Q: I am a receiver for a corporation, in a case arising out of fraud allegations. I have asserted claims against various insiders. They are willing to settle with me for a significant sum, but only if the court bars investors, customers and vendors from suing them. Can the court issue such a bar order?

A: Maybe. It will depend on the types of claims the third parties possess. The issue of third party releases is a hot topic in bankruptcy. It recently arose in the infamous Purdue Pharma bankruptcy, where the Saclker family agreed to pay $4.55 billion, but only if they were released from any third party civil suits. After the settlement, with such a bar order, was approved by the bankruptcy court, the approval was overturned by the district court, which ruled that the bankruptcy court cannot bar litigation against parties who themselves are not in bankruptcy. In re Purdue Pharma LP, 635 B.R. 26 (S.D.N.Y. 2021). While an appeal of the district court’s order was pending, the Sacklers agreed to increase their payment to $6 billion. At the end of May 2023, the Second Circuit reversed the district court and approved the settlement and bar order. This issue, however, may ultimately end up in the Supreme Court, because the circuits split on whether such releases are enforceable. The dispute focuses on specific bankruptcy provisions, not equitable principles or receivership law. Some circuits hold that because 11 U.S.C. §524(c) provides a discharge does not affect the liability of any other entity, or the property of any other entity, from such debt, third party releases are not allowed. Other circuits rely on 11 U.S.C. §105(a), which permits a court to issue any order necessary to carry out the bankruptcy laws, so such releases are permitted. The Second Circuit, supra., relied on 11 U.S.C. §§105(a) and 1123(b)(6). The issue of third party releases, however, is not confined to bankruptcy. It occasionally arises in receivership cases.

In a new case, the Sixth Circuit Court of Appeals held that receivership courts lack the power to issue such bar orders. Digital Media Solutions, LLC v. South University of Ohio, LLC, 59 F.4th 772 (6th Cir. 2023) ( “Digital”).  In doing so it had to distinguish, and criticize, decisions from two other circuits, which permitted such orders. Zacarias v. Stanford International Bank, Limited, 945 F.3d 883 (5th Cir. 2019)( “Zacarias”); SEC v. DeYoung, 850 F.3d 1172 (10th Cir. 2017) (“DeYoung”).

The Digital decision is an interesting read, because it focuses on what power a court of equity has to issue releases. It notes that, in federal court at least, “Receivers must administer the debtor’s property in accordance with the ‘historical practice’ of courts of equity. Fed. R. Civ. P. 66.” Digital at 774. And this rule “codifies the Supreme Court’s repeated admonition that, absent legislative change, a federal court’s exercise of its equitable powers must fall within the traditional principles of equity exercised by the High Court of Chancery in England at the founding [i.e 1789].” Digital at 778.

Dream Center Foundation was a non-profit that purchased three university systems. The sellers overestimated the revenues and underestimated the expenses. As a result, it was deluged by litigation from vendors, landlords and a class action by certain art students who alleged they had been defrauded. It considered bankruptcy, but was afraid it would lose its main source of income: federal student loans. When one vendor, Digital Media Solutions, sued and asked for a receiver, Dream Center consented, hoping the receiver could turn things around. Among the assets were two officer and director insurance policies. The receiver contended Dream Center had claims against the officers and directors and, eventually, negotiated a settlement for $8.5 million. However, it was contingent on a bar order prohibiting third parties, including the art students, from pursuing any claims against the officers, directors and the insurers.

The court, after examining historic receivership practices, stated that a receiver can only assert claims that the entity in receivership could. If a different party held the claim, the receiver could not pursue it. And if he could not pursue the claim, he could not settle it. It gave as an example, that a receiver cannot pursue claims a debtor’s customers have against third parties. Digital at 780.

Because the art students’ claims for fraud against the officers and directors were owned by the students based on injuries specific to them, and the receiver under traditional equity practice could not assert those claims, the court had no power to bar the student from pursuing their claims, just because it might crater the receiver’s settlement. The court analogized to defrauded investors suing brokers who defrauded them into investing – claims a receiver would not assert. “This type of suit seeks to recover for personal injuries to the investors based on their individual causes of action. The investors’ personal ownership of these claims again has relevance for equity-receivership proceedings. This personal ownership means that the receiver lacks the authority to litigate them under the traditional principle of equity that bars a receiver from pursuing claims owned by others. The Supreme Court made this same point concerning the authority of a bankruptcy trustee, who may not pursue claims personally owned by a bankruptcy entity’s creditors.” Digital at 783 (citations omitted, emphasis in original).

The court distinguished both Zacarias and DeYoung on the ground that in both cases the investors and the receiver were pursuing claims for the same injury and neither case examined the pivotal issue: who owned the claims being asserted. The touchstone, according to the court, in determining whether a bar order is permissible is: “What party…would have possessed the right to assert their respective causes of action outside the receivership context?” Digital at 785. If the entity in receivership could not assert the claim outside of the receivership, then the court cannot bar third parties from doing so.

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