The U.S. House of Representatives Judiciary Committee recently passed legislation that would limit relief available in bankruptcy proceedings. The legislation, known as the Nondebtor Release Prohibition Act of 2021 (“NRPA”), focuses on protections sometimes extended to “nondebtors” or entities that did not seek bankruptcy protection but are affiliated with a bankrupt company or “debtor.”1
Bankruptcy Courts have, on occasion, extended protections to nondebtors, either in the form of a release of claims or stay of litigation, in order to facilitate the restructuring of their bankrupt affiliates. Motivated in part by media coverage of the Purdue Pharma and other mass tort bankruptcy cases, the NRPA was introduced to limit nondebtor relief by significantly reducing the availability and scope of nondebtor releases and injunctions. This legislation also provides for the mandatory dismissal of Chapter 11 cases where the debtor was involved in a “divisional merger,” or effectively separated its assets from its liabilities, within a ten-year period prior to the bankruptcy.
Nondebtor releases are a device used in Chapter 11 plans of reorganization. Simply put, a Chapter 11 plan is a document that provides for, among other things, the distribution of assets and discharge of claims against the debtor. Nondebtor releases relieve nondebtors of claims and liability owed to third parties, such as creditors of the debtor.2 When nondebtors are provided with releases, it is usually in consideration for a substantial contribution of money or other resources to facilitate the debtor’s reorganization. Such releases may be consensual, with the creditor’s knowledge and consent, or non-consensual and approved over the creditor’s objection.
There is a split of authority among the courts as to whether non-consensual nondebtor releases are permissible. Some courts have concluded that such releases may be authorized under the equitable provisions of the Bankruptcy Code, namely 11 U.S.C. § 105.3 Others have found that the Bankruptcy Code expressly prohibits any discharge or release in favor of nondebtors.4 The NRPA seeks to resolve this conflict by prohibiting nondebtor releases unless the affected third party receives clear and conspicuous notice and expressly consents in a signed writing to the release of its claim.5
Third Party Litigation Stays
While nondebtor releases are undoubtedly the centerpiece of this bill, the NRPA includes other provisions that could affect bankruptcy proceedings and may otherwise limit access to bankruptcy protection. Bankruptcy Courts have the discretion, again under the equitable provisions of section 105 of the Bankruptcy Code, to temporarily enjoin or stay litigation against a nondebtor. Stays in favor of nondebtors are sometimes granted where the continued prosecution of the litigation would impair a debtor’s ability to reorganize.6 Bankruptcy Courts currently have the discretion to determine the duration and scope of such stays; however, the NRPA proposes to limit the duration of any stay to 90 days after the stay order unless the creditor consents to a longer period or an appeal from the stay order is adjudicated within the 90 day period.7
Mandatory Dismissal Following Divisional Mergers
Lastly, the NRPA includes provisions that would require a Bankruptcy Court to dismiss a Chapter 11 proceeding if, within the ten-year period prior to the bankruptcy filing, the debtor engaged in a “divisional merger” or transaction that was designed to separate its assets from liabilities. Specifically, the proposed language provides that a Bankruptcy Court must dismiss a bankruptcy case if the debtor, or a predecessor of the debtor, was the subject of a divisional merger or “equivalent transaction” that had “the intent or foreseeable effect” of “separating material assets from material liabilities” and “assigning or allocating a substantial portion of those liabilities to the debtor.” This provision is clearly intended to preclude debtors from divesting assets before seeking bankruptcy protection and hence minimizing the opportunity for meaningful creditor recovery.8
To be sure, this bill has its critics and proponents. Opponents envision that the legislation will substantially and adversely impact bankruptcy proceedings by eliminating contributions from the nondebtor parties.9 The bill’s proponents argue that: (i) nondebtor releases are expressly prohibited under the Bankruptcy Code: and (ii) a company or individual should not receive the benefits of bankruptcy, namely a release of claims and stay of litigation, without filing for bankruptcy and being subject to the requirements of the Bankruptcy Code. Bankruptcy Courts may also have difficulty interpreting the mandatory dismissal provisions. Analysis of a transaction ten years after the fact to determine whether a foreseeable effect of the transaction was to separate material assets from material liabilities is a difficult task and may lead to unintended consequences.