Two recent decisions by U.S. District Courts have rejected attempts to include nonconsensual third party releases in chapter 11 reorganization plans.  These rulings suggest third party releases may be facing increasing push back from the courts.

Traditionally, bankruptcy only operates to eliminate claims held by creditors against the debtor.  Over the last few years, however, corporate debtors have increasingly attempted to include nonconsensual third party releases in chapter 11 plans of reorganization.  These third party releases, when approved by the bankruptcy court, operate to preclude creditors of the debtor from pursuing claims they possess against non-debtor third parties.  Despite being increasingly found in chapter 11 restructurings, however, third party releases have remained controversial and the subject of heated debates, both inside and outside the courtroom.

These debates culminated in the United States District Court for the Southern District of New York’s reversal of the bankruptcy court’s order confirming a plan for Purdue Pharma, L.P. (“Purdue”), in which it held that the bankruptcy court did not have statutory authority to approve the plan’s third party releases.  The court noted that Purdue, a pharmaceutical company with most of its revenue stemming from the sale of the prescription opioid OxyContin, has found itself faced with a “veritable tsunami of litigation” arising from the marketing and sale of OxyContin.  As a result, Purdue filed for bankruptcy protection in September 2019.  After two years of litigation and extensive negotiation, Purdue obtained confirmation of a reorganization plan which, among other things, contained third party releases eliminating claims held by creditors of Purdue directly against its private owners (the Sackler family) and other non-debtor entities, including claims arising from alleged willful misconduct and fraud.  In return, the Sacklers agreed to contribute approximately $4.5 billion to fund charities and certain recoveries under the plan.  While the plan was supported by an overwhelming majority of creditors, many states and other creditors objected and appealed the plan following confirmation.

On appeal, the Southern District of New York vacated the confirmation order.  In a 142-page decision, the District Court held that nothing either express or implied in the Bankruptcy Code gave a bankruptcy court statutory authority to confirm a plan containing nonconsensual third party releases.  Among other things, the District Court rejected the argument that Bankruptcy Code sections 105(a), 1123(a)(5), 1123(b)(6) and 1129(a)(1), either singularly or in the aggregate, permit the approval of third party releases, noting that none of the sections could, in context, be read to grant such a wide-ranging ability to release the claims of non-debtors against non-debtors.  The District Court similarly reasoned that Congress’s enactment of Bankruptcy Code sections 524(g) and (h)—which permit third party releases but only in asbestos cases—indicated that such releases were not permissible in other cases.

In the second case, Patterson v. Mahwah Bergen Retail Group, Inc., the United States District Court for the Eastern District of Virginia left open the door for third party releases but imposed significantly more stringent requirements for their inclusion than the bankruptcy court had applied.  This case involved the bankruptcy of a retail chain which sold apparel for women and girls.  The debtor sold off their assets and then filed a plan that contained broad third party releases.  The debtors gave creditors the ability to affirmatively opt-out of the third party release, but, unless they opted-out, creditors were deemed to have accepted the release’s terms.  The bankruptcy court treated the third party releases as consensual due to the existence of the opt-out, and confirmed the debtor’s plan.

On appeal, the District Court vacated the confirmation order.  It held that the third party releases in the plan purported to extinguish an “extraordinarily vast range of claims” and that, before confirming a plan containing such releases, a bankruptcy court had to determine whether it had jurisdiction over those claims.  Id. at *41.  Here, the District Court held it took only a “cursory review” to determine the third party releases exceeded the bankruptcy court’s constitutional authority under Stern v. Marshall, 564 U.S. 462 (2011), because many of the released claims had no apparent connection to the debtor’s bankruptcy.  Thus, even if the releases were constitutional, the court ruled the bankruptcy court could not constitutionally order them.  The District Court reconciled its ruling with the recent Third Circuit decision in In re Millennium Lab Holdings II, LLC, 945 F.3d 126, 139 (3d Cir. 2019) upholding the bankruptcy court’s constitutional authority to impose the coerced third party releases under Stern, noting that in Millennium Lab Holdings II the third party releases had been found to be integral to the debtor’s restructuring based on a wealth of detailed factual findings.  The same could not be said in this case.

The District Court also held that the bankruptcy court had been incorrect to infer consent from parties’ inaction in failing to affirmatively opt-out of the releases.  The District Court held that while non-consensual third party releases may, when jurisdiction exists, be approved, they must satisfy the Fourth Circuit’s seven factor test in Behrmann v. Nat’l Heritage Found., Inc., 663 F.3d 704 (4th Cir. 2011), and even then, they should be used “cautiously and infrequently.”  The seven factor test adopted by the Fourth Circuit in Behrmann (following the Sixth Circuit’s ruling in In re Dow Corning Corp., 280 F.2d 648 (6th Cir. 2002)), only permits non-consensual third party releases where: (1) there is an identity of interests between the debtor and the third party such that a suit against the non-debtor 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; (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 claims, 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; and (7) the bankruptcy court made a record of specific factual findings that support its conclusions.

Both of these decisions, which are well worth reading in full, demonstrate significant legal issues not previously fully analyzed causing the District Courts to reject third party releases in chapter 11 plans, and indicate that the tide may be turning against them.  Moreover, as the Southern District of New York hinted at in the Purdue Pharma case but neither of these two courts decided, even if the Bankruptcy Code did authorize non-consensual third party releases, they remain subject to many potential constitutional challenges that have not yet been litigated.  Only time (and further decisions) will tell, however, if the party truly is over for nonconsensual third party releases.