Since the passage of the modern version of the Bankruptcy Code in 1978, chapter 11 has been used as a tool by debtors to address mass litigation liabilities. While there are certain limitations and exceptions, chapter 11 can be a preferred avenue to address mass litigation liabilities because (1) the automatic stay of § 362 of the Bankruptcy Code generally halts most pending litigation, (2) cases pending in different jurisdictions around the country potentially can be removed and consolidated in front of a single court for resolution pursuant to 28 U.S.C. § 1452, and (3) the related liabilities from such litigation generally can be discharged by the debtor pursuant to § 1141 of the Bankruptcy Code.
In addition to these and other relevant statutory provisions in the Bankruptcy Code, chapter 11 cases seeking to address mass litigation liabilities have seen the development of third-party release provisions and related channeling injunctions that limit or extinguish the liability of nondebtors. In effect, in exchange for a large contribution of value to fund recoveries for litigation claimants, a nondebtor entity with a close relationship to the debtor effectively obtains the benefit of the discharge under § 1141 of the Bankruptcy Code through a broad channeling injunction and release of claims. Indeed, the use of such third-party releases and channeling injunctions to address the massive litigation liabilities arising from asbestos exposure was codified with the addition of § 524(g) to the Bankruptcy Code in 1994.
However, for mass litigation liabilities that are not related to asbestos exposure, there is no specific provision in the Bankruptcy Code authorizing such channeling injunctions for the benefit of nondebtors. Moreover, there is a split of authority among the circuit courts regarding the propriety of such provisions. With a new wave of mass-litigation-driven bankruptcy cases pending and more likely to follow in the years ahead, this article briefly reviews where the battle lines have been drawn on nonconsensual third-party releases and highlights recently proposed legislation that would specifically limit the scope of nonconsensual third-party releases to exclude claims asserted by governmental entities.
Circuit Split on Nonconsensual Third-Party Releases
The majority of circuit courts that have addressed the issue, including the Second, Third, Fourth, Sixth, Seventh and Eleventh Circuits, have held that nonconsensual third-party releases are permissible in special or exceptional circumstances based on the broad grant of power to bankruptcy courts under § 105(a) of the Bankruptcy Code. On the other hand, the Fifth and Tenth Circuits have held that nonconsensual third-party releases are not permissible. In the view of the Fifth and Tenth Circuits, nonconsensual third-party release provisions conflict with § 524(e) of the Bankruptcy Code, which states that the “discharge of a debt of the debtor does not affect the liability of any other entity on ... such debt.” Given the apparent conflict, these two circuit courts have concluded that they cannot rely on the general grant of authority under § 105(a) of the Bankruptcy Code to approve nonconsensual third-party releases. The Ninth Circuit previously followed the Fifth and Tenth Circuits, but recently approved a nonconsensual third-party exculpation clause that covered only “closely involved” parties and was limited to acts and omissions arising out of the chapter 11 cases, but also explicitly noted that its holding did not permit sweeping global releases of third parties.[1]
Standards for Approving Nonconsensual Third-Party Releases
Although courts have applied varying standards to approve nonconsensual third-party releases, some common threads have emerged. For example, the circuit courts that allow nonconsensual third-party releases require a fact-intensive inquiry into whether the releases are integral to the restructuring, require a close relationship between the debtor and the nondebtor being released, and will only approve such releases in extraordinary circumstances. The U.S. Bankruptcy Court for the Western District of Missouri promulgated an influential test in In re Master Mortgage Investment Fund Inc. that permits nonconsensual third-party releases in unusual circumstances. Courts following the Master Mortgage test will evaluate whether:
(1) There is an identity of interest between the debtor and the third party, usually an indemnity relationship, such that a suit against the non-debtor is, in essence, a suit against the debtor or will deplete the assets of the estate.
(2) The non-debtor has contributed substantial assets to the reorganization.
(3) The injunction is essential to reorganization. Without ... it, there is little likelihood of success.
(4) A substantial majority of the creditors agree to such injunction, specifically, the impacted class, or classes, has “overwhelmingly” voted to accept the proposed plan treatment.
(5) The plan provides a mechanism for payment of all, or substantially all, of the claims of the class or classes affected by the injunction.
168 B.R. 930, 935 (Bankr. W.D. Mo. 1994).
Recent Developments in Case Law Regarding Nonconsensual Third-Party Releases
In 2019, the Third Circuit affirmed the bankruptcy court’s constitutional authority to approve nonconsensual third-party releases in the case of In re Millennium Labs Holdings II, LLC.[2] A creditor challenged the bankruptcy court’s constitutional authority to grant third-party releases based on the Supreme Court’s holding in Stern v. Marshall.[3] The Third Circuit held that constitutional authority existed under Stern, since the releases in the debtors’ plan of reorganization were “integral to the restructuring of the debtor-creditor relationship.”
More recently, in In re Purdue Pharma, L.P., an ad hoc group of states has objected to Purdue’s proposed third-party release for the Sackler family in exchange for the Sackler family’s $4.275 billion contribution to fund a trust for opioid litigation claimants (the “Proposed Sackler Release”). The objecting states are arguing that the debtors’ proposed chapter 11 plan impermissibly releases state police power claims against the Sacklers and that the debtors have not satisfied the Metromedia standards that courts in the Second Circuit apply when evaluating the propriety of nonconsensual third-party releases. Further, the states are arguing that Congress never intended to allow a bankruptcy proceeding to discharge police power claims held by governmental entities because (1) § 524(g) of the Bankruptcy Code, which authorizes channeling injunctions in asbestos cases, does not allow for the release of claims held by governmental units; and (2) 28 U.S.C. § 1452(a) “prohibits removal of state police power actions to any federal court pursuant to its bankruptcy authority.” Finally, the states are arguing that the bankruptcy court does not have subject-matter jurisdiction to approve the releases because the Sackler family is unlikely to have indemnification claims against the debtors given the nature of the alleged wrongdoing.
The U.S. Bankruptcy Court for the Southern District of New York held a hearing regarding Purdue Pharma’s disclosure statement on May 26, 2021. Although Judge Robert D. Drain ultimately approved Purdue Pharma’s disclosure statement, the Proposed Sackler Release in Purdue Pharma’s proposed plan of reorganization has remained a major point of contention among the parties and, absent a consensual resolution with the various objecting parties, will likely be a major issue at Purdue Pharma’s upcoming plan-confirmation hearing, which was scheduled for August 9, 2021, at press time.
Recent Proposed Legislation and the Potential Future of Nonconsensual Third-Party Releases
In addition to ongoing court battles over the propriety, constitutionality and scope of nonconsensual third-party releases, the Proposed Sackler Release recently attracted the attention of Congress. On March 19, 2021, representatives Carolyn B. Maloney (D-N.Y.) and Mark DeSaulnier (D-Calif.) introduced the proposed Stop Shielding Assets from Corporate Known Liability by Eliminating Non-Debtor Releases Act (the “SACKLER Act”) to prevent third parties from using the bankruptcy process to obtain releases from governmental claims. The SACKLER Act would specifically amend § 105 of the Bankruptcy Code to prohibit the release of claims of state and federal governmental units and federally recognized tribes against nondebtor third parties. Although the SACKLER Act was assigned to the House Committee on Oversight and Reform, it has not yet been scheduled for a committee hearing date.
Conclusion
Although the SACKLER Act, if passed, would prohibit the nonconsensual release of claims held by governmental units and tribes against nondebtor third parties, it would continue to allow the nonconsensual release of nongovernmental claims. The passage of such legislation, and its implicit acknowledgment of nonconsensual third-party releases of nongovernmental claims, might potentially strengthen arguments in favor of such releases in future cases. It is also possible that Congress will address nonconsensual releases at another time, particularly if there is a controversial and high-profile use of such releases in the future.
For now, the split of authority regarding nonconsensual third-party releases is likely to continue among the circuit courts unless and until the Supreme Court takes up the issue. Until then, such releases likely will continue to play an integral role in mass tort bankruptcies, and companies facing mass litigation liabilities will be more likely to consider commencing chapter 11 cases in jurisdictions that permit nonconsensual third-party releases.
[1] Blixseth v. Credit Suisse, 961 F.3d 1074, 1085 (9th Cir. 2020).
[2] 945 F.3d 126 (3d Cir. 2019).
[3] 564 U.S. 462 (2011).