Courts frequently approve chapter 11 plans containing a general release designed to protect third parties, such as the debtor's officers, directors, shareholders, and specified others, from claims related to the debtor that may be asserted against them after confirmation of the debtor's plan. However, because a chapter 11 discharge is intended for the benefit of the debtor, courts generally exercise considerable care in the granting and enforcement of nondebtor releases. In Applewood Chair, the Fifth Circuit answered in the negative the narrow question of whether a general release is sufficient to extinguish the liability of a director and a shareholder of a chapter 11 debtor on a personal guaranty of a loan to the debtor.
Approximately four months before filing for chapter 11 relief, Applewood Chair Company borrowed a large sum of money from Three Rivers Development District. The loan was secured by an interest in all equipment, parts, and inventory of Applewood Chair. Ronnie Spivey, the president of Applewood Chair, and his wife, Margaret Spivey, a shareholder, were co-borrowers on the loan and executed an agreement granting Three Rivers a mortgage lien on their own real property as guaranty for the loan.
After Applewood Chair filed under chapter 11, a company subsequently named Applewood Furniture Industries purchased its assets and assumed its indebtedness to Three Rivers. Under the terms of the purchase agreement, the purchaser did not assume the individual indebtedness of the Spiveys under the promissory note and mortgage agreement; nor did Three Rivers release that indebtedness. Thus, the order approving the sale left unaffected Three Rivers' security interest in its collateral and the Spiveys' personal guaranty of the loan to Applewood Chair. Applewood Chair's chapter 11 plan was subsequently confirmed.
Less than one year after the completion of the transfer of assets and the Three Rivers loan obligation from Applewood Chair to Applewood Furniture, Applewood Furniture defaulted on the Three Rivers loan, and the Spiveys defaulted on their payment obligations under the loan guaranty. When Three Rivers called upon Applewood Furniture to pay the remaining indebtedness, it learned that Applewood Furniture was out of business. Moreover, Three Rivers was unable to enforce its security interest in the equipment, as the parts and inventory serving as its collateral were nowhere to be found.
Three Rivers looked to the mortgage lien on the Spiveys' property that guaranteed the loan. The Spiveys asserted that the confirmation of Applewood Chair's chapter 11 plan, which discharged the debts owed by Applewood Chair to its creditors, also discharged Applewood Chair's officers, directors, and shareholders from any debt owed to parties involved in the chapter 11 case. The Spiveys reasoned that because Ronnie Spivey was a director and Margaret Spivey was a shareholder, claims against them held by creditors of Applewood Chair had been released. Three Rivers suspended efforts to foreclose on the Spiveys' property and filed a motion for clarification on the issue.
The bankruptcy court ruled that its order approving the sale of Applewood Chair's assets and the subsequent order confirming Applewood Chair's chapter 11 plan contained "insufficient language and were not intended" to release the individual indebtedness of the Spiveys to Three Rivers. The district court affirmed the bankruptcy court's order, and Applewood Chair appealed the decision to the Fifth Circuit.
On appeal, the Spiveys argued that any action by Three Rivers to enforce the Spiveys' guaranty was barred by res judicata, a judicial doctrine pursuant to which a competent court's judgment on the merits is conclusive and absolutely bars any subsequent action by the parties involving the same cause of action. The Spiveys contended that confirmation of Applewood Chair's chapter 11 plan, which included a general release, barred Three Rivers from asserting its claim against the Spiveys under the theory of res judicata.
The Fifth Circuit cited the general rule set forth in section 524(e) - that a discharge in bankruptcy of the debtor's debts does not affect a guarantor's liability. For the Spiveys to prevail, they would need to rely on an exception to this general rule, and they based their argument on a well-known Fifth Circuit decision, Republic Supply v. Shoaf. In that case, the Fifth Circuit had "held that the confirmation of a clear and 'unambiguous plan' of reorganization that 'expressly released' a third-party guarantor has a res judicata effect on a subsequent action against the guarantor who is also a creditor." The Spiveys noted that the general release in Applewood Chair's confirmation order discharged the debtor, "its officers, shareholders and directors from all claims that arose prior to Confirmation." Because Mr. Spivey was an officer, director, and shareholder, and Mrs. Spivey was a shareholder, the Spiveys argued that any claims against them were discharged by the general release and, therefore, the Shoaf rationale applies to their case.
The Fifth Circuit found the facts in Shoaf distinguishable from the facts in this case and rejected the Spiveys' argument. The court noted that in Shoaf, the court-approved reorganization plan expressly provided for the release of a third-party guarantor who was also a creditor. Because the confirmation order had expressly released Shoaf's guaranty, the order was accorded res judicata effect. In contrast, the release the Spiveys relied upon was merely a general release that did not expressly designate the Spiveys' mortgage lien as the subject of the release. The Fifth Circuit pointed out that a specific discharge or release of the Spiveys' individual guaranty was not discussed in the bankruptcy proceedings, nor was it enumerated or approved by the bankruptcy court. Moreover, the Fifth Circuit observed that a lender obtains a loan guaranty for the specific purpose of ensuring an alternative source of repayment if the borrower's debt is discharged in bankruptcy. Therefore, allowing a guaranty to be discharged by the confirmation of a reorganization plan would defeat the purpose of a loan guaranty.
The decision in Applewood Chair makes clear that the general rule of Bankruptcy Code section 524(e) will only be abrogated to discharge a guaranty of a nondebtor third party in those narrow circumstances where a plan of reorganization contains a specific discharge of the indebtedness of the third party. In cases where creditors or shareholders object to a release of a nondebtor, courts that may approve such a release generally consider the existence of special factors, such as the identity of interest between the debtor and the third party, a substantial contribution to the reorganization or additional consideration provided to creditors in exchange for the release, or the necessity for the release to a successful reorganization. Moreover, in certain jurisdictions, courts have narrowly construed section 524(e) and have held that releases of nondebtor third parties under a plan of reorganization are not enforceable as a matter of law.
Applewood Chair Co. v. Three Rivers Planning & Dev. Dist. (In re Applewood Chair Co.), 203 F.3d 914 (5th Cir. 2000).
Republic Supply v. Shoaf, 815 F.2d 1046 (5th Cir. 1987).