New York and Delaware Agree: Releases Are Constitutionally Ok in Confirmation Orders

Within the space of three weeks, district judges in Delaware and New York have held that bankruptcy courts possess core jurisdiction and constitutional power to enter chapter 11 confirmation orders, including so-called non-debtor, third-party releases of non-bankruptcy claims.

On September 21, Chief District Judge Leonard P. Stark of Delaware handed down Opt-Out Lenders v. Millennium Lab Holdings II LLC (In re Millennium Lab Holdings II LLC), 17-1461, 2018 BL 343110 (D. Del. Sept. 21, 2018). He held that bankruptcy courts have constitutional authority to issue non-consensual, third-party releases of non-bankruptcy claims along with confirmation of a chapter 11 plan. To read ABI’s discussion of Millennium Lab, click here.

Chief District Judge Colleen McMahon of Manhattan reached the same legal conclusion in an October 10 opinion. Her case involved a minority shareholder appealing a confirmation order and contending that a shareholders’ agreement preluded the chapter 11 filing without his consent.

Bankruptcy Judge Robert D. Drain of White Plains, N.Y., ruled earlier in the reorganization that the majority shareholders had not violated a shareholders’ agreement by filing an involuntary petition against the corporate debtor. In the course of his decision denying the minority shareholder’s motion to dismiss or abstain, Judge Drain concluded that the dispute over breach of the shareholders’ agreement was core. The minority shareholder did not appeal.

Later, the majority shareholders filed a chapter 11 plan that Judge Drain confirmed. The plan gave control to the majority shareholders. Confirmation included a non-consensual, third-party release prohibiting the minority owner from initiating an arbitration in London aimed at showing that the bankruptcy was commenced in violation of the shareholders’ agreement.

Contending that the bankruptcy court lacked jurisdiction and constitutional power to enjoin later litigation of non-bankruptcy claims, the minority owner appealed to District Judge McMahon, to no avail.

Judge McMahon said there “is no consensus among the courts” about the jurisdictional basis for third-party releases. She said that a minority, including the Third Circuit, hold that extinguishing third-party claims is an exercise of non-core jurisdiction.

On the other hand, Judge McMahon said that a majority — including the District of Columbia Circuit and Judge Stark in Millennium Lab — hold that bankruptcy courts exercise core jurisdiction in confirming plans with third-party releases.

Judge McMahon said that approving a non-consensual, third-party release “does not address the merits of the claims being released.” She reasoned that an “incidental effect on claims beyond the scope of the immediate bankruptcy proceeding does not render the bankruptcy court’s jurisdiction non-core.”

The releases, Judge McMahon said, were not an “adjudication of the merits of third-party claims.” Rather, she said, the “involuntary third-party releases merely extinguish those claims as part of a core bankruptcy process” of confirming a plan within the strictures of Sections 1123 and 1129.

Judge McMahon rejected the notion that third-party injunctions would give bankruptcy courts a “blank check” to exercise “infinite jurisdiction.” Finding limits to the constitutional power, she said it “surely would be improper” to confirm a plan with third-party releases that were “unrelated (or even tangentially related) to the debtor or the bankruptcy case.” She said that the release “must be sufficiently related to the issues before the bankruptcy court in order for core jurisdiction to cover an order extinguishing that claim.”

Inclusion of the injunction was a core function, Judge McMahon said, to prevent the minority owner from mounting a “collateral attack” through arbitration in London.

Alternatively, res judicata prevented the minority shareholder from attacking the releases in the plan because the bankruptcy judge had ruled (in an order that the minority owner did not appeal) that disputes regarding the shareholders’ agreement were core and therefore within the final adjudicatory power of the bankruptcy court.

Even if the releases were non-core, Judge McMahon went on to rule that the minority shareholder had impliedly consented to final adjudication in bankruptcy court by participating in proceedings below without raising the constitutional issue. She said that consent by implication is necessary to prevent “gamesmanship.”