Two recent U.S. district court rulings have rejected attempts to include non-consensual third-party releases in Chapter 11 reorganization plans. These rulings suggest that third-party releases may face growing backlash from from the courts.

Traditionally, bankruptcy serves only to eliminate claims held by creditors against the debtor. In recent years, however, corporate debtors have increasingly attempted to include third-party non-consensual releases in Chapter 11 reorganization plans. These third-party releases, when approved by the court of bankruptcy, have the effect of preventing the debtor’s creditors from pursuing their claims against non-debtor third parties. Although increasingly present in Chapter 11 restructurings, third-party releases have remained controversial and the subject of heated debate, both inside and outside the courtroom. .

These proceedings culminated in the United States District Court for the Southern District of New York. reversal the bankruptcy court’s order confirming a plan for Purdue Pharma, LP (“Purdue”), in which it held that the bankruptcy court did not have the legal authority to approve third-party waivers of the plan. The court noted that Purdue, a pharmaceutical company whose bulk of its revenue comes from the sale of the prescription opioid OxyContin, found itself facing a “veritable tsunami of litigation” stemming 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 negotiations, Purdue obtained confirmation of a reorganization plan which, among other things, contained third-party releases eliminating the claims held by Purdue’s creditors directly against its 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 about $4.5 billion to fund charities and some recoveries under the plan. While the plan was supported by an overwhelming majority of creditors, many states and other creditors opposed and appealed the plan after confirmation.

On appeal, the Southern District of New York overturned the confirmation order. In a 142-page decision, the district court found that nothing, either expressly or by implication, in the Bankruptcy Code gave a bankruptcy court statutory authority to confirm a plan containing non-consensual waivers to third parties. Among other things, the District Court rejected the argument that Sections 105(a), 1123(a)(5), 1123(b)(6) and 1129(a)(1) of the Bankruptcy Code, taken individually or in the aggregate, permit the approval of third-party releases, noting that none of the sections could, in its context, be interpreted as granting such a broad ability to discharge the claims of non-debtors against non-debtors . The district court also held that Congress’ enactment of Sections 524(g) and (h) of the Bankruptcy Code – which allow third-party releases but only in asbestos cases – indicated that such releases are not were not allowed in other cases.

In the second case, Patterson vs. Mahwah Bergen Retail Group, Inc., the United States District Court for the Eastern District of Virginia left the door open to third-party releases, but imposed much stricter requirements for their inclusion than the bankruptcy court had applied. This case concerned the bankruptcy of a chain of stores that sold clothing for women and girls. The debtor sold its assets, then filed a plan containing broad third-party waivers. The debtors gave the creditors the opportunity to affirmatively opt out of the third party’s release, but unless they opted out, the creditors were deemed to have accepted the terms of the release. The bankruptcy court considered the third party waivers to be consensual due to the existence of the opt-out and confirmed the debtor’s plan.

On appeal, the district court overturned the confirmation order. He ruled that the third-party releases in the plan were intended to extinguish an “extraordinarily wide range of claims” and that before upholding a plan containing such releases, a bankruptcy court must determine whether it has jurisdiction over those claims. Identifier. to *41. Here, the district court ruled that it only took a “cursory review” to determine that the third-party releases were beyond the constitutional authority of the bankruptcy court under Stern vs. Marshall, 564 US 462 (2011), because many of the claims released had no apparent connection to the debtor’s bankruptcy. So even though the releases were constitutional, the court ruled that the bankruptcy court could not constitutionally order them. The District Court reconciled its decision with the recent Third Circuit ruling in In re Millennium Lab Holdings II, LLC945 F.3d 126, 139 (3d Cir. 2019) affirming the constitutional power of the bankruptcy court to impose the compulsory discharges of third parties under Backnoting that in Millennium Lab Holdings II the third party releases had been considered an integral part of the debtor’s restructuring based on a multitude of detailed factual findings. The same could not be said in this case.

The district court also ruled that the bankruptcy court erred in inferring consent from the parties’ inaction in failing to affirmatively opt out of the releases. The district court held that while third-party non-consensual releases can, where jurisdiction exists, be approved, they must pass the Fourth Circuit’s seven-factor test in Behrman v. Nat’l Heritage Found., Inc., 663 F.3d 704 (4th Cir. 2011), and even then they should be used “with caution and infrequently.” The seven-factor test adopted by the Fourth Circuit in Behrmann (following the Sixth Circuit’s decision in In re Dow Corning Corp., 280 F.2d 648 (6th Cir. 2002)), permits non-consensual third-party releases only when: (1) there is identity of interest between the debtor and the third party such that an action against the non-debtor will exhaust the assets of the estate; (2) the non-debtor contributed substantial assets to the reorganization; (3) the injunction is essential to the reorganization; (4) the relevant class or classes voted overwhelmingly in favor of accepting the plan; (5) the plan provides a mechanism to pay all or substantially all of the claims of the group or groups subject to the injunction; (6) the plan provides an opportunity for claimants who choose not to settle to recover fully and; and (7) the bankruptcy court made specific findings of fact in support of its conclusions.

Both of these decisions, which are worth reading in full, demonstrate significant legal issues that had not previously been fully analyzed, leading district courts to reject third-party releases in chapter plans. 11, and indicate that the wind could turn against them. Moreover, as the Southern District of New York suggested in the Purdue Pharma case, but neither of these two courts decided, even though the bankruptcy code allowed non-consensual releases by third parties, they remain subject to numerous potential constitutional challenges that have yet to be litigated. Only time (and other decisions) will tell, however, if the party is really over for non-consensual third-party releases.

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