Third-party releases have become a common and oft-litigated issue in connection with confirmation of a Chapter 11 plan. This is especially so if the party being released is the target of claims arising out of questionable prepetition transactions. And although rare and usually reserved for special circumstances, releases of third parties have been granted to a non-debtor on a nonconsensual basis if the contribution by the non-debtor party to the bankruptcy case is significant.

A recent decision by the federal Delaware district court in Millennium Lab Holdings, however, sets another roadblock to the bankruptcy court’s authority to approve nonconsensual  third-party releases. See Opt-Out Lenders v. Millennium Lab Holdings II, LLC (In re Millennium Lab Holdings), No. 16-110-LPS, 2017 WL 1032992 (D. Del. Mar. 20, 2017). The district court in Millennium found that even where a bankruptcy court might have jurisdiction to approve plan-based third-party releases, it may lack constitutional authority to approve those releases on a nonconsensual basis. The remand of the district court’s decision was recently heard by Judge Silverstein of the Delaware bankruptcy court, and a decision is forthcoming.

Background

Before commencing its bankruptcy cases, Millennium Lab Holdings — a provider of laboratory-based diagnostic testing services — was the subject of a multiyear investigation by the Department of Justice (DOJ) into its billing practices and issues of Medicare fraud. While the  investigation was ongoing, Millennium consummated a dividend recapitalization in 2014, whereby it borrowed $1.825 billion in secured debt, $1.3 billion of which was immediately transferred to its equity sponsors (TA Millennium, Inc. and Millennium Lab Holdings, Inc.) as a dividend.1 A year later, in mid-2015, the company reached a $250 million settlement of the DOJ’s Medicare fraud investigation and negotiated the terms of a restructuring of its debt with a majority of its secured lenders. The negotiations culminated in the filing of prepackaged Chapter 11 cases in November 2015. The Chapter 11 plan filed by the Debtors contemplated a $325 million contribution to the bankruptcy estates from the equity sponsors in exchange for a “full release and discharge” of all claims arising prior to the petition date, including claims that could be brought by third parties relating to the dividend recapitalization.

The day before plan confirmation, a minority group of secured lenders commenced an action in Delaware federal district court against the equity sponsors alleging, among other things, fraud, deceit, and intentional misrepresentation and violations of the Racketeer Influenced and Corrupt Organizations Act (RICO). The minority lenders also challenged plan confirmation on the grounds that the plan inappropriately provided for a nonconsensual third-party release of claims against the equity sponsor, including the claims being pursued by the minority lenders, and challenged the court’s jurisdiction to approve such releases. Days later, the bankruptcy court overruled the minority lenders’ objection and confirmed the Debtors’ plan. In ruling on confirmation, the court found that it had “related to” subject matter jurisdiction over the minority lenders’ claims and found the release of those claims appropriate. The bankruptcy court did not, however, address whether it had constitutional authority to issue a final order releasing the claims against the equity sponsors. 

The minority lenders appealed, arguing that they had a constitutional right to have their common-law claims adjudicated by an Article III judge, and that the bankruptcy court’s nonconsensual release of those claims was unconstitutional. The Debtors argued that the plan had been substantially consummated and could not be unwound without losing the $325 million contribution, thereby rendering the appeal equitably moot. The Debtors further argued that the bankruptcy court had both jurisdiction and constitutional authority to approve a plan with nonconsensual third-party releases, and even if it did not, the district court could review and approve the confirmation order de novo, mooting the minority lenders’ appeal.

Subject Matter Jurisdiction and Constitutional Authority

Federal district courts are established pursuant to Article III of the Constitution, and litigants are given the constitutional right to have their common-law claims adjudicated by an Article III judge. Bankruptcy courts, in contrast, are established under Article I of the Constitution and are automatically referred any proceedings arising under or related to a bankruptcy case by the district court pursuant to 28 U.S.C. § 157(a). By statute, bankruptcy courts are given the authority to render final judgments on “core” matters; i.e., orders in “cases under title 11” and “proceedings arising under title 11, or arising in a case under title 11.”  See 28 U.S.C. § 157(b). For matters that are only “related to” a bankruptcy case, the bankruptcy court is limited to hearing the matter and proposing findings of facts and conclusions of law to the district court for its de novo review and determination. 

In Stern v. Marshall, the Supreme Court added another layer of complexity to the core/non-core analysis by distinguishing between the bankruptcy court’s statutory and its constitutionalauthority to render a final determination on certain claims. 131 S. Ct. 2594 (2011). The Supreme Court found that for a non-Article III judge to have constitutional authority to adjudicate a claim (separate from statutory authority), the claim must involve matters of “public rights.” In the bankruptcy context, “public rights” applies to claims that “stem [] from the bankruptcy itself or would necessarily be resolved in the claims allowance process.” Id. at 2618. Thus, under the facts of Stern, even though an estate’s defamation counterclaim is a “core” matter by statute, the Supreme Court found that the bankruptcy court did not have constitutional authority to adjudicate the claim because it arose under state law, it did not arise from the bankruptcy and its adjudication was not necessary to the bankruptcy claims resolution process. 

The District Court’s Opinion: Constitutional Authority to Grant Third-Party Releases

The district court began its decision by noting that it believed the Debtors’ argument on mootness was persuasive, but found it “cannot consider” the mootness argument without first analyzing whether there was a defect in the court’s constitutional authority to grant the releases. The court then went on to agree with the bankruptcy court that the bankruptcy court had “related to” jurisdiction over the releases, but stated that this should not have been the end of the bankruptcy court’s analysis. The bankruptcy court should have also considered whether it had constitutional authority to release third-party claims without such parties’ consent. And after reading the pleadings and transcript from the bankruptcy hearing, the district court was “not convinced” the bankruptcy court even had the opportunity to hear or rule on this issue.

With respect to the bankruptcy court’s constitutional authority, the district court observed that there is no dispute that the “state common law fraud and RICO claims are non-bankruptcy claims between non-debtors which do not stem from the bankruptcy itself and would not necessarily be resolved in the claims allowance process.” Although the Debtors cited cases overruling Stern-based challenges to third-party releases based on a “public rights” exception for matters resolved in connection with confirmation of a Chapter 11 plan, the court did not find any “public rights” involved in the minority lenders’ state law-based claims. Based on this analysis, the court stated the minority lenders “appear” to be entitled to Article III adjudication of their claims. 

The court then noted that the “permanent extinguish[ment]” of the minority lenders’ claims through the third-party release was “tantamount to resolution of those claims on the merits.” And because the minority lenders had a constitutional right to an adjudication on the merits of their claims by an Article III court, the bankruptcy court lacked constitutional authority to adjudicate those claims through the third-party release.

Finally, the court rejected the Debtors’ argument that even if the bankruptcy court did not have the constitutional authority to issue a final order releasing the claims, the district court, as an Article III court, could “cure” such a constitutional violation by reviewing and ratifying the confirmation order independently. The court found there had been no adjudication of the minority lenders’ claims against the sponsors on the merits — a process that would, at a minimum, require discovery. As such, a de novo review and approval of the confirmation order would be insufficient to remedy any constitutional violations by the bankruptcy court.

Ultimately, while the district court was persuaded by the minority lenders’ arguments, it declined to issue a ruling on the issue because the bankruptcy court had not yet had the opportunity to do so. It therefore remanded the matter to the bankruptcy court to determine whether it has constitutional authority to approve the releases. Alternatively, the court suggested that the court “strike the nonconsensual release of [the minority lenders’] claims from the Confirmation Order.”

Observations

Judge Silverstein of the Delaware bankruptcy court heard over six hours of oral argument on the remand of these proceedings on July 27, but at the time of this article has not rendered a decision. If the bankruptcy court were to find that — consistent with the apparent views of the district court — it lacks constitutional authority to approve the nonconsensual third-party release contained in a plan, this decision could have significant implications in the bankruptcy and plan-negotiation process. If nonconsensual third-party releases such as those in this case can no longer be approved by a bankruptcy court as a constitutional matter, and if, as the district court suggests, there needs to be an adjudication of any such claims on the merits by an Article III court before they can be released, nonconsensual third-party releases as part of a Chapter 11 plan will be even more difficult to obtain than they are already. Such a decision will give more leverage to holdout creditors, and lead defendants to shy away from making substantial contributions to the estate for a release.

In addition, such a decision may create additional complexities. While the district court found that approving a third-party release was a decision on the merits in violation of Article III, it nevertheless found that it could not ratify the confirmation order because the bankruptcy court had not actually decided the claims on the merits. The question then becomes whether a bankruptcy court is required to analyze each claim subject to a nonconsensual release on the merits before determining whether the release is appropriate, and whether this requirement extends to not only pending claims but also all potential claims that are the subject of the release. Additionally, and as noted by the court and the parties on remand before the bankruptcy court, a finding that Stern is implicated in approving nonconsensual third party releases in a plan could impact the bankruptcy court’s ability to approve other aspects of a plan on a final basis and/or its ability to render decisions on a multitude of other issues that have become commonplace, including issues involved in bankruptcy sales.  

Finally, while a party can consent to adjudication of its claim by an Article I judge, the Millennium district court decision does not provide any clarity on the mechanism for such consent. “Consensual” third-party releases in a bankruptcy often come in the form of (i) an affirmative vote in favor of a plan, (ii) an “opt-in” to a release or (iii) the failure to “opt out” of a release. Also, the plan proponents argued on remand that “consent” to the bankruptcy court’s constitutional authority could come from consent to entry of the confirmation order as a final order without expressly preserving the issue. Whether a party can waive its constitutional rights to have claims adjudicated by an Article III court by consent to entry of a final order is currently before the bankruptcy court; whether “consent” to adjudication by an Article I judge can be given through the plan voting process is a question for another day.