SDNY Bankruptcy Court strikes down insider releases in chapter 11 plan as improper retention-related transfers

On July 19, 2024, Judge Michael Wiles of the US Bankruptcy Court for the Southern District of New York issued a ruling in In re Mercon Coffee Corporation, Case No. 23-11945, invalidating insider releases in a proposed chapter 11 plan on the basis that the releases were improper retention-related transfers.

Judge Wiles found that he could not approve the releases – even though the debtors had promised them and insiders had relied upon that promise – because the releases did not meet the strict requirements of Bankruptcy Code Section 503(c).

Background

Mercon Coffee Corporation and its affiliated debtors (collectively, the debtors) are part of the Mercon Coffee Group, a vertically integrated global coffee supplier founded in the late 19th century.

In recent years, the debtors faced numerous challenges, including the global impact of the COVID-19 pandemic, a decline in coffee market prices, labor shortages, and supply chain disruptions. Increased transportation costs and logistical bottlenecks for shipments compounded these problems.

Increasing interest rate pressures and lack of available liquidity resulted in defaults and acceleration under their credit agreement with Coöperatieve Rabobank UA, New York Branch, and the debtors filed chapter 11 petitions on December 7, 2023.

In connection with the bankruptcy filing, the debtors filed a declaration stating that they intended to pursue an orderly sale of their assets to maximize the value of their estates, and to confirm a chapter 11 plan for the orderly wind down of the estates.

After consummating various asset sales, the debtors filed a disclosure statement for their chapter 11 plan that proposed releases for a broad range of parties, including all current and former directors, officers, representatives, members of management, and other employees of the debtors. The UST filed an objection, arguing that there was no evidence in the record concerning the consideration provided by the released parties in exchange for the releases, nor any evidence as to the value of the claims being released.

At a hearing on May 14, 2024, the debtors argued that the releases could be addressed at the confirmation hearing, but Judge Wiles noted that the disclosure statement should include an explanation of why the debtors were granting such broad releases, as well as disclosure concerning whether the debtors had investigated the potential claims and their conclusions about the merits of the claims.

In response, the debtors made several modifications, including limiting the release to 19 named individuals. In pre-confirmation submissions, the debtors raised numerous arguments to support the releases, including that: 

(1) the proposed releases were not “full” releases, as they only release claims in excess of available insurance coverage, and did not release claims for fraud, willful misconduct or gross negligence

(2) the releases were the result of hard-fought arms’ length negotiations among the debtors, their secured lender and the creditors’ committee

(3) the releases were necessary and integral components of the plan that were necessary to gain stakeholder support 

(4) the released parties had contributed to the debtors’ sale process and had helped maximize the value of the debtors’ estates, and 

(5) the debtors would receive mutual releases.

The debtors also noted that several of the proposed released parties lived in foreign countries, where potential claims would be difficult and expensive to pursue and collect.

In a declaration filed a day before the confirmation hearing, Harve Light, the debtors’ chief restructuring officer, stated that the 19 individuals who would be “released parties” fell into three categories: 

(a) Individuals who did not have direct responsibility or control of the global company or its finances and did not have managerial control beyond their local country 

(b) Individuals who made significant contributions to the debtors’ sale and financing activities or went “above and beyond” to maximize the value of the debtors’ assets, and 

(c) Individuals as to which there would be no tangible economic benefit in pursuing claims, due to their location outside the US and the anticipated expense of obtaining and collecting a judgment.

Several individuals fell into more than one of these categories, and it was unclear which of the individuals were actually insiders.

The debtors solicited votes from stakeholders and proceeded to a hearing to confirm the plan. The only objections to the plan were filed by the Office of the US Trustee (UST), which, among other things, objected to the granting of “releases to certain parties without adequate consideration.” 

Bankruptcy Code Section 503(c) limits post-petition insider releases

The UST’s objection represented the primary focus of the confirmation hearing, namely whether the proposed releases were supported by adequate consideration. This led Judge Wiles to inquire whether the debtors could provide evidence that the releases satisfied the requirements of Bankruptcy Code Section 503(c).

Section 503(c)(1) places significant restrictions on a debtor’s ability to make any transfer to, or for the benefit of, an insider of the debtor in connection with a retention agreement. Specifically, such transfers are prohibited unless:

(A) the transfer or obligation is essential to retention of the person because the individual has a bona fide job offer from another business at the same or greater rate of compensation;

(B) the services provided by the person are essential to the survival of the business; and

(C) either –

(i) the amount of the transfer made to, or obligation incurred for the benefit of, the person is not greater than an amount equal to 10 times the amount of the mean transfer or obligation of a similar kind given to nonmanagement employees for any purpose during the calendar year in which the transfer is made or the obligation is incurred; or

(ii) if no such similar transfers were made to, or obligations were incurred for the benefit of, such nonmanagement employees during such calendar year, the amount of the transfer or obligation is not greater than an amount equal to 25 percent of the amount of any similar transfer or obligation made to or incurred for the benefit of such insider for any purpose during the calendar year before the year in which such transfer is made or obligation is incurred. 11 U.S.C. §503(c)(1).  

In sum, Section 503(c)(1) bars post-petition transfers to insiders in connection with a retention agreement unless (a) the insider has a bona fide employment offer from another business at the same or greater compensation, (b) the insider provides services that are essential to the survival of the business, and (c) the amount of the transfer does not exceed the metrics set forth in Section 503(c)(1)(C).

Confirmation hearing

At the confirmation hearing, Judge Wiles questioned whether the releases could withstand application of Section 503(c). The debtors explained that releases had been promised to a number of officers and directors several months prior to the hearing, in response to threats by these individuals that they planned to terminate their employment, and as an inducement for the individuals to continue their employment with the debtors.  

The debtors argued that the releases were the product of hard-fought, arm’s length negotiations, were critical to gaining support for the plan, and were integral to the plan. The debtors further posited that granting the releases was a reasonable exercise of their business judgment, based on the significant contributions these individuals had made to the bankruptcy process. 

During the confirmation hearing, Judge Wiles approved the releases for non-insiders, but “expressed reservations about the theory that was being offered in support of the proposed releases” for insiders.

In particular, Judge Wiles questioned whether Bankruptcy Code Section 503(c), which limits transfers to insiders tied to an employment retention arrangement, should apply to the proposed releases.

Counsel to the debtors acknowledged that the proposed releases to the insiders could not withstand application of Section 503(c). Nonetheless, Judge Wiles granted the parties an opportunity to submit post-hearing briefs on the applicability of Section 503(c) to the approval of insider releases.

In their post-hearing submission, the debtors argued that Section 503(c) applies only to cash payment of administrative expenses, and that the proposed releases did not involve such payments.  

Judge Wiles rejected that argument based on the plain language of Section 503(c) – which by its terms applies to post-petition “transfers” and “obligations,” not just cash payments. Judge Wiles noted that (a) under the debtors’ analysis, Section 503(c) could be easily evaded if a debtor agreed to provide an insider with consideration other than cash and (b) since a release is a transfer of property, the non-cash releases in the plan ran afoul of the requirements of Section 503(c).  

Judge Wiles also stated that a retention-inducing promise to grant a release in the future was impermissible, as it would provide an easy but unwarranted mechanism to circumvent Section 503(c). According to Judge Wiles, nothing in the Bankruptcy Code suggests Section 503(c) can be ignored to obtain approval of such a retroactive retention payment under a chapter 11 plan.

Judge Wiles also rejected debtors’ argument that they had the ability to grant the releases as part of a settlement under Bankruptcy Code Section 1123(b)(3) and Bankruptcy Rule 9019. Judge Wiles stated that those provisions could not be used to evade Section 503(c).  

Because the plan did not comply with Section 503(c), it did not satisfy Bankruptcy Code Section 1129(a)(1) – which requires a chapter 11 plan to comply with all provisions of the Bankruptcy Code in order to be confirmed – and thus could not be confirmed.

The ruling

In ruling that the proposed releases to insiders were invalid, Judge Wiles noted that he was sympathetic to the insiders who “did good work” and faced personal risks and hardships in continuing their employment with the debtors.  

Nonetheless, Judge Wiles ultimately concluded that the Court was constrained by the terms Section 503(c), and that those terms had not been met because the “sole consideration for the proposed release in favor of the insiders was their agreement to remain in the Debtors employment.” As such, Judge Wiles declined to approve the releases. 

In closing, Judge Wiles noted that at the confirmation hearing, the debtors raised the possibility of limiting the releases to claims otherwise covered by insurance, releasing the insiders only for liability in excess of insurance for that subset of claims.

Judge Wiles explained that “[i]n theory a more limited release of this kind might have other justifications in terms of facilitating the pursuit of claims that are covered by insurance.”  

However, because the debtors had not made that modification at the time of the ruling, Judge Wiles declined to rule on the propriety of such hypothetical modified releases. 

Takeaways of Mercon Coffee

In Mercon Coffee, the debtors appear to have made a good faith commitment to grant releases to insiders who continued in their positions to achieve a successful restructuring. The insiders fulfilled their end of the bargain and expected the debtors would do the same.  

However, the Mercon Coffee ruling reinforces that courts will likely not approve transfers (including releases) of consideration as part of post-petition retention agreements with insiders absent compliance with Section 503(c).

The insider releases in Mercon Coffee might have been approved if the basis for the releases had been something other than a retention agreement. Judge Wiles hinted at this possibility in his discussion of the debtors’ suggestion of limiting the releases to insider liability for claims otherwise covered by insurance, stating that such limited releases might have “other justifications.”  

Such limited releases could benefit the debtors by facilitating pursuit of those claims, as the insiders would be more likely to cooperate with the debtors if their personal liability above the insurance amount were released. Judge Wiles did not address whether such releases would vitiate or otherwise impact the availability of existing director and officer liability insurance, and because the debtors never revised the plan to limit the releases in response to Judge Wiles’ questions, Judge Wiles did not consider any “other justifications.”