Plan Discharge and Injunction Provisions: Creditors Beware

In re Orleans Homebuilders, Inc., 561 B.R. 46 (Bankr. D. Del. 2016)

A reorganized debtor brought a motion in bankruptcy court to enforce a chapter 11 plan of reorganization injunction: It sought a court order directing a residential condominium association to discontinue litigation it brought in state court against the reorganized debtor and others relating to alleged construction defects.

The debtor and related entities obtained confirmation of a plan of reorganization, which became effective in February 2011. In February 2013 the project’s condominium association filed a state court action against the debtor and others for alleged construction defects in common elements of a project that was completed prior to bankruptcy.

The debtor went back to bankruptcy court to ask the court to enforce a plan injunction provision by requiring the Association to discontinue the state court litigation and finding it in civil contempt with an assessment of sanctions (including requiring the Association to pay the debtors’ costs and attorney fees for defending the state court litigation and seeking relief in the bankruptcy court).

Development of the residential condominium project followed a typical pattern:

  • The project was built around 2004 through 2008. It included 51 buildings that were clad with vinyl siding and other materials.
  • In April 2005 the debtor incorporated the project’s condominium association.
  • The debtor sold units in the project between 2005 and 2009.
  • Each purchaser received a public offering statement.
  • The debtor controlled the Association board until it sold 75% of the units (around August 2008), at which time it transitioned control of the board to the unit owners.

The debtor filed bankruptcy ~6 months after the last unit was sold. Within a year the debtor and related entities obtained confirmation of a plan of reorganization, and the plan went effective.

Two years later the Association filed a complaint against the debtors and certain former employees based on claims for “negligence, breach of express warranties, breach of implied warranties, breach of fiduciary duty, and breach of PREDFDA [Planned Real Estate Development Full Disclosure Act].” The defects alleged in the complaint included those relating to “vinyl siding, stucco, stone veneer, windows and doors, flashings, foundation walls and slabs, decks, and roof and roof structures.”

In support of its breach of warranty and fiduciary duty claims, the Association alleged that:

  • The debtor created, designed and constructed the project.
  • It established the Association to “own, administer, manage, operate, maintain, repair and replace the common elements” at the project.
  • The individual defendants were the initial members of the Association’s board.
  • While the debtor controlled the board, it “failed to discover and/or disclose and/or maintain and/or correct various defects and deficiencies in the design and construction of the common elements.”
  • After the transition to unit owner control, the Association became aware of various defects and deficiencies.

In response, the debtor argued in part that the discharge and injunction provisions of the confirmed plan barring creditors from bringing litigation against the debtors arising from pre-petition claims applied to the Association’s state court litigation.

Under applicable precedent, “a claim arises when an individual is exposed pre-petition to a product or other conduct giving rise to an injury, which underlies a ‘right to payment’ under the Bankruptcy Code.” In this case all units were sold and transition of control of the Association board from the debtor to the owners occurred prior to bankruptcy. Thus the court found that the Association’s claims were pre-petition claims, and it was barred from commencing litigation based on those claims under the plain language of the plan discharge injunction.

The Association countered that a different provision in the plan provided that certain agreements survived bankruptcy, so that the Association’s claims could be pursued post-petition. Specifically, the plan provided that generally agreements related to developments that were revesting in the debtors that were embodied in orders, ordinances and other official governmental action, as well as governmental and quasi-governmental agreements, etc. “as are necessary, appropriate, beneficial, or required, to permit the continued construction and development of any of the Revesting Developments entered into prior to the Petition Date” were to be treated as executory contracts that were assumed on the plan effective date.

According to the Association, this covered any agreements of a “governmental nature” related to the developments. Since the state development statute required the debtor to issue a public offering statement, and this statement included warranties about construction of the common areas, the Association’s claims were based on a quasi-governmental agreement that was treated as an assumed executory contract.

The court acknowledged that the development act prohibited a developer from disposing of interests in a planned real estate development without delivering a public offering statement, and that the offering statement was required to include information – specifically including a statement explaining developer warranties or guarantees. Further, applicable regulations required a developer to provide certain warranties regarding common facilities which were described in the offering statement.

The court also noted that the public offering statement was attached to an agency order registering the project (which clearly was a document covered by the revesting provision). However, the court found that the plan revesting provision could not be read so broadly as to include agreements incorporated within agreements that benefited non-governmental third parties. With respect to the individual defendants, the court went through a similar analysis of the plan’s exculpation provision (which was exceedingly broad, as usual).

Consequently, the court found that the Association’ claims in the state court litigation were barred by the plan discharge injunction and exculpation provisions.

It is not unusual to see broad discharge and exculpation provisions in a plan of reorganization, and the line between pre-petition and post-petition claims can be far from clear. If a creditor contemplates pursuing any claims against a debtor post-confirmation it would be well advised to take a close look at the plan to determine if the debtor will be able to argue that the claims are barred.

Vicki R Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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