan and therefore does not absolve any securities law violation arising outside the disclosure and solicitation processes." Id. (citing Jacobson, 50 F.3d at 1496; Yell Forestry Products, Inc. v. First State Bank, 853 F.2d 582, 584 (8th Cir. 1988)).

Notwithstanding the apparent limitations stated in Jacobson and Universal Express, Chapter 11 plans routinely contain language that provides for the exculpation of, among others, the debtor, its professionals, and the United States Trustee, for, among other things, acts or omissions made in connection with formulating, implementing, confirming or consummating the plan of reorganization. In the Ninth Circuit, authority for such a limitation of liability can be found in In re Western Asbestos, Co., 313 B.R. 832, 846 (Bankr. N.D. Cal 2003). There, at issue was a release provision that provided:

Neither the Plan Proponents nor any of their agents, including their attorneys, shall be liable, other than for willful misconduct, with respect to any action or omission prior to the effective date in connection with the Debtors' operations, the Plan, or the conduct of the bankruptcy case. This provision includes actions and omissions that took place before these bankruptcy cases were filed.

Id. Relying primarily on In re PWS Holding Corp., 228 F.3d 224, 245 (3rd Cir. 2000), the plan proponents in Western Asbestos contended that the provision was entirely proper, and should not be limited to the debtors, nor to acts taken post-petition. Id.

In PWS Holding, the court held that a plan provision releasing a creditors' committee and its professionals from third-party claims, other than for willful misconduct or ultra vires acts, did not violate § 524(e). Section 524(e) provides that "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." 11 U.S.C. § 524(e). The Third Circuit held that the release provision was permissible because it gave the committee and its professionals no more protection than they already had under the applicable provisions of the Bankruptcy Code. Id. at 245-46.

The plan proponents in Western Asbestos also cited In re Drexel Burnham Lambert Group, 138 B.R. 717 (Bankr. S.D.N.Y. 1992), and Vasconi & Assoc., Inc. v. Credit Manager Ass'n of Cal., CIV. 96-20994 SW, 1997 WL 383170 (N.D. Cal. 1997). In Drexel Burnham, the court upheld a release provision affecting the members of an equity security committee and its counsel, other than for willful misconduct, because, according to the court, the release provision "merely stated applicable law." Western Asbestos, 313 B.R. at 846 (summarizing Drexel Burnham, 138 B.R. at 722). The court concluded that the committee and its counsel had limited immunity from such claims. Id.

Similarly, in Vasconi, the court affirmed the dismissal of an adversary proceeding against the members of a creditors' committee for breach of fiduciary duty and negligence in their implementation of a confirmed plan. Vasconi, 1997 WL 383170, at *5. Citing a provision in the plan of reorganization that insulated the creditors' committee from liability unless the committee's actions amounted to gross negligence or willful misconduct, the court held that "it is clear from both the bankruptcy code and the Plan that Appellees are afforded qualified immunity for all actions falling within the scope of their authority." Id. at *4.

The objectors in Western Asbestos contended that the Ninth Circuit views such provisions with disfavor, citing In re WCI Cable, Inc., 282 B.R. 457, 477 (Bankr. D. Or. 2002). In WCI Cable, the court, however, approved two release provisions in a Chapter 11 plan. Id. The WCI Cable court concluded that the provision releasing the creditors' committee (but not its professionals) from liability, other than for willful misconduct and ultra vires acts, merely accurately stated the law. Western Asbestos, 313 B.R. at 847 (citing WCI Cable, 282 B.R. at 476-77). While expressing some concerns about the provision releasing the plan proponents, and their officers, directors, and professionals, the WCI Cable court ultimately approved the release, provided that it was modified to apply only to post-petition acts Id. (citing WCI Cable, 282 B.R. at 479).

Thus, the only issue that remained in Western Asbestos was whether it was appropriate for the release to apply to pre-petition acts. The court ultimately held that the release provisions were overbroad, but not to the extent contended by the objectors. Id. Based on the authorities recited above, the court concluded that the release provisions could permissibly include all of the plan proponents and their agents, including their professionals, and may apply to pre-petition, as well as post-petition acts. Id.

Bankruptcy courts in Arizona would likewise hold that § 1125(e) permits the broad protections approved by the Western Asbestos court. Exculpatory clauses that, for example, focus only on post-petition acts and omissions made in good faith, would likely not run afoul of § 524(e), because any such release is not dependent on the debtor's discharge. Accordingly, knowing that the Ninth Circuit gives wide latitude to exculpatory language contained in Chapter 11 plans, Arizona bankruptcy practitioners should not be hesitant to navigate the waters of § 1125(e).