Sixth Circuit Does Not Permit Third-Party Releases in Equity Receiverships

The Sixth Circuit’s recent decision in Digital Media Solutions v. South Univ. of Ohio, 59 F.4th 772 (6th Cir. 2023) provides a cautionary tale about the limitations of federal equity receiverships as a restructuring tool. It serves as a reminder that the law and the judicial landscape governing restructuring proceedings are not static.

Background

Digital Media involved a California nonprofit (the Foundation) that formed a subsidiary (the Dream Center) to purchase three university systems (including certain Art Institutes) to turn them into nonprofits. 59 F.4th at 774. The Dream Center struggled to operate the university systems and faced mounting lawsuits from unpaid creditors, including students from one of the Art Institutes (the Art Students), who brought a class-action lawsuit in state court against the Dream Center, the Foundation, and their directors and officers for allegedly hiding the loss of the institute’s accreditation. Id. at 775. The Art Students contended the loss of accreditation impaired the value of their degrees and harmed their employment prospects. Id. at 783.

A bankruptcy filing was not a viable option as it would render the Dream Center ineligible for federal student loans or aid (its main source of funding). Id. at 776. In contrast, a federal receivership did not trigger this ineligibility. The Dream Center consented to its placement in a federal equity receivership, and the federal court appointed a receiver (the Receiver) to operate the Dream Center and its subsidiaries. Id. at 775. The receivership estate included insurance policies protecting directors and officers against liabilities in connection with their oversight of the Dream Center and defense costs related to covered claims. Id. at 776. The Receiver negotiated a settlement with the directors and officers, the Foundation, and the insurance company to bring proceeds from the policies into the Dream Center’s receivership estate. The settlement included releases by the Receiver from claims against directors and officers, and the directors and officers likewise released any claims against the Dream Center and the Receiver. Id. The settlement was contingent on the district court’s entry of an order (the “Bar Order”) that would bar non-settling third parties (including parties like the Art Students) from pursuing claims against not just the Dream Center, but also the Foundation, the directors and officers of the Dream Center and the Foundation, and the insurance company. Id.

The Art Students objected to the proposed Bar Order because the settlement would prohibit them from litigating their state court lawsuit against parties outside the receivership. Id.

The District Court Decision

The district court approved the settlement and entered the Bar Order, finding the Dream Center “suffered an injury traceable to the actions” of directors and officers and the allegation could trigger the Dream Center’s right to obtain insurance proceeds if it won a judgment against them. Id. As these same proceeds were the target of the Art Students’ claims, the Art Students’ suit implicated “assets claimed by the receivership.” Id. The district court also found the Bar Order necessary because the directors and officers would not agree to waive their rights to proceeds if they remained at risk of third-party claims. Id. at 777. As such, the district court felt the better route was to allow the Receiver to create a “litigation trust” to allow the Art Students to raise their claims in the receivership. Id. The district court also found (i) the Bar Order fell within the “range of reasonableness” and was in the “best interests” of the Dream Center’s estate, and (ii) as a “mandatory condition” of the settlement, entering into it was “an appropriate exercise of the court’s sound discretion to facilitate settlements.” Id.

The Sixth Circuit Opinion

The Sixth Circuit reversed and remanded, concluding that the district court had no equitable power to enter the Bar Order, which enjoined claims by nondebtor third parties against other nondebtor third parties that were not part of the receivership estate.

The Sixth Circuit noted that the case required it to determine whether traditional rules of equity vested the district court with equitable power to issue the Bar Order.^[1]

The Sixth Circuit’s analysis was grounded in a receivership court’s quasi-in-rem jurisdiction over a debtor and the debtor’s assets, which traditionally excluded the power to enjoin in personam suits. Id. at 787 (citing Riehle v. Margolies, 279 U.S. 218, 223-228 (1929)). The Art Students did not file an in rem action asserting claims to the policy proceeds but instead filed an in personam action asserting claims against the directors and officers of the Foundation. As the receivership court could not enjoin in personam claims against the receivership debtor, it could not enjoin in personam claims against non-receivership entities. Id. The Sixth Circuit also noted the receivership court traditionally could issue injunctions only to protect assets of the debtor that its creditors could execute upon and, thus, lacked any equitable power to protect assets outside of the receivership. Id. Because the Bar Order sought to protect assets that fell outside the receivership (including all other property possessed by directors and officers of the Foundation), this, too, fell outside the district court’s equitable powers (and the district court’s in rem jurisdiction). See id. at 787-790.

In reaching its conclusion, the Sixth Circuit also analyzed whether the Receiver could settle the Art Students’ claims. The Art Students asserted direct claims based upon harm to the students, and, therefore, the Sixth Circuit viewed these claims as separate and distinct from the receivership estate and outside of the Receiver’s power to settle. Id. Their claims were not like derivative claims that a shareholder could have against a corporation but instead were like those of creditors or investors trying to sue insiders for fraud. Id. at 783.

The Sixth Circuit also considered whether the Art Students’ claims interfered with the court’s exclusive control of receivership property. If the Bar Order had been limited to protecting the insurance policy proceeds, which were property of the Dream Center’s estate and were negatively affected by the Art Students’ lawsuit, that would have served as a basis for relief prohibiting the directors and officers from paying for their defense out of the insurance proceeds. Id. at 786. The bar order, however, went beyond this narrow protection and represented a remedy “previously unknown to equity jurisprudence.” Id. at 787 (citing Grupo Mexicano de Desarrollo S.A. v. All. Bond Fund, Inc., 527 U.S. 308, 332 (1999)).

Implications

The Sixth Circuit’s ruling may have implications for other relief commonly sought in federal receiverships,^[2] such as “free and clear” orders for asset sales in receivership, which may not be expressly provided for by statute but which a receivership court could find falls within its equitable powers.^[3] Parties may choose a receivership based on perceived advantages as a restructuring alternative over a voluntary bankruptcy: receiverships may be more cost-effective than bankruptcy and less publicized (which may alleviate concerns over the potential stigma of bankruptcy). But, in light of the Sixth Circuit’s ruling, at least a federal receivership in the Sixth Circuit may not offer the same “toolbox” as a Chapter 11 process, where courts (including the Sixth Circuit) have permitted third-party releases.^[4] See In re Dow Corning Corp., 280 F.3d 648, 657 (6th Cir. 2002).

Distressed companies seeking to restructure should carefully consider all strategic alternatives and consult with restructuring counsel, who may be best equipped to guide a company through those challenges.

^[1] The Sixth Circuit noted if a receivership court had subject matter and quasi-in-rem jurisdiction, the court must also “exercise its powers only in a way that comport[s] with ‘the accepted principles of equity[.]’” 59 F.4th at 779 (citing Gordon v. Washington, 295 U.S. 30, 56 (1935)). That is, the court’s powers were limited to relief that a court of equity could grant. Id.
^[2] Receiverships may also be commenced under state law. While not directly on point, given that federal and state law receivership share common foundational principles, Digital Media could influence the scope of relief that may be obtained in state-law-based receiverships.
^[3] See, e.g., Sec. & Exch. Comm'n v. Capital Cove Bancorp LLC, No. SACV 15-980-JLS, 2015 WL 9701154 (C.D. Cal. Oct. 13, 2015).
^[4] The Supreme Court will soon review whether a bankruptcy court can approve a reorganization plan that provides for nonconsensual releases of claims against nondebtor third parties. See Harrington v. Purdue Pharma, L.P., Order Granting Cert. (Aug. 10, 2023).