Is the End Near for Third Party Releases In Chapter 11 Plans?

When the Bankruptcy Reform Act of 1978, the foundation on which the current Bankruptcy Code is constructed, was enacted, bankruptcy cases customarily involved a debtor addressing claims only against it. Consistent with that norm, Bankruptcy Code Section 524 provides that “discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt.”

However, perhaps because they recognize that the primary target of their claims may file for bankruptcy and discharge its debts, plaintiffs have sued multiple parties with increasing frequency. Former Boy Scouts allegedly abused sue not only the alleged scoutmaster-abuser, but the Boy Scouts of America and the churches that hosted the scout meetings. Parties damaged by misuse of opioids do not just sue the manufacturer of the drug, but the officers of the manufacturer, the doctor who prescribed it, and the pharmacy that filled the prescription. Consequently, companies facing multiple tort claims that seek Chapter 11 bankruptcy protection to stem the tide of litigation have sought to extend the protections afforded by the Bankruptcy Code to their co-defendants by seeking confirmation of plans of reorganization without the consent of their creditors which prohibit creditors of the debtor company from pursuing claims against their co-defendants. Although they have not passed muster with all courts, such so-called “non-consensual third-party releases” have become common features of Chapter 11 plans in large, complex Chapter 11 cases.

Although there is no provision of the Bankruptcy Code expressly authorizing non-consensual third-party releases, only three of the eleven United States Courts of Appeal have expressly prohibited them. The other Circuits have either expressly approved them or left the door open to approval in “rare” or “limited” circumstances. However, recent decisions in two major Chapter 11 cases and legislation now pending in Congress may portend that the trend of using Chapter 11 to protect entities other than the Chapter 11 debtor may soon be reversed. The two recent decisions are the decision of the United States District Court for the Southern District of New York in the Purdue Pharma, L.P. case and the decision of the United States District Court for the Eastern District of Virginia in the Mahwah Bergen Retail Group, Inc. case. The pending legislation is HR4777 in the House of Representatives and S2497 in the Senate.

There are stark differences between the facts in Purdue Pharma and the facts in Mahwah Bergen Retail Group. In Purdue Pharma, the members of the Sackler family protected by the non-consensual third-party release were contributing $4.325 billion to fund a Chapter 11 plan of Purdue Pharma whose going concern value was only $1.8 billion. The terms of Purdue Pharma’s plan were negotiated during extensive mediation sessions by ten groups representing different creditor constituencies, including multiple state governments, with the benefit of more than 160 million documents produced in discovery in pre-bankruptcy multi-district litigation. Notice of the terms of the plan “reached roughly 98% of the adult population of the United States and 80% of the adult population in Canada.” The bankruptcy judge who confirmed the plan made extensive findings of fact and conclusions of law in what the District Court characterized as a “judicial tour de force.”

In Mahwah Bergen Retail Group, the third parties protected by the non-consensual third-party releases were officers who had ceased working for the debtor before the Chapter 11 case was filed and were contributing nothing to fund the plan. None of the creditors who were enjoined from pursuing claims against them participated in negotiation of the terms of the plan. Notice of the terms of the plan was sent only to registered security holders, not all creditors who would be enjoined, and there was no information in the record as to how many of the security holders actually received the notice. The bankruptcy judge who confirmed the plan “extinguished these claims with little or no analysis.”

Despite the differences in the facts, the opinions in Purdue Pharma and Mahwah Bergen Retail Group are strikingly similar in one respect. Both District Courts concluded that direct claims of creditors against parties other than the debtor are, in bankruptcy parlance, “non-core claims” that could be adjudicated only by courts established under Article III of the Constitution whose judges enjoy life tenure to insure their independence. Bankruptcy judges, who serve 14-year terms, could not bar the enforcement of such claims, effectively adjudicating them, without running afoul of the Constitution. Although bankruptcy judges may adjudicate “core” bankruptcy claims under Article I of the Constitution, “Article III simply does not allow third-party non-debtors to bootstrap any and all of their disputes into a bankruptcy case to obtain relief.”

Because it was not bound by prior law in its Circuit approving non-consensual third-party releases as the court was in Mahwah Bergen, the Court in Purdue Pharma added another reason to vacate the confirmation of the plan. The Purdue Pharma Court went on the hold that even if the bankruptcy court could adjudicate creditor claims against non-debtors without violating the Constitution, nothing in the Bankruptcy Code gave it statutory authority to enjoin creditors from pursuing claims against non-debtors. Noting that Congress amended Section 524 of the Code in 1984 to authorize bankruptcy courts to enjoin prosecution of claims resulting from exposure to asbestos against non-debtors under carefully delineated circumstances, the Court said that “The notion that statutory authority can be inferred from Congressional silence is counterintuitive when, as with the Bankruptcy Code, Congress put together a ‘comprehensive scheme’ designed to target specific problems with ‘specific solutions.’”

Before the plan in Purdue Pharma was confirmed, but after the plan proposing non-consensual third-party releases was filed and stirred public debate over the use of Chapter 11 to shield the Sackler family, identically titled bills were introduced in the U.S. House of Representatives and U.S. Senate as HR4777 and S2497, respectively. The “Nondebtor Release Prohibition Act of 2021,” if enacted, would prohibit discharging liability of non-debtor third-parties to creditors without the creditors’ consent and limit the time period during which a bankruptcy court may stay prosecution of creditor claims against non-debtor third-parties while a bankruptcy case is pending to 90 days. Neither Bill has reached a floor vote to date.

Congress has much more on its plate than addressing the ability of Chapter 11 debtors to use Chapter 11 to shield non-debtors from liability. The debate over the propriety of non-consensual third-party releases in Chapter 11 plans seems destined to rage on in the courts, with mixed results, for the foreseeable future.