In trotting a path out of Chapter 11, debtors in most cases will need to engage various key stakeholders, some of whom are not entitled to a distribution in the bankruptcy. As a form of remuneration, non-debtors may insist on receiving a release of liability - not only from claims belonging to the debtor, but also the claims of third-parties - in exchange for their support and contribution to the case.

As we explained in a previous article published in the New York Law Journal, one frequently litigated issue is whether a Chapter 11 plan can release a non-debtor’s claims against a non-debtor, third-party absent the releasing party’s consent. This type of release is known as a “non-consensual, third-party release.” The lion share of decisions have focused on the bankruptcy court’s subject matter jurisdiction over the claims and application of circuit precedent governing releases, often assuming, without deciding, that the court has constitutional authority to grant the release if warranted under the substantive case law.

The Delaware district court appeared to upend this way of thinking in Opt-Out Lenders v. Millennium Lab Holdings II, Civ. No. 16-110-LPS (D. Del. March 17, 2017). There, the court suggested in dicta that the bankruptcy court lacked constitutional authority to release a group of dissenting lenders’ RICO and common law fraud claims under the requirements of Article III of the U.S. Constitution and Stern v. Marshall, 564 U.S. 462 (2011). In the end, however, the district court remanded the case because the parties did not properly brief the issue before the bankruptcy court.

Earlier this month, the bankruptcy court issued its decision on remand holding that it had constitutional authority to grant the releases at issue. In disarming the dissenting lenders’ Stern challenge, the bankruptcy court found that granting the releases was not an “adjudication” of the lenders’ claims, but rather was a question of federal bankruptcy law governing plan confirmation. While this decision ostensibly lifts the shadow over the viability of non-consensual, third-party releases in Delaware, this reprieve may only be temporary. The dissenting lenders recently appealed the bankruptcy court’s decision, making this case an important one to watch.

Factual Background

Prior to Chapter 11, Millennium Lab provided laboratory-based diagnostic testing services, deriving a significant portion of its revenues from Medicare and Medicaid reimbursements. The business ran into trouble when the Department of Justice (DOJ) launched an investigation that culminated in fraud claims against Millennium. As a result, other government agencies revoked the company’s Medicare billing privileges.

Millennium eventually reached an agreement with the DOJ and other government agencies to settle the fraud claims in exchange for approximately US$250 million. Millennium then proceeded to work out a deal with its lenders. Under the deal that was reached, Millennium and certain of its affiliates commenced prepackaged Chapter 11 cases to implement a plan under which the company’s non-debtor shareholders would contribute US$325 million to fund the government settlement and also pay lenders who consented to the deal. In exchange, the shareholders would receive a broad release of claims, including those belonging to other non-debtor, third-parties. The plan did not provide an opportunity for parties to “opt-out” of the releases.

Initial Proceedings Before The Bankruptcy Court

A group of dissenting lenders objected to confirmation in the bankruptcy court, asserting that the plan could not release the lenders’ claims against the company’s shareholders and two executives who were also beneficiaries of the proposed releases. To crystalize their claims, the dissenting lenders filed a complaint in district court alleging RICO violations and common law fraud. The dissenting lenders argued that the bankruptcy court lacked subject matter jurisdiction to grant the releases and that the releases were impermissible as a matter of substantive law. The dissenting lenders did not challenge the bankruptcy court’s constitutional authority to grant the releases.

The bankruptcy court overruled the dissenting lenders’ objection and confirmed the plan. The bankruptcy court found that it had subject matter jurisdiction and that the releases were permissible under In re Continental Airlines, 203 F.3d 203 (3d Cir. 2000). There, the Third Circuit rejected the debtors’ requested releases, but suggested that non-consensual, third-party releases might be permissible in other cases, outlining three “hallmarks” that would support such a release - “fairness, necessity to the reorganization, and specific fact findings to support these conclusions....” The bankruptcy court found that the releases at issue met these hallmarks because they were “fair and necessary to the reorganization,” considering that the shareholders would not have contributed the US$325 million without them. The bankruptcy court did not address whether it had constitutional authority to grant the releases. The dissenting lenders appealed.

Appeal to the District Court

On appeal, the dissenting lenders refocused their arguments on the bankruptcy court’s constitutional authority to release the claims. In the context of a motion to dismiss the appeal as equitably moot, the district court then directed the parties to brief “whether a constitutional defect…deprived [the bankruptcy court] of the power to issue [the] decision.”

In ruling, the district court suggested that the bankruptcy court lacked constitutional authority to grant the releases, reasoning that the dissenting lenders “appear to be entitled to Article III adjudication of [their] claims” under Stern because the claims did not involve matters of “public rights” which could be assigned to a non-Article III judge. In the district court’s opinion, the releases affected claims “between two private parties based on state common law or statutes that are not closely intertwined with a federal regulatory program.” The district court rejected Millennium’s argument that Stern was inapplicable because the releases did not amount to an adjudication of the claims, reasoning that the “release, which permanently extinguished [the lenders’] claims, is tantamount to resolution of those claims on the merits against [the lenders].” Nonetheless, the district court remanded the issue to the bankruptcy court, “given the lack of time and attention the parties ascribed to [it] in their briefing and arguments below.”

The Bankruptcy Court’s Decision On Remand

On remand, the bankruptcy court found that it had constitutional authority to release the dissenting lenders’ claims, reasoning that Stern did not govern the analysis at all. As a first principle, the bankruptcy court found that, while there are varying interpretations of Stern, even the broadest interpretations are limited in application to whether an Article I court can adjudicate state law claims. The bankruptcy court then opined: “[i]n this matter, the operative proceeding for purposes of a constitutional analysis is confirmation of a plan. Confirmation of a plan is not a ‘claim’ or ‘counterclaim.’ It is not an ‘action’ as the word is used in Stern.” In the bankruptcy court’s view, plan confirmation is more appropriately a question of federal law, which “do[es] not ask the bankruptcy judge to examine or make rulings with respect to the many claims that may be released….” In so ruling, the bankruptcy court expressed concern that the dissenting lenders’ interpretation of Stern would drastically change the division of labor between the bankruptcy and district courts.

As alternative grounds, the bankruptcy court held that the dissenting lenders forfeited and waived their right to contest the court’s constitutional authority. The bankruptcy court reasoned that, “[i]f a party has a constitutional objection to the bankruptcy judge’s adjudicatory authority to enter final orders, it is incumbent upon the party to place that objection squarely before the judge.” The bankruptcy court found that the dissenting lenders failed to do so.

Implications

This case is significant and should be watched for a few reasons.

First, if the dissenting lenders’ appeal in the district court is successful, this could affect future venue decisions where the parties seek non-consensual, third-party releases. As we explained in our New York Law Journal article, other courts - namely, the Bankruptcy Courts for the Southern District of New York and District of Massachusetts - have rejected Stern challenges in this context. See In re MPM Silicones LLC, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014); In re Charles Street African Methodist Episcopal Church of Boston, 499 B.R. 66 (Bankr. D. Mass 2013). Thus, to the extent more than one venue option is available, debtors may rethink their venue choices. Indeed, it is possible that the back and forth volley in Millennium is already influencing these choices.

Second, for those courts that allow non-consensual, third-party releases, but where the precedent precedes Stern or the court has not faced a similar challenge, a reversal of the bankruptcy court on appeal could cast doubt on the continued validity of that precedent. Simply put, without constitutional authority to adjudicate the claims at issue, the court cannot release them, whether or not prior decisions allowed it.

Finally, so long as the state of the law is in flux, dissenting creditors and other parties may be more likely to challenge non-consensual, third-party releases.