Disallowance Of An Indemnification Claim Under Section 502(e)(1)(B) Decided On State Law Distinction, Not The Text Of The Code

The bottom line

Section 502(e)(1)(B) of the Bankruptcy Code governs the disallowance of certain indemnity or contribution claims when the holder of such a claim “is liable with” the debtor on the claim and the claim is contingent as of the time of allowance or disallowance. The phrasing of this provision leaves practitioners with a gating question: When does the claimant need to be “liable with” the debtor? A recent Eleventh Circuit Court of Appeals case, In re AE OpCo III, LLC, No. 25-11348 (11th Cir. Apr. 15, 2026), considered this very question when a debtor settled a dispute with a contract counterparty and that contract counterparty then pursued damages against the entity (the indemnitor) that had guaranteed the debtor’s obligations under the contract. The indemnitor argued that the indemnification claim should be allowed because the settlement made the indemnitor no longer “liable with” the debtor when its claim was asserted. The debtor disagreed and argued that such a determination should be made as of the petition date, consistent with when most other determinations about prepetition claims in bankruptcy are made. 

The Eleventh Circuit sidestepped the textual arguments raised by the parties with an important reminder: Bankruptcy law does not create new rights for parties; it merely provides a forum and a process for administering already existing rights, commonly created under state law, absent some prevailing federal interest. In the end, the court’s decision to disallow the claim turned on the difference between a release and a covenant not to sue — entirely an issue of state law — and an issue that neither party fully considered in their briefs. 

Background

On April 15, 2026, the Eleventh Circuit issued a published opinion affirming the bankruptcy court’s disallowance of, among other claims, an indemnification claim (the Indemnification Claim) raised on direct appeal by AAR Corp. against AE OpCo III, LLC (AE OpCo or the Debtor). The Indemnification Claim was based on amounts a separate creditor, Short Brothers, sought to recover from AAR in litigation pending in Northern Ireland. 

The Indemnification Claim arose out of a triangular arrangement predating the bankruptcy between AE OpCo, AAR and Short Brothers. In 2009, AAR and Short Brothers executed a procurement contract (the Procurement Contract) under which AAR’s manufacturing subsidiary agreed to make airline parts for Short Brothers, with AAR guaranteeing its subsidiary’s performance in the event of default. 

In 2020, AE OpCo acquired AAR’s composite materials operation, which included the Procurement Contract. Short Brothers agreed to the counterparty swap on the condition that AAR guarantee AE OpCo’s performance. In return, AE OpCo agreed to indemnify AAR if AE OpCo defaulted (the Indemnification Agreement). Importantly, both AE OpCo and AAR were potentially liable to Short Brothers under the Procurement Contract. AE OpCo was directly liable to Short Brothers if it failed to fulfill its obligations under the Procurement Contract and AAR was indirectly liable through its guaranty of AE OpCo’s performance. 

In 2022, AE OpCo filed for bankruptcy and moved to reject the Procurement Contract as having under-market terms. Short Brothers and AAR filed claims for breach of contract and indemnification, respectively. Short Brothers ultimately settled with AE OpCo to minimize the effect of a wholesale rejection (the Settlement) and agreed to increased pricing terms under the Procurement Contract. The Settlement was approved by the bankruptcy court. As a part of the Settlement, Short Brothers executed a covenant not to sue AE OpCo but did not affirmatively release claims against AE OpCo. Short Brothers also revised its proof of claim to reflect the increased costs it would now bear under the Procurement Contract and to include the executed covenant not to sue AE OpCo. 

Separately, Short Brothers sued AAR in Northern Ireland on its guaranty obligations, seeking over $30 million. After the commencement of the Northern Ireland litigation, AAR filed an indemnification claim against AE OpCo for the damages that AAR would owe Short Brothers at the conclusion of the Northern Ireland litigation as provided for in the Indemnification Agreement. AE OpCo moved to disallow AAR’s indemnification claim under Section 502(e)(1)(B) as a contingent claim from jointly liable parties. The bankruptcy court agreed with the Debtor and disallowed the claim. AAR directly appealed the disallowance to the Eleventh Circuit, arguing that the Settlement released AE OpCo from its liability to Short Brothers by virtue of the covenant not to sue. The Eleventh Circuit then accepted the appeal to consider the question of when the joint liability determination needed to be made for purposes of Section 502(e)(1)(B).

Section 502(e)(1)(B) textual arguments

Under Section 502(e)(1)(B), a claim must be disallowed if (1) it is for “reimbursement or contribution,” (2) the claimant “is liable with” the debtor on a creditor’s claim, and (3) the claim is “contingent as of the time of allowance or disallowance.”

AAR’s Indemnification Claim clearly satisfied the first and third prongs. The central dispute, therefore, focused on whether AAR was liable with AE OpCo on the Indemnification Claim given both parties’ obligations to Short Brothers under the Procurement Contract. AAR and AE OpCo both briefed this question as one of timing: Does the claimant need to be liable with the debtor as of the petition date (which AAR certainly was) or by the time the claim was being either allowed or disallowed (which AAR argued it was not)?

AAR argued the Settlement eliminated AAR’s co-liability by the time the Indemnification Claim was asserted, as Short Brothers would not pursue damages against AE OpCo under the Procurement Contract by virtue of the covenant not to sue in the Settlement. To support this position, AAR asserted that the statute would say “was liable,” not “is liable,” if the bankruptcy court were meant to consider co-liability earlier than a potential hearing on allowance. AAR further pointed to the purpose of Section 502(e)(1)(B), which is to prevent double recovery, and asserted that the risk of double recovery no longer exists once the underlying claim is settled. 

By contrast, AE OpCo argued that the Bankruptcy Code implicitly requires this decision to be made as of the petition date, as the Bankruptcy Code repeatedly fixes various rights as of that date, and Congress would have specified a different operative date if one were intended. AE OpCo further argued that, as a matter of policy, the bankruptcy court should not contemplate a regime where settlements open a debtor’s estate to additional exposure from otherwise disallowed claims. 

The court declined to resolve the statutory interpretation question, however, because it determined the Settlement never released AE OpCo from liability — it embodied mutual covenants not to sue — and Delaware law recognizes the formal distinction between liability releases and covenants not to sue. 

Delaware law: “Covenants not to sue” versus releases

While a covenant not to sue and a release operate similarly, Delaware law treats the two as distinct. Under Delaware law, a release is the cancellation of the claim and discharge of the released party, while a covenant not to sue formally preserves the cause of action with the covenanting party agreeing to stand down. The Settlement was unambiguously titled “Covenant Not to Sue,” and its text clearly satisfied the definition of such a covenant under Delaware law. As a result, the court determined that AE OpCo was still liable to Short Brothers under the Settlement and that Short Brothers would simply not be requesting further performance on that liability.

AAR asserted several counterarguments to this conclusion but fatally did not raise any arguments rooted in Delaware law. AAR argued that the covenant not to sue had the practical effect of a release, attempted to raise the mootness doctrine and asserted that refusing to treat the covenant as a release would “invite mischief,” enabling debtors to reach “discount settlements” with underlying creditors while leaving indemnitees holding the bag. 

The court rejected AAR’s counterarguments. First, it emphasized that the practical effect of the covenant was beside the point because the court was bound by the governing state law and Delaware law’s interpretation of the two clauses. Second, the court rejected AAR’s analogy to Article III’s mootness doctrine, noting that mootness and liability ask different questions: The former concerns whether a live controversy continues while the latter concerns whether a legal obligation formally exists. And finally, the court concluded that regardless of the incentive that may or may not be created by such a holding, “[f]or good or ill, [the court’s] hands are tied” by Delaware law.

The upshot: Regardless of when co-liability was measured, AAR remained liable with AE OpCo at all relevant times.

Why this case matters

The court’s treatment of the Indemnification Claim illustrates that the treatment of a claim under governing state law has an impact on how that claim is treated in bankruptcy and, specifically, that under Delaware law, a covenant not to sue and a formal release carry materially different consequences for co-obligors under Section 502(e)(1)(B). Despite AAR’s assertion that the holding in this case will create improper outcomes and incentives, enabling debtors to reach discount settlements with underlying creditors while leaving indemnitees holding the bag, the court found itself bound by Delaware law. Accordingly, parties negotiating bankruptcy settlements involving co-liability arrangements should take care in choosing the precise form of any discharge to avoid unintended consequences under governing state law. 

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