A McHenry County judge ruled Robert and Judith Stevens’ lawsuit against James Dobbs was barred by a settlement agreement that was approved by a bankruptcy judge in Woodfield Planning Corp.’s Chapter 7 case, even though the two refused to sign the agreement. And the Illinois Appellate Court — noting that U.S Circuit Courts of Appeal “are divided over whether a bankruptcy court may issue a nondebtor release and enjoin a non-consenting party who has participated fully in the bankruptcy proceedings but who has objected to the nondebtor release” — affirmed summary judgment for Dobbs based on the “majority view.” Stevens v. Woodfield Planning Corp., 2020 IL App (2d) 190218-U (February 26, 2020).

Woodfield Planning petitioned for bankruptcy protection after the plaintiffs sued Woodfield and Dobbs, its president, “for alleged wrongdoing in procuring plaintiffs’ mortgage loans,” Justice Michael J. Burke recounted.

Here are highlights of Burke’s Rule 23 decision (with light editing and omissions not noted):

The material facts regarding the bankruptcy proceeding are not disputed. Plaintiffs filed a creditor’s claim and participated.

The trustee met with the parties and suggested that Dobbs, individually, pay $25,000 to settle plaintiffs’ claim. After the meeting, plaintiffs objected by e-mail but did not file a formal objection in the proceeding.

The agreement expressly mentioned this action and the release of plaintiffs’ claim against defendants. Dobbs signed the document twice: individually and as president of Woodfield Planning. The bankruptcy court approved the agreement, and plaintiffs accepted the payment and cashed the check.

Under special circumstances, bankruptcy courts have approved agreements that enjoin a non-consenting party from making claims against a nondebtor that would undermine the operations of the reorganized entity.

Assuming arguendo that plaintiffs did not consent to the agreement because they did not sign it and objected informally, the majority view is that the bankruptcy court nevertheless was authorized to approve the agreement releasing Dobbs from liability for plaintiffs’ claim, even though he was a nondebtor.

Federal circuit courts are divided over whether a bankruptcy court may issue a nondebtor release and enjoin a non-consenting party who has participated fully in the bankruptcy proceedings but who has objected to the nondebtor release. In re Seaside Engineering & Surveying, 780 F. 3d 1070 (11th Cir. 2015).

The minority view is that nonconsensual, nondebtor releases are foreclosed by Section 524(e) of the Bankruptcy Code, which provides in relevant part that “the 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.”

However, the majority of circuits, including the 7th U.S. Circuit Court of Appeals, hold that nondebtor releases or injunctions are permitted, under certain circumstances. Seaside Engineering, 780 F. 3d at 1078 (citing In re Airadigm Communications, 519 F.3d 640 (7th Cir. 2008)).

In Seaside Engineering, the 11th Circuit Court of Appeals endorsed the majority view, relying on the wide latitude granted to bankruptcy courts by Section 105(a) of the Bankruptcy Code, which provides as follows:

“The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title. No provision of this title providing for the raising of an issue by a party in interest shall be construed to preclude the court from, sua sponte, taking any action or making any determination necessary or appropriate to enforce or implement court orders or rules, or to prevent an abuse of process.”

The 11th Circuit explained that Section 105(a) authorizes the bankruptcy court to enter the nondebtor release where the settling defendant provides funds for the bankruptcy estate, but would not have entered into the settlement in the absence of such release, and where the bankruptcy court found that the settlement was fair and equitable. Seaside Engineering, 780 F. 3d at 1078 (citing In re Munford, 97 F. 3d 449 (11th Cir. 1996)).

The Seaside Engineering court agreed with the 7th Circuit that “the natural reading of Section 524(e) does not foreclose a third-party release from a creditor’s claims.” Seaside Engineering, 780 F. 3d at 1078 (quoting In re Airadigm Communications, 519 F.3d 640 (7th Cir. 2008)).

Pursuant to Section 524(e), the discharge of the debtor’s debt does not itself affect the liability of a third party, but Section 524(e) says nothing about the authority of the bankruptcy court under Section 105(a) to release a nondebtor from a creditor’s claims. Seaside Engineering, 780 F. 3d at 1078.

“As the Airadigm court noted, if Congress had meant to limit the powers of bankruptcy courts, it would have done so clearly, as it did in other instances, or it would have done so by creating requirements for plan confirmation as in Section 1129(a).” Seaside Engineering, 780 F. 3d at 1078 (citing 11 U.S.C. Sec. 1129(a) (“The court shall confirm a plan only if the following requirements are met...”)).

In agreement with Airadigm, Seaside Engineering and Munford we reject the minority position that Section 524(e) bars nonconsensual, nondebtor releases. Although the statute provides that “discharge of a debt of the debtor does not affect the liability of another entity on... such debt,” it does not expressly preclude the approval of a settlement agreement that does so.

We agree with the view that such agreements are authorized by Section 105(a), which codifies the established law that a bankruptcy court “applies the principles and rules of equity jurisprudence.” Seaside Engineering, 780 F. 3d at 1078.

However, we also adhere to the corollary that nondebtor releases should be reserved for those unusual cases where enjoining claims against a nondebtor is necessary for the success of the debtor, and only in situations in which such an order is fair and equitable under all the facts and circumstances. See Seaside Engineering, 780 F. 3d at 1079.

A seven-factor test guides a bankruptcy court when deciding whether a nondebtor release from a creditor’s claim is appropriate:

“When the following seven factors are present, the bankruptcy court may enjoin a non-consenting creditor’s claims against a non-debtor: (1) 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 (2) The non-debtor has contributed substantial assets to the reorganization (3) 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 (4) The impacted class, or classes, has overwhelmingly voted to accept the plan (5) The plan provides a mechanism to pay for all, or substantially all, of the class or classes affected by the injunction (6) The plan provides an opportunity for those claimants who choose not to settle to recover in full and (7) The bankruptcy court made a record of specific factual findings that support its conclusions.” Seaside Engineering, 780 F. 3d at 1079 (quoting In re Dow Corning, 280 F. 3d 648 (6th Cir. 2002)).

Bankruptcy courts should have discretion to determine which of the Dow Corning factors are relevant in each case. Seaside Engineering, 780 F. 3d at 1079. The factors should be considered a nonexclusive list of considerations to be applied flexibly, always mindful that nondebtor releases should be used cautiously and infrequently and only where essential, fair, and equitable. Seaside Engineering, 780 F. 3d at 1079.

In this case, there was an identity of interest between Woodfield Planning and Dobbs such that plaintiffs’ suit against one essentially was a suit against the other. The agreement provided a mechanism to pay plaintiffs, who were effectively enjoined by the release.

Plaintiffs were parties to the settlement negotiation, and despite their objection by e-mail, they did not file a formal objection in the bankruptcy proceeding.

Despite their mild protestations, plaintiffs accepted the $25,000 payment from Dobbs and cashed the check. Dobbs provided these funds on behalf of the bankruptcy estate and joined as a party to the agreement in exchange for the release from liability for plaintiffs’ claims in this action.

The release was fair and equitable, as shown by plaintiffs’ acceptance of the payment. Under these unusual circumstances, plaintiffs were bound by the agreement releasing defendants from liability.

Plaintiffs assert that, to the extent that Airadigm and cases like it permit nondebtor releases, such agreements are appropriate in Chapter 11 bankruptcies only. Plaintiffs conclude that the summary judgment for Dobbs is not supported by the agreement, because Woodfield Planning’s bankruptcy was filed under Chapter 7.

Plaintiffs have not adequately articulated a basis for distinguishing filings under the two chapters.

Although Airadigm, SeasideEngineering and Munford involved Chapter 11 bankruptcies, plaintiffs cite no authority for the proposition that a nonconsensual release of a nondebtor may not be entered in a bankruptcy filed under Chapter 7.

The pro-release and anti-release theories discussed in these cases are based on Section 105(a) and Section 524(e), respectively, not on any section of Chapter 11. Plaintiffs do not explain how these sections apply differently to Chapter 7 filings, or why the principles and rules of equity jurisprudence, codified in Section 105(a), must be curtailed in such filings.

Construing the pleadings, depositions, admissions and affidavits strictly against Dobbs and liberally in favor of plaintiffs, we conclude that there is no genuine issue as to any material fact and that Dobbs was entitled to judgment as a matter of law. Reasonable persons would not draw different inferences from the undisputed facts about whether the agreement is fair and reasonable.