2022 brings continued disagreement among US courts as to the validity of third party releases in US chapter 11 plans

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Global | Publication | Q4 2022

A third party release in an insolvency proceeding refers to a release that is given to a non-debtor party that prevents that released party from being sued by creditors of the debtor. There are two types of third party releases in insolvency cases—voluntary and involuntary. For instance, voluntary third party releases are those to which a releasing creditor has consented. by agreeing to the release on its plan ballot. On the other hand, involuntary third party releases release a non-debtor without consent of the creditors. Third party releases in insolvency cases are generally used to facilitate a settlement between a debtor and its stakeholders by preventing certain claims from being asserted against the released parties after confirmation of the debtor's plan of reorganization. The usefulness of these releases is apparent in contentious restructurings; indeed, many countries (including England and Canada) regularly permit creditors to release their claims against non-debtor third parties.¹

United States courts, however, are divided on the question when considering chapter 11 cases. The Fifth, Ninth and Tenth Circuit Courts of Appeal have entirely rejected third party releases outside of asbestos-related cases where the US Bankruptcy Code explicitly allows such releases. In comparison, the First, Third, Fourth, Sixth, Seventh, Eighth, Eleventh and DC Circuit Courts of Appeal have found the releases to be authorized under various sections of the Bankruptcy Code and under a bankruptcy court's "residual authority." Despite their authorization of third party releases, even those courts use phrases like "extraordinary," "unusual" and "when circumstances warrant" in defining their applicability.²

Continuing to fuel this uncertainty, courts in 2022 have issued significant but divergent decisions on the use of third party releases in chapter 11—either striking down plans on the grounds that bankruptcy courts do not have the requisite authority to approve such releases or, on the other hand, finding the requisite authority and approving the use of such third party releases this uncertainty, coupled with legislation now before the US Congress, indicates that non‑consensual third party releases are now in the cross-hairs. As a result, parties that are using (or might use) US courts to restructure their liabilities where third party releases are needed should pay close attention to these shifting views as they consider their strategic options. We discuss below the 2022 decisions reaching different decisions on this important topic.

The Eastern District of Virginia (In re Ascena Retail Group) deals another blow to third party releases

In January 2022, the US District Court for the Eastern District of Virginia vacated the confirmation order that was on appeal in Patterson, et al. v. Mahwah Bergen Retail Group, Inc., on the ground that the plan contained impermissible non-consensual third party releases. 636 B.R. 641 (E.D. Va. 2022) ("Ascena Retail Group"). Ascena Retail Group was a publicly held retailer of apparel for women and girls that filed for bankruptcy in 2020 and owned brands such as Ann Taylor, LOFT, Lane Bryant and Lou & Grey. The debtors liquidated their assets through a series of sales and proposed a plan providing for the distribution of the estate's remaining cash to creditors, which the Bankruptcy Court confirmed (the "Ascena Plan").

The Ascena Plan also included the usual broad third party releases, covering any type of claim that existed or could have been brought against any person or entity associated with the debtors as of the effective date of the Ascena Plan, including a securities fraud class action lawsuit then pending against certain prepetition executives of Ascena. The releases bound anyone that did not affirmatively "opt out" of such releases in a plan ballot. Because creditors had the ability to opt out of the third party releases in connection with their plan ballot, the Bankruptcy Court treated the releases as "consensual." Following confirmation, the United States Trustee and the securities fraud litigation plaintiffs appealed the bankruptcy court's decision to the District Court.³

The District Court first conducted an extensive analysis of whether the Bankruptcy Court has jurisdiction to determine the released claims, including the class action lawsuit, and determined that the court lacked constitutional authority to grant the releases. The District Court criticized the Bankruptcy Court for (i) not identifying whether it had jurisdiction over the claims the plan released, and (ii) not engaging in a content-based analysis of whether the claims being released were core or non-core, as required by Stern v. Marshall, 564 U.S. 462 (2011), the US Supreme Court case establishing that US Bankruptcy Courts may only determine "core" bankruptcy claims that fall within the constitutional grant bestowed by Article I of the US Constitution. The District Court found that many of the claims being released by the plan, including several claims in contract and tort that arose prior to the debtors' petition, had no bearing on the property of the debtors' estate or the administration of the case. As a result, the District Court concluded that these claims clearly did not constitute "core" matters with respect to the debtors' bankruptcy case. Thus, the Bankruptcy Court lacked jurisdiction to determine such claims and as a result lacked the power to release the claims absent the consent of the releasing parties.⁴

Second, the District Court found that the releases were not consensual, noting that the Bankruptcy Court did not consider the proper threshold question in determining whether the releases were consensual; rather, the Bankruptcy Court looked only to whether a releasing party had returned the required "Release Opt-Out Form" (if not, the release would automatically be deemed consensual). The District Court rejected that approach, holding that the US Bankruptcy Code requires an overt act—such as affirmatively "opting in" to the release—evidencing the party's consent to resolve the claim. Inaction in the form of failing to opt out of a release was insufficient given the constitutional standard for active, knowing and voluntary consent.

As a result of the District Court's decision, the debtors sought confirmation of a modified Ascena Plan without the third party releases invalidated by the District Court. The modified Ascena Plan was ultimately confirmed by the Bankruptcy Court on March 3, 2022.

Delaware Bankruptcy Courts continue to approve third party releases

In February 2022, the US Bankruptcy Court for the District of Delaware (Bankruptcy Judge Dorsey) confirmed a plan in In re Mallinckrodt that contained non-consensual third party releases. See In re Mallinckrodt PLC, 639 B.R. 837 (Bankr. D. Del. 2022) ("Mallinckrodt"). Mallinckrodt and its debtor affiliates produced and sold a variety of pharmaceutical products, including opioids. Mallinckrodt filed its bankruptcy case to settle numerous lawsuits in connection with its production of opioids, and its plan provided four different types of releases: (a) releases by the debtors; (b) releases by non-debtor third parties where certain claimants were given a chance to "opt out" of third party releases; (c) non-consensual releases by opioid claimants; and (d) releases by the debtors and affiliates of the opioid claimants. Although the Plan was overwhelmingly supported by the creditors, the US Trustee, the SEC, and the State of Rhode Island objected to different releases. The objectors argued that the releases were "vastly overbroad, releasing persons and entities that did not contribute anything of value to the reorganization." The US Trustee also argued that the Bankruptcy Court lacked jurisdiction to approve the releases and that creditors' due process rights would be violated.

While acknowledging Ascena and other cases, Bankruptcy Judge Dorsey concluded that under precedent in the Third Circuit Court of Appeals (which covers Delaware), the Bankruptcy Court had the requisite authority to approve the non-consensual opioid releases. He remarked, "[t]here can be no debate over the proposition that a bankruptcy court can approve a plan that includes third party releases" in the Third Circuit.⁵ First, Judge Dorsey determined the Bankruptcy Court possessed constitutional authority because these releases were integral to the success of the debtors' plan; therefore, they were a core matter. Judge Dorsey reasoned that without the releases, settlements that were essential to the plan would not be effectuated and, without the settlements, the plan would fall apart.

Second, Judge Dorsey—in contrast to the District Court in Ascena—found that the opt-out provisions of the third party releases rendered them consensual. In making this determination, Judge Dorsey examined the extent of the notice given and found ample evidence in the record that the debtors made every effort to ensure that the releasing parties were sent notices in a variety of ways that clearly explained in "no uncertain terms" that action was required to preserve claims. The Mallinckrodt Plan went effective on June 16, 2022, although some issues unrelated to the releases remain on appeal to the Third Circuit Court of Appeals.

Most recently, the Delaware Bankruptcy Court (Bankruptcy Judge Silverstein) confirmed a plan in In re Boy Scouts of America and Delaware BSA, LLC, No. 20-10343, 2022 WL 3030138 (Bankr. D. Del. Jul. 29, 2022) ("Boy Scouts"). In Boy Scouts, Bankruptcy Judge Silverstein followed the Third Circuit's opinion in Millennium to determine that "a bankruptcy court has both statutory and constitutional authority to enter a final order confirming a plan containing non-consensual third party releases . . . ." Specifically, Judge Silverstein agreed with Judge Dorsey's decision in Mallinckrodt that opt-out provisions make such a release consensual and further, that nonconsensual releases fall within the Bankruptcy Court's constitutional authority where the release is "integral to the debtor-creditor relationship."

Judge Silverstein also concluded that "there is statutory authority to grant third-party nonconsensual releases." This finding is in contrast to recent rulings in other districts which have found that the Bankruptcy Code does not provide statutory authority to release third party claims against non-debtors. In those cases, courts have surveyed the Bankruptcy Code and determined that the only section of the Bankruptcy Code that authorizes third party releases against non-debtors without the consent of third parties is section 524(g), but section 524(g) only applies in asbestos cases and, according to those courts, no other section provides statutory mechanism.

Disagreeing with this narrow interpretation, Judge Silverstein surmised that where a bankruptcy court is constitutionally authorized to grant such a release, the statutory authority to do so must be found in the bankruptcy court's ability "to exercise its inherent equitable power consistent with §§ 105(a), 1123(a)(5) and 1123(b)(6) of the Bankruptcy Code." Further, while agreeing that the Bankruptcy Code does not expressly authorize non-consensual releases outside of asbestos cases, Judge Silverstein observed that "neither does it prohibit them." Having then found both the constitutional and statutory authority required, the plan in Boy Scouts eventually joined the ranks of those gaining approval of third party non-consensual releases. Notices of appeal of Judge Silverstein's confirmation order were filed on September 21, 2022.

Conclusion

As these recent decisions suggest, the validity and authority of third party releases in US chapter 11 cases lack the uniformity and predictability many parties seek in a restructuring venue. Also of note, in July 2021, Congress took up the controversy of third party releases in the Nondebtor Release Prohibition Act (the "NRPA"), which would restrict a bankruptcy court's ability to approve non‑debtor third party releases. If approved, the Nondebtor Release Prohibition Act would require the releasing party to "expressly consent in a signed writing" before a third party release would be deemed consensual, thus doing away with the ability to implement "opt-out" releases or otherwise obtain releases of claims from non-voting creditors. If a third party release or injunction does not qualify as consensual under the NRPA's strict standard, such relief would be prohibited, subject to limited, specific exceptions. Therefore, the passage of the NRPA could have significant consequences on chapter 11 filings and restructuring. Absent releases, non-debtors normally motivated to fund settlements in chapter 11 plans in order to obtain those releases may instead be incentivized to engage in prolonged litigation to limit their liability. After introduction and referral, the House Judiciary Committee voted to recommend the NPRA be considered by the full House of Representatives, while the analogous Senate version of the NPRA remains in the Senate Judiciary Committee.

Because the use of non-debtor third party releases is commonplace in certain other jurisdictions, international debtors should carefully consider their filing forum—whether in the US or in a foreign venue. Such a significant divergence in reasoning within the US could have serious implications on the ultimate success of a plan of reorganization under the Bankruptcy Code and thus will likely dictate which venue within the US debtors may use in the future to restructure their liabilities and/or whether non-US venues may receive more serious consideration as options of the restructuring.

Footnotes

¹ For example, Canadian courts see third party releases as an important aspect of the restructuring process. Accordingly, it is well-established in Canada that insolvency courts have the jurisdiction necessary to approve a plan of compromise or arrangement that includes releases in favor of non-debtor third parties, including releases that are binding on parties beyond the jurisdiction of the granting court. Canadian restructuring plans, including such non-debtor third party releases, have further been recognized by US courts pursuant to chapter 15 of the US Bankruptcy Code.

² The Second Circuit Court of Appeals was thought by many to have previously indicated that non-consensual third party releases of claims against non-debtors could be approved in "appropriate, narrow circumstances." Deutsche Bank A.G. v. Metromedia Fiber Network, Inc., (In re Metromedia Fiber Network, Inc.), 416 F.3d 136, 141 (2d Cir. 2005). That view, however, was upended last year by a December 2021 decision from the Southern District of New York determining that the Second Circuit Court of Appeals had not directly addressed whether the Bankruptcy Code provided the requisite authority to grant non-consensual third party releases and holding that the Bankruptcy Code, in fact, did not so provide. Accordingly, in that decision, the releases were denied.

³ The District Court ultimately determined that the securities litigation plaintiffs lacked standing to appeal because they opted out of the release and, therefore, the releases had no impact on them. The United States Trustee, however, was allowed to proceed. Mahwah Bergen Retail Group, Inc., 636 B.R. at 663–64.

⁴ The District Court explained that the Bankruptcy Court only "stated in conclusory fashion" that the third party releases were integral to the plan, basing this finding only "on the fact that the Plan stated as much." Instead, the Bankruptcy Court should have made specific findings of fact to determine whether it was justified in approving a third party release. The District Court specifically found that the Bankruptcy Court had not conducted the proper seven-factor test adopted by the Fourth Circuit Court of Appeals, (that is binding precedent in the Eastern District of Virginia), which requires all of the following: "(1) There is an identity of interests between the debtor and the third party, usually an indemnity relationship, such that a suit against the non-debtor is, in essence, a suit against the debtor or will deplete the assets of the estate; (2) The non-debtor has contributed substantial assets to the reorganization; (3) The injunction is essential to reorganization, namely, the reorganization hinges on the debtor being free from indirect suits against parties who would have indemnity or contribution claims against the debtor; (4) The impacted class, or classes, has overwhelmingly voted to accept the plan; (5) The plan provides a mechanism to pay for all, or substantially all, of the class or classes affected by the injunction; (6) The plan provides an opportunity for those claimants who choose not to settle to recover in full; and (7) The bankruptcy court made a record of specific factual findings that support its conclusions." Mahwah Bergen Retail Group, Inc., 636 B.R. at 681 (citing Behrmann v. Nat'l Heritage Found., 663 F.3d 704, 711–12 (4th Cir. 2011)).

⁵ In making this determination, Judge Dorsey cited In re Millennium Lab Holdings II, LLC, 575 B.R. 252 (Bankr. D. Del. 2017) aff'd 945 F.3d 126 (3rd Cir. 2019) cert denied 140 S.Ct. 2805 (2020). But, Millennium only stands for the proposition that a Bankruptcy Court possesses constitutional authority to approve non-consensual third party releases and does not directly address whether the US Bankruptcy Code provides a statutory mechanism to do so.