Articles

Rewarding Good Behavior: Courts Should Approve Exculpation for the Pre-Petition Conduct of RSA Parties

Originally published by American Bankruptcy Institute Journal 

Exculpation is a standard—but often overlooked—component of chapter 11 plans. Exculpation clauses typically appear alongside a plan’s more talked-about release provisions, such as debtor releases and third-party releases, but they offer a distinct form of protection. Whereas releases protect debtors or third parties from liability for certain pre-petition conduct, exculpation clauses protect estate fiduciaries, including the debtor, the official committee of unsecured creditors, and their advisors, from liability for conduct related to the reorganization process.[1] 
 
The rationale for exculpation is straightforward: if you contribute to or participate in the debtor’s reorganization efforts, you should not face liability for your good-faith efforts. This protection fosters a fair, transparent restructuring process by reducing barriers to entry and incentivizes stakeholders to play a part in the development of a confirmable plan. Without exculpation, key creditors and competent professionals may shy away from the bankruptcy process, which would undermine the main purpose of chapter 11–achieving a successful restructuring.
 
Narrow Exculpation Is the Norm

The standard exculpation provision in many chapter 11 cases today features two limitations.[2]  First, exculpation only covers estate fiduciaries and their employees or agents.[3] As the Third Circuit Court of Appeals has explained, because an official committee has a fiduciary duty to the estate, it has immunity under 11 U.S.C. § 1103(c) “for actions within the scope of [its] duties” and are liable for its own “willful misconduct or ultra vires acts.”[4] The group of fiduciaries extends to “estate professionals, the [c]ommittees and their members, and the [d]ebtors’ directors and officers.”[5]  
 
Second, the exculpation clause is temporally limited, extending only to the estate fiduciaries’ post-petition conduct in connection with the chapter 11 case.[6] The temporal guardrail functions as a bracket. Exculpated parties receive protection for their actions beginning on the petition date and continuing through the plan’s effective date.[7] This limitation dovetails with the exculpated parties’ status as estate fiduciaries, with the rationale being that the party can only be protected for conduct that occurs while the bankruptcy estate exists. As explained in a recent opinion in In re Mallinckrodt PLC, 
   
As a result, bankruptcy courts regularly strike or narrow exculpation provisions included in chapter 11 plans that go beyond estate fiduciaries and their good-faith conduct occurring between the petition date and the plan effective date.[9] Generally speaking, these two limitations make sense because most, if not all, of the negotiation and plan formation occurs between the debtors and the unsecured creditors committee after the petition date. However, in many larger cases, the debtors have a complex capital structure that necessitates including the secured lender and ad hoc creditor groups in the restructuring process well before any bankruptcy case is filed. This often results in a pre-packaged chapter 11 case or a chapter 11 plan that involves significant support from key constituencies who have executed a restructuring support agreement (an “RSA”) with pre-negotiated plan terms. In these situations, courts should approve exculpation for non-estate fiduciaries, which includes protection for their good-faith, pre-petition conduct that is related to the plan formation and approval process.
               
The Case for Pre-Petition Exculpation for Non-Estate Fiduciaries
 
Some courts already have been flexible in granting exculpation to non-fiduciary parties for their pre-petition conduct.[10] In such cases, bankruptcy courts have recognized that broader exculpation is appropriate where the protected conduct relates to the chapter 11 case and contributes to a confirmable plan.[11] 
 
For instance, in the 2019 case of Aegean Marine Petroleum Network Incorporated, the debtors proposed a plan that included exculpation for certain non-estate fiduciaries, including pre-petition secured lenders, pre-petition unsecured notes indenture trustees, and debtor-in-possession lenders and agents, based on their participation in the restructuring support agreement and certain restructuring transactions.[12] The United States Trustee objected, arguing that exculpation should be limited to the debtors, the committee members, and their respective advisors, and should not extend to the pre-petition lenders, who were not estate fiduciaries.[13] The bankruptcy court overruled the objection and approved the expanded exculpation protection.The bankruptcy court reasoned,
   
Likewise, in the In re Station Casinos Incorporated case, the United States Bankruptcy Court for the District of Nevada approved a similar exculpation provision, explaining
   
The broad exculpation provision was an “additional incentive for the various major parties to the Chapter 11 Cases to commit to and support the Plan,” which was ultimately confirmed without objection.[16]
 
As these cases demonstrate, the proper circumstances for expanded exculpation typically arise in pre-negotiated or pre-packaged bankruptcy cases. In such cases, debtors and their creditors engage in pre-petition restructuring negotiations that may address a variety of issues, including the timing and venue of a bankruptcy filing, the terms and amount of DIP financing, the classification and treatment of claims, and the sale of any of the debtor’s claims or assets, and the source and nature of funding for the reorganized debtors.[17] These are precisely the type of negotiations that traditionally happen after a bankruptcy filing in the formation of a confirmable plan and for which estate fiduciaries can expect to be exculpated under §§ 1103 and 1125. It follows naturally, then, that exculpation should be extended to parties that participate in good faith in pre-petition negotiations that lead to a confirmed plan of reorganization.
 
The recent case of Murray Metallurgical Coal Holdings LLC is an apt example.[18] In that case, on the day prior to the petition date, the debtors finalized and executed an RSA with pre-petition term lenders holding approximately $169 million of the debtors’ $270 million in outstanding debt obligations, certain additional creditors and customers, and certain affiliates of the debtors.[19] The signing of the RSA was the culmination of negotiations by the various parties that extended back many months and ultimately paved the way for an effective reorganization.[20] The RSA contemplated a multi-step restructuring that included various asset sales and the transfer of reclamation obligations.[21] The RSA also contemplated certain post-petition financing arrangements to fund the reorganization of the debtors and their emergence from chapter 11.[22] In part based on the RSA, the debtors were able to file their proposed plan of reorganization and disclosure statement less than two months after the petition date.[23]
 
The plan included an exculpation clause that covered the debtors, the unsecured creditors’ committee and its members, the DIP lenders and the RSA parties, as well as each exculpated party’s employees, directors, agents, professionals and affiliates.[24] The exculpation clause protected these parties from liability for any conduct, in pertinent part, “based on the negotiation, execution, and implementation of any transactions approved by the Bankruptcy Court in the Chapter 11 Cases, including the RSA[.]”[25] The United States Trustee objected to the exculpation clause on the grounds that it was overly broad based on the parties covered and the temporal scope.[26] The debtors countered, contending that the exculpation provision was an integral component of the plan that was supported by virtually all creditors.[27] 
 
The bankruptcy court acknowledged that the pre-petition negotiations leading to the RSA ultimately enabled the debtors to obtain DIP financing, fund their post-petition operations, and develop the proposed plan.[28] Siding with the debtors, the bankruptcy court held,
   
Conclusion
 
Exculpation should extend to pre-petition conduct in appropriate circumstances. Pre-negotiated and pre-packaged cases involve important pre-petition negotiations that help the debtor fare better once in and upon exiting chapter 11. In such cases, exculpation for RSA parties and their pre-petition conduct incentivizes a fair, transparent, and efficient chapter 11 process.