Third party releases in a chapter 11 plan have become fairly common in the United States. A recent decision by the Delaware District Court in Opt-Out Lenders v. Millennium Lab Holdings II, LLC (In re Millennium Lab Holdings II, LLC), however, questions whether the bankruptcy court has the authority to approve nonconsensual third party releases as part of confirmation of a chapter 11 plan. Although the decision seems to have received little attention, it could alter the way parties structure and seek approval of nonconsensual third party releases.

Background

A nonconsensual third party release is an involuntary release of a non-debtor’s claim against another non-debtor. Confirmation by the bankruptcy court of a chapter 11 plan containing such a release is the vehicle for sanctioning the release. The Millennium chapter 11 plan purported to release certain of the debtor’s equity holders from fraud and RICO claims that the debtors’ lenders might have against them. The release was provided in exchange for a $325 million contribution by the debtor’s equity holders to the bankruptcy estate. The lenders objected to the release, but the bankruptcy court confirmed the chapter 11 plan over their objection. After confirmation, the lenders appealed to the district court and argued that the U.S. Supreme Court’s ruling in Stern v. Marshall and its progeny forbid a bankruptcy court from entering a final order approving nonconsensual third party releases.

Bankruptcy Court Jurisdiction and Stern

The authority of U.S. bankruptcy courts to adjudicate proceedings is derived from U.S. district courts, and a bankruptcy court is considered a “unit” of the district court. Unless a party consents to having a bankruptcy court render a judgment on its claim, a bankruptcy court can only adjudicate a claim if it has the statutory and constitutional authority to do so. Otherwise, assuming that the claim is at least “related to” the bankruptcy case, the bankruptcy court can still propose findings of fact and conclusions of law on the claim, which are subject to the independent review of, and entry of judgment by, the district court.

District Court Decision

In Millennium, the district court stated that, because a nonconsensual third party release implicates a determination of the merits of the underlying released claims, the bankruptcy court might not have had the authority to approve the release. If the bankruptcy court did not have such authority, then such release could only be approved by the district court. Although the debtors argued that the district court simply could rule on the merits of the third party releases in the context of the lenders’ appeal, the district court noted that the Millennium bankruptcy court had not even considered whether it had the authority to approve the third party release and had not made any findings regarding the merits of the lenders’ claims against the equity holders. Accordingly, the district court did not have a sufficient record before it to consider the merits of the releases in the context of the appeal. The district court stated it would not, before the bankruptcy court had the opportunity to do so, decide whether the bankruptcy court has the authority to adjudicate on a final basis the nonconsensual third party releases.

Although it did not decide the authority issue, the district court did comment on the persuasiveness of arguments in favor of holding that the bankruptcy court does not have such authority. It noted that the underlying lender claims do not appear to involve matters of “public rights” that can be assigned to a bankruptcy court. Instead, the claims are between two private parties based on state common law or statutes that are not closely intertwined with a federal regulatory program. The district court stated that “[i]f Article III [of the U.S. Constitution] prevents the Bankruptcy Court from entering a final order disposing of a non-bankruptcy claim against a nondebtor outside of the proof of claim process, it follows that this prohibition should be applied regardless of the proceeding (i.e., adversary proceeding, contested matter, plan confirmation).”

Ultimately, the district court remanded the case to the bankruptcy court to consider whether the bankruptcy court has the authority to approve the nonconsensual release of the lenders’ claims and, if it does not have such authority, to submit proposed findings of fact and conclusions of law regarding the final disposition of those claims, or, alternatively, to strike the nonconsensual release from the confirmation order.

Analysis

An actual holding as to whether a bankruptcy court has the authority to enter a final order on nonconsensual third party releases may come later in the case. If it ultimately is determined that a bankruptcy court does not have authority to approve a nonconsensual third party release, then every plan containing such a release will have to go before the district court for approval. This either would involve a two-step confirmation process by which the bankruptcy court could enter proposed findings of fact and conclusions of law for approval by the district court. Alternatively, parties might seek to have the district court preside over the plan confirmation, even though confirmation of a chapter 11 plan is squarely within the bankruptcy court’s authority. Either path could create significant delays in a debtor’s emergence from chapter 11. Moreover, by suggesting that a court must address the merits of the underlying claims to be released, the Millenium court raises the bar for approving nonconsensual third party releases. As such, the Millenium decision likely will change the way practitioners approach approval of nonconsensual third party releases.