U.S. Trustee’s Unreasonable Crusade Against All Third-Party Releases: The Latest Example (In re Kalos)

The U.S. Trustee is on a crusade to eradicate every type of third-party release from all Chapter 11 bankruptcy plans—no matter what the facts or circumstances might be.

It’s a policy based on the idea that, if the Bankruptcy Code doesn’t specifically and explicitly authorize something, then that something cannot be done . . . ever . . . under any circumstances . . . no matter what . . . period . . . end of story.

We now have another manifestation of that bright-line and unyielding position. Fortunately, the Bankruptcy Court rejects the U.S. Trustee’s objection.

In this case:

virtually every creditor that could conceivably be affected by a third-party release in a Subchapter V plan votes to accept the plan;
no creditor opposes the plan; but
still, the U.S. Trustee objects to the third-party release, by manufacturing the idea of an unknown creditor who might be affected and does not have the opportunity to consent.

This is unreal!

The opinion is In re Kalos Capital, Inc., Case No. 22-58326, Georgia Bankruptcy Court (issued October 31, 2023; Doc. 133). What follows is a summary.

Overview

This is a Subchapter V case. Debtor’s principals propose to fund a Chapter 11 plan in exchange for third-party releases for themselves. The third-party releases are similar to those in newsworthy mass tort bankruptcies—but without complicating factors like unknown or future claimants.

All voting creditors accept the plan, and the plan is set for consensual confirmation.

Nonetheless, the U.S. Trustee objects to confirmation of Debtor’s plan because of the releases.

The Court rules that, under the evidence and Eleventh Circuit law, the releases are appropriate. And so, the Court confirms the plan.

Debtor’s History

Debtor was a securities broker-dealer registered with the Securities and Exchange Commission and a member of the Financial Industry Regulatory Authority.

Among Debtor’s offerings were non-public investments in entities related to GPB Capital Holdings, LLC. In June 2018, GPB was unable to complete its financial audits and failed to file a timely registration statement with the SEC.

Since 2019, Debtor has received arbitration demands from several brokerage clients relating to the GPB offering. All arbitrations name Debtor as respondent, but some also name Debtor’s principals (who haven’t filed bankruptcy).

Unable to afford increasing legal expenses for the arbitrations, Debtor decides to wind down its business and liquidate its assets through a Subchapter V process.

The Bankruptcy

Debtor files its Subchapter V petition on October 17, 2022, and on that same day initiates an adversary proceeding within the bankruptcy to enjoin claimants from continuing the arbitration proceedings against non-debtor principals until confirmation of Debtor’s plan.

The Bankruptcy Court enters a temporary restraining order and, after trial, issues a preliminary injunction barring claimants from pursuing their arbitration claims against non-debtor principals until the Court confirms a plan or orders otherwise.

Mediated Settlement

The Bankruptcy Court orders the parties into mediation.

After a months-long mediation process between Debtor, the non-debtor principals and arbitration claimants holding over $6.7 million in filed claims:

The non-debtor principals agree to contribute $1.3 million to the plan for distribution to creditors; and
in exchange, receive a release of liabilities from claims arising from or in connection with Debtor, its business operations, or its bankruptcy case.

Plan

Then, Debtor files a plan incorporating the mediated settlement. The plan provides:

settling creditors will divide among themselves $1 million of the $1.3 million contribution and forego any further plan distribution—this reduces the face value of general unsecured claims from over $11 million to less than $5 million; and
the remaining general unsecured creditors, the vast majority of which are non-settling arbitration claimants, will receive the remainder of the $1.3 million contribution plus Debtor’s other available assets valued at $1.175 million.

Votes

All voting claimants in each class of claims accept the plan, and no ballot rejecting the plan is cast.

Here are some voting details:

All eligible creditors in the following classes vote to accept the plan—Class 1 (Debtor’s former employees with priority claims), Class 3 (creditors who settled in mediation), and Class 4 (Debtor’s equity holder); and
In Class 2 (general unsecured creditors other than investors), 17 of the 38 eligible voters accept the plan, and the remaining 21 do not vote.

Of the 21 in Class 2 who do not vote:

1 withdraws its claim;
8 are taxing authorities, ordinary course vendors and service providers not subject to the third-party releases; and
of the remaining 12, at least 11 are represented by legal counsel in this bankruptcy, and none has asserted a claim against any of the non-debtor principals.

U.S. Trustee’s Objection

The U.S. Trustee objects to plan confirmation, arguing:

the Bankruptcy Court does not have statutory authority to grant nonconsensual third-party releases;
granting the third-party releases would violate due process; and
Debtor fails to show that the facts of the case warrant the releases under applicable Eleventh Circuit law.

The Bankruptcy Court overrules this objection. What follows is a summary of the Court’s rationale for doing so.

Statutory Authority

Circuits are split on whether bankruptcy courts have authority to enjoin third-party claims against non-debtors as part of a Chapter 11 plan.

The Fifth, Ninth, and Tenth Circuits prohibit nonconsensual third-party releases solely by their interpretation of § 524(e), which states 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.” They reason:
- “Congress did not intend to extend such benefits to third-party bystanders,” especially those that have not fully opened their books and records to their creditors; and
- one must submit to the entire bankruptcy process to receive a discharge of their debts.
The Eleventh Circuit and majority of other circuits (including the Second, Seventh, and Sixth Circuits) do not interpret § 524(e) to bar such releases. They reason:
- although § 524(e) provides that debtor’s discharge of a debt does not affect a third party’s liability on the debt, the section “says nothing about the authority of the bankruptcy court to release a non-debtor from a creditor’s claims”; and
- they read § 524(e) to demarcate the effect of a discharge of a debtor’s debt rather than to delimit a bankruptcy court’s equitable powers relative to third parties.

Statutory authority for third-party releases (according to Eleventh Circuit law) arises from the following two sections:

§ 105(a) provides bankruptcy courts equitable powers to confirm a plan containing nonconsensual third-party releases under appropriate circumstances; and
§ 1123(b)(6) provides that “a plan may . . . include any other appropriate provision not inconsistent with the applicable provisions of this title.”

These two statutes (§ 105(a) and 1123(b)(6)) taken together permit bankruptcy courts “to release third parties from liability to participating creditors if the release is ‘appropriate’ and not inconsistent with any provision of the bankruptcy code.”

Due Process

Just in case its direct attack on third-party releases fails, the U.S. Trustee adds a due process argument.

In a single sentence, the U.S. Trustee argues that the Fifth Amendment’s Due Process Clause prohibits third-party releases “absent proper notice and a hearing.”

Such due process concerns, in the U.S. Trustee’s argument, pertain to a hypothetical former client of Debtor who may have a claim against the released parties but is not yet aware of such claim.

The procedural due process standard involves a two-part inquiry: (1) whether a party was deprived of a protected interest, and, if so, (2) what process was the party due.

Under this standard, the Bankruptcy Court declares:

the released causes of action in this case are a constitutionally protected property interest; and
so, the question is whether the hypothetical former client was given adequate notice and opportunity to be heard.

Due process requires notice that is (i) reasonably calculated to reach all interested parties, (ii) reasonably conveys the required information, and (iii) gives the parties reasonable time to respond.

Such requirements are satisfied in this case, the Bankruptcy Court concludes, because:

The proposed releases have been a conspicuous feature of Debtor’s bankruptcy since day one;
On multiple occasions, notices were sent via first class mail to all of Debtor’s potential claimants, including all former customers, contract counterparties, and trade creditors, containing conspicuous language describing the releases; and
The U.S. Trustee is unable to describe with any specificity any former customers that may have unknown or future claims against the non-debtor principals, or the nature of those potential claims.

Moreover, Debtor was a broker-dealer with a limited group of potential claimants.

Dow Corning Factors

The Eleventh Circuit has cautioned that nonconsensual third-party releases “ought not to be issued lightly and should be reserved for those unusual cases in which such an order is necessary for the success of the reorganization, and only in situations in which such an order is fair and equitable under all the facts and circumstances.”

To aid in determining whether this is one of those “unusual cases,” the Eleventh Circuit provides a seven-factor test set forth by the Sixth Circuit in Dow Corning. Under this test, a bankruptcy court may enjoin a nonconsenting creditor’s claims against a non-debtor if the following seven factors weigh in favor of granting the injunction:

There is an identity of interests between the debtor and the third party, usually an indemnity relationship, such that a suit against the non-debtor is, in essence, a suit against the debtor or will deplete the assets of the estate;
The non-debtor has contributed substantial assets to the reorganization;
The injunction is essential to reorganization, namely, the reorganization hinges on the debtor being free from indirect suits against parties who would have indemnity or contribution claims against the debtor;
The impacted class, or classes, has overwhelmingly voted to accept the plan;
The plan provides a mechanism to pay for all, or substantially all, of the class or classes affected by the injunction;
The plan provides an opportunity for those claimants who choose not to settle to recover in full; and
The bankruptcy court made a record of specific factual findings that support its conclusions.

The Bankruptcy Court’s opinion, in a lengthy analysis, applies the evidence to each of these seven factors and decides:

the facts of this case support approving the releases as part of Debtor’s plan.

Conclusion

The In re Kalos Capital, Inc., case discussed above is the latest example of how the U.S. Trustee’s inflexible, bright-line crusade against third-party releases is unreasonable, extreme and bad policy.

Here’s hoping the U.S. Supreme Court reigns in the U.S. Trustee’s crusade on this issue.

** If you find this article of value, please feel free to share. If you’d like to discuss, let me know.