Non-consensual third-party releases remain a controversial topic in bankruptcy proceedings. The validity of such releases in the context of settlement within a Chapter 11 plan continues to be attacked by dissenting creditors. While at times, objections have addressed the release of derivative claims, the more controversial topic is a release of direct claims held by creditors and/or equity holders. The former is regarded as property of the estate subject to the provisions of Chapter 11 of the Bankruptcy Code and undoubtedly a core bankruptcy matter, while the latter must find its support in the extent to which it is “related to” bankruptcy and vital to the plan.

The fundamental issue is whether and to what extent a non-debtor should benefit from a bankruptcy plan by obtaining protection against suits and claims by creditors. In some circuits (Fifth, Ninth, and Tenth) such releases are not permitted as only debtors can be discharged from liability through a bankruptcy case. Where such releases are permitted, they must be narrowly drawn (e.g., third parties are not released from fraud, gross negligence or willful misconduct and releases cannot act as blanket immunity for all wrongdoing). The level of creditor support for a plan providing for such releases can also be a consideration. In all events, however, the proposition divides the circuits and even where permissible, getting approval of third-party releases is said to be extraordinary or rare. While most cases focus on the specific features of the release, the plan and the contributions made by the released parties, two recent decisions from Delaware and Colorado Bankruptcy Courts address whether a bankruptcy court has subject matter jurisdiction over and constitutional authority to approve third-party releases as part of plan confirmation process. In considering this question, albeit facing very different plans, the two courts came to different conclusions.

Midway Gold

In a recent case from the Colorado Bankruptcy Court, a mining company—Midway Gold U.S. and affiliates—sought confirmation of a plan that contained releases by creditors of claims against non-debtors for causes of action, claims, debts and other obligations, whether existing on or after the petition date but prior to the effective date of the plan that were “in any way related to” the debtors, their Chapter 11 cases or the plan at issue. In re Midway Gold US, Case No. 15-16835 (MER), 2017 WL 4480818 (Bankr. D. Colo. Oct. 6, 2017). The decision addressed a number of release and exculpation provisions set forth in a plan. The decision upheld some releases (exculpation for fiduciaries acting in a Chapter 11 case), found others unnecessary or otherwise addressed (release of the lenders), or adequately addressed by the discharge of the debtor. In this context of a review of a number of releases the decision also addressed the protection extended to non-debtors through releases and injunctions provided by the Chapter 11 plan and proposed confirmation order. As presented in the decision, litigation claims and settlements did not have as prominent a role as the injunction protecting non-debtors.

The court reasoned that whether the bankruptcy court may consider approval of such releases hinges on whether the bankruptcy court has subject matter jurisdiction over the “peripheral claims” purportedly released under the plan. Presiding Judge Michael E. Romero concluded that it did not, because a bankruptcy jurisdiction only extends to “all proceedings arising under title 11, or arising in or related to a case under title 11″ and the released claims would not necessarily fall into one of those categories.

First, because the plan did not limit the released causes of action to those under the Bankruptcy Code, such as avoidance actions, the released claims did not “arise under title 11.” Second, while the releases were included within a proposed Chapter 11 plan, and “confirmation of plans” are expressly made a core proceeding under 28 U.S.C. §157(b)(2)(L), the court strongly felt that it could not “permit third-party non-debtors to bootstrap their disputes into bankruptcy case in this fashion.” Therefore, the claims did not “arise in” the debtors' bankruptcy cases. Finally, the court found that the claims were also not “related to” the bankruptcy cases, because the potentially released claims included claims strictly among non-debtors which may have had no connection to the debtors, the property of the debtors' estates or the administration of the Chapter 11 cases. There seemed to be no evidence of indemnity or other ties to the debtors.

The court reasoned that the fact that the non-debtor released parties “may have contributed financially” to the proposed Chapter 11 plan was “insufficient alone for the court to find it [could] exercise 'related to' jurisdiction” over the potentially released claims. The fact that success of the plan may depend on releases being given in exchange for the contributions and settlements entered into alone did not provide sufficient basis. The court saw danger in going down this path, as under this precedent “a debtor could create subject matter jurisdiction over any non-debtor third-party by structuring a plan in such a way that it depended upon third-party contributions.” This would potentially lead to non-debtors being able to “purchase immunity from unrelated torts through their contribution to a debtor's reorganization.”

Millennium Lab Holdings

In Millennium Lab Holdings, a recent case from the Delaware Bankruptcy Court, on remand from the district court, the Bankruptcy Court considered whether non-debtor releases exceeded the constitutional authority of bankruptcy court as an Article I court. In this case the creditors had appealed the Bankruptcy Court approval of releases granted to key insiders under a Chapter 11 plan on multiple grounds, including raising on appeal whether the bankruptcy courts had constitutional authority to approve the nonconsensual release of creditors' direct non-bankruptcy common law fraud and RICO claims against the non-debtor equity holders under the standing precedent of Stern v. Marshall. In re Millennium Lab Holdings II, Case No. 15-12284 (LSS), 2017 WL 4417562 (Bankr. D. Del. Oct. 3, 2017). On remand to consider this issue, the Bankruptcy Court rejected the appellants' “expansive reading of Stern,” which, according to Presiding Judge Laurie S. Silverstein, “not only applies Stern outside of the narrow context in which it was made, but far beyond the holding of any court, and which would, if accepted, dramatically change the division of labor between the bankruptcy and district courts.” This decision, in contrast to Midway Gold, did not base its decision on subject matter jurisdiction, as the indemnity claims of insiders against Millennium brought the claims under the “related to” jurisdiction of the bankruptcy court. See In re Millennium Lab Holdings II, Case No. 15-12284 (LSS) [ECF No. 206] (Bankr. D. Del. Dec 15, 2015).

Millennium Lab Holdings II and affiliates, providers of laboratory-based diagnostics services, filed voluntary petitions under Chapter 11 of the Bankruptcy Code on November 10, 2015 with their pre-packaged plan of reorganization. The filing was a culmination of a lengthy negotiation process which resulted in multiple settlements and a restructuring support agreement with both an ad hoc group of bondholders and certain non-debtor equity holders. The plan further provided for release of both debtor and third-party claims against these non-debtor equity holders in exchange for $325 million payment to fund the reorganization. The releases included a release of potential claims under the federal RICO statute and common law fraud claims held by certain lenders under the term loan. The plan solicitation process did not allow for an option to opt out of the releases.

Certain term loan lenders voted to reject the plan and objected to confirmation, arguing, among other things, that the court did not have subject matter jurisdiction to grant non-consensual third-party releases. Nevertheless, the Bankruptcy Court confirmed the plan on Dec. 14, 2015. The term loan lenders appealed.

On appeal, the term loan lenders argued that the Bankruptcy Court did not have the constitutional authority to enter a final order confirming a plan containing nonconsensual third-party releases—an issue that was not previously addressed by the Bankruptcy Court. The district court remanded the case for further proceedings on this issue.

In arguing that the bankruptcy court lacked constitutional authority appellants relied on the Supreme Court's decision in Stern v. Marshall, 131 S. Ct. 2594 (2011). In Stern, the Supreme Court considered whether a bankruptcy court had the constitutional authority to enter a final judgment on a state law governed counterclaim brought by a debtor in bankruptcy court against a counterclaimant. The Supreme Court held that the bankruptcy court, as a non-Article III court, did not have such authority because the claim at issue did not stem from the bankruptcy itself or would not be necessarily resolved through the bankruptcy proof of claim process, as it was an unrelated tort claim.

The appellants argued that Stern should be interpreted to provide an absolute right to have the merits of their claims determined in the context of a civil lawsuit, i.e., before an Article III judge. The argument equated granting insider releases of the appellants' claims over their objection to an “adjudication” of the RICO lawsuit, which, under their interpretation of Stern, is prohibited. Judge Silverstein disagreed with appellants' “expansive reading of Stern.” First, Judge Silverstein emphasized that Stern analysis is limited to a state law claim or counterclaim brought by the debtor-in-possession or trustee. Here, the operative proceeding was confirmation of a plan, which is neither a “claim” nor a “counterclaim.” An order confirming a plan with releases “does not rule on the merits of the state law claims being released,” rendering Stern inapplicable. Further, the court pointed out that third-party releases are quintessentially federal in nature – there is no state law analogue and they do not exist without regard to the bankruptcy proceeding. “Rather, a ruling approving third-party releases is a determination that the plan at issue meets the federally created requisites for confirmation and third-party releases.”

Finally, the court further reasoned that adopting appellants' interpretation would dramatically change the division of labor between the bankruptcy and district courts, because under this interpretation certain day-to-day functions of the bankruptcy courts—including approval of §363 sales that allow purchase of assets free of successor liability, substantive consolidation in which the rights of creditors and non-creditors against non-debtor entities are rearranged, recharacterization and/or subordination (in which state law debts are transformed), among others—would have to be adjudicated by district courts, absent creditor consent. The Court asserted that “[i]t seems at least arguable that consent could be withheld to leverage a party's position.”

Notably, Bankruptcy Judge Silverstein did consider and determine that there was subject matter jurisdiction over third-party releases, due to the indemnity claims of the released insiders, as the indemnification obligations satisfied the necessary nexus between the release and the bankruptcy matters and the releases were thus “related to” the Chapter 11 case. In re Millennium Lab Holdings II, Case No. 15-12284 (LSS) [ECF No. 206] (Bankr. D. Del. Dec. 15, 2015). Moreover, the court reasoned that dealing with such claims in the context of confirming a plan containing third-party releases brought the matter within a core jurisdiction of the bankruptcy court.

Conclusion

While there is a continuing division among the circuits regarding validity of third-party releases, even in jurisdictions where they are permitted, the court must be sufficiently satisfied that such releases are critical to the reorganization. The relief is neither ordinary nor readily available. Unfortunately, in Midway Gold, the plan at issue, at least as described in the decision, did not present the settlement of a substantial litigation or other clear connection to the bankruptcy case and the objector was not a creditor or equity holder that was seeking to preserve claims against the released parties, but instead was the Office of the United States Trustee. The Millennium court, in contrast, did consider objections by creditors seeking to preserve their claims against the insiders released under the Chapter 11 plan. Further appeal is likely. The Bankruptcy Court determined that the reorganization of Millennium is critically dependent upon the settlement with insiders. The ability to use third-party releases to support reorganization to end substantial litigation, through favoring settlements of actions that are tied to derivative actions, tied to the debtor though indemnity claims and which provide substantial value to the rehabilitation of a debtor is a continuing and important issue. The ability of debtors facing crippling or massive litigation, limited insurance resources as well as mounting indemnity and cross-claims to reorganize and continue as a going concern may be entirely dependent upon using third-party releases. The appropriate balance between favoring reorganization and obtaining meaningful recovery for creditors as against the rights of individual creditors to bring claims is an issue which is fundamental to the debtor creditor relationship. Providing for such relief has been a critical tool, which must be carefully approached, as it can be the core of a reorganization which has received broad support and should not be subject to the proverbial “holdouts” essentially attempting to assert a veto over reorganization and settlement of litigation. Where there are limited resources and massive claims, substantial settlements through a plan can be the only viable solution. It is hardly a “bootstrap.” Abuse of such relief should not be confused with judicious use of well-supported and critical, if not necessary, relief.

Corinne Ball is a partner at Jones Day.