Judge Colleen McMahon recently opined in Purdue1 that “the lower courts desperately need a clear answer” as to the validity of third-party releases. On January 13, 2022, the United States District Court for the Eastern District of Virginia (the “District Court”) provided its guidance – at least for the bankruptcy courts in the Eastern District of Virginia – by holding that third-party releases are invalid absent meaningful fact-finding, requisite consent, and careful analysis to support the “rare and exceptional” cases that may warrant approval of third-party releases.

Introduction

Hot on the heels of the recent ruling by the Southern District of New York in Purdue, the District Court vacated the confirmation order of Ascena Retail Group, Inc.’s (“Ascena” and together with its debtor affiliates, the “Debtors”) plan of liquidation (the “Plan”) entered by the United States Bankruptcy Court for the Eastern District of Virginia (the “Bankruptcy Court”) and voided the third-party releases contained therein. The District Court also voided the Plan’s exculpation provision, although noted that this provision could be remedied by redrafting on remand. The District Court took issue with the “exceedingly broad” third-party releases that, under applicable Fourth Circuit precedent, should only be used “cautiously and infrequently.”2 The Virginia District Court noted that the Bankruptcy Court has “regularly” approved third-party releases and, in this instance, granted them “with little to no analysis.” According to the District Court, the Bankruptcy Court exceeded the constitutional limits of its authority, ignored the mandates of Fourth Circuit precedent, and “offended the most fundamental precepts of due process” by granting the third-party releases. Notably, the District Court questioned the constitutional power of Bankruptcy Court to issue final orders approving third-party releases and also undercut the use of an “opt-out” mechanism in the Plan through which releasing parties that receive notice are deemed to consent to granting the third-party releases if they do not opt-out of the releases, a common approach that has been used in many chapter 11 cases.

The District Court further rejected the Debtors’ equitable mootness arguments, concluding that the appeal was not equitably moot because, among other things, the vacated Plan confirmation order no longer constituted a final judgment. Similarly, the District Court noted that inclusion of a nonseverability clause in the Plan on its own cannot support a finding of equitable mootness and found that severing the third-party releases from the Plan would not impact the Plan’s viability. Accordingly, the District Court remanded the case to a different bankruptcy judge for possible confirmation of the Plan with a redrafted exculpation provision and without the objectionable third-party releases.3 The District Court’s opinion provides continued pressure on the use of third-party releases in chapter 11 plans and demonstrates that parties should not assume third-party releases will be immune from further scrutiny or even rejection following plan confirmation by a bankruptcy court.

Background4

Ascena provided women and girl’s retail apparel under a portfolio of popular brands, including Ann Taylor, LOFT, Lane Bryant, Catherines, Justice, Lou & Grey, and Cacique. On June 7, 2019, Joel Patterson and Michaella Corporation (the “Securities Litigation Lead Plaintiffs”) filed a complaint as a putative class action alleging securities fraud against Ascena, David Jaffe and Robert Giammatteo (the “Securities Litigation”). David Jaffe previously served as the Chief Executive Officer of Ascena, and Robert Giammatteo previously served as the Chief Financial Officer. Both were no longer employed by Ascena when, in July 2020, the Debtors filed chapter 11 bankruptcy and subsequently liquidated the business.

The Plan reflected the Debtors’ wind down process and maximized value to stakeholders. The Plan also contained third-party releases, an exculpation provision, and an injunction provision. The District Court concluded that the third-party releases “cover[ed] any type of claim that existed or could have been brought against anyone associated with the Debtors as of the effective date of the Plan.” However, the District Court also noted that the Bankruptcy Court had only focused on the Securities Litigation and did not conduct any analysis or fact-finding in regard to all of the claims of “at least hundreds of thousands of potential plaintiffs” that were covered by the breadth of the releases. As a result of this focus on the Securities Litigation, the Bankruptcy Court ordered that the Debtors send a notice of the third-party releases, as well as an option to return a ‘release opt-out form,’ only to parties believed to be potential members of the Securities Litigation while failing to examine other possible causes of action released. Ultimately, the Bankruptcy Court confirmed the Debtors’ Plan over the objection of the Securities Litigation Lead Plaintiffs to the third-party releases. Subsequently, both the Securities Litigation Lead Plaintiffs and the United States Trustee filed notices of appeal arguing that the Bankruptcy Court erred in approving the third-party releases.5

The District Court Opinion

Stern and Bankruptcy Court Jurisdiction

The District Court began its discussion of the third-party releases by examining whether bankruptcy courts have the constitutional power to approve them. In doing so, the Court cites the seminal U.S. Supreme Court Case Stern v. Marshall6 for its holding that bankruptcy courts only have the constitutional authority to adjudicate “core” claims that “stem from the bankruptcy itself or would necessarily be resolved in the claims allowance process.”7 The District Court found that the Bankruptcy Court “took no steps” to determine if it had jurisdiction over the “extraordinarily vast range” of claims that were extinguished by the third-party releases prior to approving them as part of Plan confirmation. The District Court noted that, although analyzing each of the claims purported to be released by the third-party releases would be a “herculean undertaking,” it nonetheless did not “absolve the Bankruptcy Court of its responsibility” to ensure it had jurisdiction over such released claims. Thus, the District Court held that the Bankruptcy Court violated Stern by exceeding its authority in approving the third-party releases. As a result of this violation, the District Court vacated the confirmation order and instead, as an initial step, treated it as a report and recommendation with proposed findings of fact and conclusions of law, which the District Court reviewed de novo.8

The Behrmann Factors

The District Court then reviewed the third-party releases under the applicable standards in the Fourth Circuit as set forth in Behrmann. Specifically, Behrmann does not prohibit third-party releases per se (as was implicitly held in Purdue) but instead adopts the Sixth Circuit’s seven-factor test for approving third-party releases outlined in In re Dow Corning Corp.9 The District Court noted that the Behrmann factors essentially task the reviewing court with determining, based on specific factual findings, how integral the releases are to a bankruptcy plan. The District Court held that the Bankruptcy Court erred in “fail[ing] to conduct any Behrmann analysis, precluding any meaningful appellate review.” The District Court then proceeded to conduct the Behrmann analysis itself, finding that the third-party releases set forth in the Plan did not satisfy the Behrmann factors. The District Court reasoned that the third-parties purported to be released, including Jaffe and Giammatteo, did not provide a substantial contribution to, and in fact played no role in, the Debtors reorganization, and the lack of a release would have no effect on the implementation of the Plan, as the Debtors had largely liquidated prior to Plan confirmation.

Consent

Throughout the District Court’s opinion, the District Court focused on whether the releasing parties consented to the jurisdiction of the Bankruptcy Court, which would remedy the Stern violation, as well as whether the parties consented to the third-party releases themselves, which could potentially overcome the deficiencies in the Behrmann analysis. Under Supreme Court precedent, a party’s consent to a bankruptcy court’s jurisdiction over a non-core claim must be “knowing and voluntary.”10 The District Court “could not discern” any actions that would support a finding of knowing and voluntary consent by the releasing parties. The Bankruptcy Court had relied on the fact that a notice of the third-party releases was mailed to individuals and contained an opportunity to opt-out of said releases. However, the District Court found that notice and an opportunity to opt out, without further action, could not meet the standard of knowing and voluntary consent to adjudication of a non-core claim.

In fact, the District Court stated that allowing such inaction – the failure to affirmatively complete and return an opt out form – to meet the standard for consent would encourage gamesmanship by allowing non-debtors to “tuck releases unrelated to a bankruptcy proceeding into bankruptcy plans, then secrete an opt-out opportunity into a convoluted legal document, send the document to non-parties previously unaware of the bankruptcy proceeding and use their non-response to extinguish all of their claims.” To this point, the District Court concludes that “[t]his type of gamesmanship, aimed at extinguishing claims of unwitting individuals and providing a golden parachute to the parties drafting the plan, cannot be tolerated.”

Similarly, and separately from the question of basic consent to basic jurisdiction, the District Court noted that this notice and opportunity to opt-out could also not form the basis for consent to the third-party releases themselves. In doing so, the District Court emphasized that the opt-out notice was directed only to the putative class members in the Securities Litigation, and the Bankruptcy Court made no effort to provide notice and obtain consent from the numerous other releasing parties. Further, as to those Securities Litigation class members who received the notice, the District Court found that there was no evidence that any of the recipients “affirmatively consented” to the release of their claims. Put simply, the District Court concluded that “[f]ailure to opt out, without more, cannot form the basis of consent to the release of a claim.”

Takeaways

The District Court’s focus on Stern and the potential jurisdictional issues involved when considering third-party releases is a novel approach and bears watching to see if it gains traction in other jurisdictions. Irrespective of the validity of the third-party releases as a legal matter, the District Court’s Stern ruling – essentially requiring an additional level of court review of those releases – could, if upheld and followed by other courts, substantially delay consummation of plans even when the strict standard for such releases is satisfied.

The District Court voiced serious concerns about the common usage of third-party releases without meaningful factual findings to support the propriety of their use. Debtors seeking to include third-party releases in chapter 11 plans may seek to create and offer a fulsome evidentiary record which demonstrates the need for such releases and shows that such releases are appropriate for the unique facts of a given case.

In the ongoing “opt-out” vs. “opt-in” debate with respect to third-party releases and due process, this case makes clear that the Eastern District of Virginia is moving away from the “opt-out” structure. It will be of interest to see how other jurisdictions handle the issue and whether they follow the approach taken by the District Court in the Ascena case. This opinion has potentially far-reaching implications for the future use of third-party releases in chapter 11 cases filed in the Eastern District of Virginia and is yet another data point in the recent debates about whether such releases are appropriate. Nonetheless, for the time being, this opinion will not have a binding precedential effect on cases outside the Eastern District of Virginia, and it remains to be seen what impact this opinion and the Purdue opinion will have on the treatment of third-party releases in other jurisdictions, including the Third and Fifth Circuits.