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Two recent decisions by U.S. District Courts have rejected attempts to include nonconsensual third party releases in chapter 11 reorganization plans.  These rulings suggest third party releases may be facing increasing push back from the courts.

Traditionally, bankruptcy only operates to eliminate claims held by creditors against the debtor.  Over the last few years, however, corporate debtors have increasingly attempted to include nonconsensual third party releases in chapter 11 plans of reorganization.  These third party releases, when approved by the bankruptcy court, operate to preclude creditors of the debtor from pursuing claims they possess against non-debtor third parties.  Despite being increasingly found in chapter 11 restructurings, however, third party releases have remained controversial and the subject of heated debates, both inside and outside the courtroom.

In the best of times, a chapter 11 reorganization is an uncertain and stressful process for all involved. When the disruptive effects of COVID-19 are added to the mix, and many businesses face significant economic difficulties, one can begin to appreciate the daunting task facing bankruptcy courts, debtors, creditors, and their lawyers.

On October 11, 2016, Martin Smith petitioned the Supreme Court for a writ of certiorari to review a decision by the Ninth Circuit. After Smith failed to file a timely tax return, the IRS assessed a deficiency against him. Smith filed a belated Form 1040, and the IRS determined he owed an additional $60,000 in taxes. By this time, Smith was unemployed and insolvent, and ultimately filed for bankruptcy. The opportunity for Smith to discharge his tax debt rests exclusively on the interpretation of two terms in the relevant statute.

Accept an unpalatable offer, or reject it and risk getting much less (or even nothing)? This is the choice stakeholders in chapter 11 bankruptcies increasingly face as a result of the proliferation of “deathtrap” provisions in plans of reorganization. For example, a class of bondholders may be forced to decide between accepting 60 cents on the dollar if they vote to accept a plan, or 40 cents if they reject. A class of equityholders may have to decide between accepting equity warrants, or rejecting and getting nothing. Adding to the paralysis of being confronted with a deathtrap is the reality that there is surprisingly little authority on whether, and under what conditions, such provisions are enforceable under the Bankruptcy Code. The authorities that do exist are split on this question—emboldening debtors seeking to precipitate chapter 11 settlements while leaving impaired classes of stakeholders to decry deathtraps as “draconian” and “coercive” mechanisms.