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Legislative Update: The Nondebtor Release Prohibition Act of 2021

Article

The Business Advisor

November 17, 2021

On July 28, 2021, United States Representatives Jerrold Nadler (D–NY) and Carolyn B. Maloney (D–NY) and United States Senators Elizabeth Warren (D–MA), Dick Durbin (D–IL), and Richard Blumenthal (D–CT) introduced the Nondebtor Release Prohibition Act of 2021 (S. 2497) (NRPA), which proposes to amend the Bankruptcy Code to (i) prohibit the use of non-consensual third party releases; (ii) limit section 105 junctions to stay lawsuits against third parties for no more than 90 days from the petition date; and (iii) provide a ground for dismissing a bankruptcy case commenced by a debtor that was formed within 10 years prior to the petition date via a divisional merger that separated material assets from liabilities. Although the NRPA was introduced in response to testimony criticizing the third-party releases and injunctions proposed in the USA Gymnastics and Purdue Pharma cases, the NRPA’s provisions are not limited to the mass tort context and, if enacted, would have significant implications for all chapter 11 cases. On November 3, 2021, the House Judiciary Committee voted at a markup hearing to send the bill to the full House of Representatives for consideration.

The use of consensual and non-consensual third-party releases in chapter 11 plans is a common feature in most chapter 11 cases, due to the fact that most chapter 11 plans are funded by the consideration provided by the released parties in return for such releases. Unlike a release given by a chapter 11 debtor, a third-party release extinguishes claims held by non-debtor third parties against other non-debtor third parties. Third-party releases can be divided into two categories: (1) voluntary, where the party has consented, usually by some affirmative act, to the imposition of a third-party release; and (2) involuntary, where a nondebtor party is made to release its claims without its consent. Involuntary or non-consensual third-party releases are more controversial and, therefore, subject to more rigorous review by the courts before they can be approved. If passed, the NRPA would narrow the scope of third-party releases and prohibit the non-consensual third-party releases in their entirety. The NRPA’s restrictions would broadly apply to court approval of “any provision, in a plan of reorganization or otherwise, for the discharge, release, termination, or modification of,” or any order granting, “the discharge, release, termination, or modification of” the liability of a nondebtor or its property for any “claim or cause of action of an entity other than the debtor or the estate,” as well as any injunction of such third-party claims or causes of action.

With respect to consensual releases, the NRPA requires that, for a third-party release to be deemed consensual as to a party, that party must “expressly consent in a signed writing.” Additionally, consent must be given after notice that is “clear and conspicuous” and “in language appropriate for the typical holder of such claim or cause of action,” and the party must not be treated more or less favorably under a plan “by reason of” such party’s consent or refusal to consent. If a third-party release or injunction does not qualify as consensual under the NRPA’s strict standard, such relief would be prohibited, subject to limited, specific exceptions. Certain of these exceptions, such as those preserving courts’ ability to authorize “free and clear” sales and prevent third parties “from exercising control over or otherwise interfering with a right or interest (including a claim or cause of action) that is property of the estate,” are narrow and would prohibit many of the third-party releases and injunctions currently seen in most chapter 11 cases.

In addition to the limitations with respect to third-party releases, the bill would require the dismissal of any bankruptcy filed after an entity undergoes a divisional merger under Texas or Delaware law – the so called “Texas two-step.” This process involves converting a business entity into a Texas organization and subsequently splitting it into two or more separate entities, with the bulk of the tort or other liabilities allocated to one entity. Subsequently, the entity holding such liabilities files chapter 11 in an effort to achieve a global resolution of the claims.

The Texas two-step is made possible by the Texas Business Organizations Code, which defines a “merger” to include “the division of a domestic entity into two or more new domestic entities or other organizations.” At its core, a divisive merger is similar to a traditional merger. The agreement and plan of merger must clearly identify the assets and liabilities allocated to each entity involved. The Texas two-step has been utilized by several companies facing mass tort liabilities resulting from asbestos and other types of exposure. Companies such as LTL Management (formed by Johnson & Johnson to address talc liabilities) to Bestwall and Aldrich Pump LLC filed chapter 11 after each was created using the divisive merger statute. Similarly, DBMP LLC, another company facing asbestos liability, filed chapter 11 after it was created by its predecessor entity upon confirmation of the predecessor’s chapter 11 plan, which included a divisional merger support agreement.

The NRPA, if enacted, will likely limit the ability of chapter 11 debtors to restructure their debts. Although non-consensual third-party releases and the use of the Texas two-step are controversial subjects, bankruptcy courts around the country are well equipped to make sure use of these tools is not subject to abuse. Gibbons will monitor this legislation and provide updates should the bill advance in Congress.