In a scorching opinion, a district judge in Richmond, Va., set aside confirmation of a chapter 11 plan that contained “extremely broad third-party (non-debtor) releases.”
District Judge David J. Novak said that the releases in the appeal before him “represent the worst of this all-too-common practice, as they have no bounds.” He described the releases as barring the claims
of at least hundreds of thousands of potential plaintiffs not involved in the bankruptcy . . . , shielding an incalculable number of individuals associated with the Debtors . . . for an unspecified time period stretching back to time immemorial . . . .” [Emphasis in original.]
Judge Novak said that the bankruptcy court “exceeded the constitutional limits of its authority . . . , ignored the mandates of the Fourth Circuit . . . , and offended the most fundamental precepts of due process.”
Referring to what he called the “ubiquity of third-party releases” approved by a bankruptcy judge in Richmond who “regularly approves third-party releases,” Judge Novak said that “[t]his recurrent practice contributes to major companies like [the debtor] using the permissive venue provisions of the Bankruptcy Code to file for bankruptcy here.”
Citing the U.S. Trustee, Judge Novak said that “the Richmond Division (just the division, not the entire Eastern District of Virginia) joins the District of Delaware, the Southern District of New York, and the Houston Division of the Southern District of Texas as the venue choice for 91% of the ‘mega’ bankruptcy cases.”
On the penultimate page of his 88-page opinion reversing and remanding, Judge Novak directed the chief bankruptcy judge to reassign the chapter 11 case to another bankruptcy judge outside of the Richmond division. If there is another appeal after remand, Judge Novak said that the new appeal would be assigned to him.
Takeaways
On December 16, District Judge Colleen McMahon in New York vacated confirmation of the Purdue Pharma LLP chapter 11 plan, holding that the court had no statutory power to impose non-consensual releases of creditors’ direct claims against non-debtor third parties. In re Purdue Pharma LP, 21-07532, 2021 BL 482465, 2021 WL 5979108 (S.D.N.Y. Dec. 16, 2021). To read ABI’s report, click here.
The January 13 opinion by Judge Novak goes beyond Judge McMahon’s more narrow preservation of creditors’ direct claims against non-debtors. Readers may draw some of the following conclusions from Judge Novak’s opinion.
- Third-party releases are virtually impermissible when the releasing parties are receiving no consideration under the chapter 11 plan and the creditors do not manifest actual consent, under high standards for what constitutes actual consent.
- Just providing creditors with an ability to opt out does not make the release consensual as a matter of fact and law.
- The limited power of a bankruptcy judge under Article I of the Constitution requires that third-party releases be approved by district judges, and confirmation orders with third-party releases should be reports and recommendations.
- The procedure for approval of third-party releases in a chapter 11 plan must comply with Federal Rule 23, which deals with class actions. Among other things, creditors who are losing the right to sue must be involved in negotiations on the plan and must be adequately represented.
- Like the Eighth Circuit, which limited the doctrine of equitable mootness almost to the vanishing point, equitable mootness will not protect third-party releases from appellate review.
- A creditor who opts out has no standing to appeal.
Judge Novak’s opinion is required reading for anyone involved in chapter 11 practice. He gathers together authorities that are either hostile to or limit third-party releases.
However, Judge Novak does not proscribe third-party releases altogether. Indeed, he could not in view of Behrmann v. Natl. Heritage Found. Inc., 663 F.3d 704 (4th Cir. 2011), where the Fourth Circuit adopted the Sixth Circuit’s approach to approval of third-party releases and rejected the idea that Section 524(e) bars them outright.
The Facts
The debtors were Mahwah Bergen Retail Group, Inc. and affiliates. Together, they operated 2,800 retail stores with names like Ann Taylor, LOFT and Lane Bryant. The debtors had about $1.6 billion in secured debt and perhaps $800 million in unsecured debt.
In chapter 11, they sold the business in three sales for more than $650 million. The chapter 11 plan paid some secured creditors and set aside $7.25 million in cash for unsecured creditors.
Before bankruptcy, plaintiffs filed a securities class action suit in New Jersey against the debtors and several individuals, including the debtors’ former chief executive and former chief financial officer. The district court had not certified the class before the chapter 11 filing brought the suit to a halt.
As confirmed by the bankruptcy court, the plan included “extremely broad” releases that “cover 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,” Judge Novak said.
At the confirmation hearing, Judge Novak said that the bankruptcy court focused on the claims that would be released against the former CEO and CFO in the class action. The bankruptcy court, he said, “ignored all of the other potential claims (both federal and state claims) released against others covered by the releases.”
The plan allowed creditors and shareholders to opt out of the releases. Shareholders were not receiving any consideration under the plan, although they would be released from any claims that the debtors might hold against those who did not opt out.
The debtors sent notices and opt-out forms to some 300,000 parties believed to be in the putative class. Almost 600 opted out, representing 0.2% of the class. Notice was published in two newspapers with nationwide publication.
Other than shareholders, the bankruptcy court did not require that notice and opt-out forms be sent to anyone else who would be giving releases, including employees, consultants, accountants, attorneys for the debtors or any of their affiliates, lenders, owners or shareholders.
The named plaintiffs in the class action opted out for themselves and attempted to opt out for the class. The bankruptcy court declined to allow the plaintiffs to opt out for the class.
The plan also contained exculpation clauses in favor of the debtors, the creditors’ committee, committee members, shareholders who did not opt out, the term loan agent and anyone related to them.
The class plaintiffs and the U.S. Trustee unsuccessfully objected to confirmation and filed appeals. They also unsuccessfully sought stays pending appeal from both the bankruptcy court and the district court.
Standing to Appeal
The debtors agreed that the U.S. Trustee had standing to appeal but challenged the appellate standing of the class plaintiffs.
Citing the Second Circuit and other appellate authority, Judge Novak said that the class plaintiffs could not establish individualized harm because they opted out and preserved their claims. Thus, the U.S. Trustee had standing to appeal but not the class plaintiffs.
The Constitution and Third-Party Releases
Judge Novak framed the question as whether the bankruptcy court had constitutional authority to impose third-party releases. He said that the releases covered “an extraordinarily vast range of claims held by an immeasurable number of individuals against a broad range of potential defendants.” Other than the claims against the former CEO and CFO, Judge Novak said that the bankruptcy court “ignored all of the other potential claims that it terminated in approving the releases.”
Delving into the statutory and constitutional power underlying the releases, Judge Novak said that the “bankruptcy court lacks any authority to act on it” if “the claim has no relation to a case under title 11.” In that regard, he said that the bankruptcy court “engaged in none of the content-based analysis demanded by” Stern v. Marshall, 564 U.S. 1058 (2011).
Judge Novak did not pause to determine whether the released claims were “core” or “noncore.” He said “it takes only a cursory review . . . to find released claims that the Bankruptcy Court lacked authority to adjudicate.” The first example he gave was the class suit against the former CEO and CFO, because the former officers had no involvement in the chapter 11 case.
Releasing claims, Judge Novak said, “amounts to adjudication of the claims for Stern purposes,” citing Judge McMahon’s Purdue opinion. He went on to say that the bankruptcy court had no in rem jurisdiction over third-party claims not against the estate or property of the estate.”
Referring to Section 105(a) and the plenary power of a bankruptcy court to confirm a plan, Judge Novak said that “Article III simply does not allow third-party non-debtors to bootstrap any and all of their disputes into a bankruptcy case to obtain relief.”
Next, Judge Novak dealt with the argument that the bankruptcy court had authority to issue the releases because the failure to opt out amounted to consent. He said that Supreme Court authorities “do not permit a finding of consent based on inaction.” [Emphasis in original.] He could not “discern any actions undertaken by the Releasing Parties to support a finding that they knowingly and voluntarily consented to Article I adjudication of the claims that they released.”
Judge Novak held that the bankruptcy court “erred in adjudicating the Stern claims without the knowing and voluntary consent of the Releasing Parties.”
Consequences of a Stern Violation
Because the bankruptcy court exceeded its power under Stern, Judge Novak vacated the confirmation order and treated the bankruptcy court’s decision as a report and recommendation. Saying that the bankruptcy court’s opinion “lacks any meaningful factfinding,” Judge Novak made his own factual findings based on the record from the confirmation hearing.
In the future, Judge Novak said it would “preferable” for a bankruptcy court to issue a report and recommendation, identifying “with specificity the claims and individuals released and provid[ing] detailed findings . . . to ensure that the released claims are truly integral to the reorganization.”
Judge Novak rejected the bankruptcy court’s findings and made five single-spaced pages of findings of his own. He said that the third-party releases were “nonconsensual both as a matter of fact and a matter of law.” He also found that the former CEO and CFO were not integral to the reorganization.
The Circuit Split on Third-Party Releases
Judge Novak cited the Fifth, Ninth and Tenth Circuits for prohibiting third-party releases under Section 524(e). He cited other circuits, like the Second and Third, that permit releases in rare cases.
In Behrmann, supra, the Fourth Circuit followed the test laid down by the Sixth Circuit for third-party releases. He ruled that the failure to opt out did not amount to the level of consent required by Behrmann.
Judge Novak said that the bankruptcy court “failed to conduct any Behrmann analysis.” He said that the released parties gave no substantial contribution as required by Berhmann. In addition, the releases were not essential to the reorganization and were not “overwhelmingly” approved by the affected class.
“Because the Plan extinguishes these claims entirely without giving any value in return, this weights strongly against granting the Releases,” Judge Novak said.
Beyond Behrmann, Judge Novak said that “no court” would have found the instant settlement “fair, reasonable and adequate under Rule 23.” No one represented the interests of those who were giving releases, and the releases did not result from negotiations with those on whom releases were imposed. Instead, he said, the negotiations only occurred between those who would benefit from the releases. Furthermore, he found that the releases given by the debtor to shareholders “lacked any value and [were] purely fictional.”
Judge Novak went on to hold that the third-party releases failed three of the four elements required to afford due process under Rule 23. “Accordingly,” he said, allowing releases only based on the failure to opt out “does not comport with due process.” He voided the third-party releases and held them unenforceable.
Severability
After confirmation, the plan said in substance that the releases were not severable from the remainder of the plan. Before confirmation, however, the releases were severable, Judge Novak said.
Again treating the confirmation order as a report and recommendation, Judge Novak examined the record and found that they did not “form an integral part of the Plan.” Stepping into the shoes of the bankruptcy court, he severed the releases.
Equitable Mootness
The debtors argued for dismissal of the appeal as equitably moot, but Judge Novak found four reasons why the appeal was not equitably moot.
“First and foremost,” he said, the confirmation order was no longer a final order, and equitable mootness does not apply when the confirmation order has been converted to a report and recommendation.
Second, equitable mootness does not apply when the government, via the U.S. Trustee, is representing absent individuals.
“Not only did the parties craft a release that would extinguish the rights of countless individuals, they did so in a way that would insulate the release from judicial review,” Judge Novak said. He refused to “apply the doctrine of equitable mootness against the Trustee when the Trustee seeks to protect the rights of absent individuals.”
Third, the “seriousness” of the bankruptcy court’s “errors counsels against a finding of equitable mootness.”
Fourth, effective relief was available. Judge Novak said he could sever the releases without altering any creditor’s recovery “or affect[ing] the bankruptcy estate in any way.”
Applying the factors to the appeal at hand, Judge Novak observed that equitable mootness “is all too often invoked to avoid judicial review, as Debtors seek to do here,” citing the recent Eighth Circuit opinion that limited equitable mootness dramatically. FishDish LLP v. VeroBlue Farms USA Inc. (In re VeroBlue Farms USA Inc.), 6 F.4th 880 (8th Cir. Aug. 5, 2021). To read ABI’s report, click here.
Judge Novak refused to allow nonseverability or equitable mootness “to preclude appellate review of plainly erroneous release provisions.”
The Exculpation Provisions
Contrasted to the releases, Judge Novak said that the plan’s exculpation provisions provided protection to “court professionals who acted reasonably while carrying out their responsibilities.”
Judge Novak remanded for the bankruptcy court to narrow the exculpation clause to cover “fiduciaries who have performed necessary and valuable duties.”
Remand
Judge Novak’s order vacated the confirmation order, voided the third-party releases, severed the third-party releases from the plan, and voided the exculpation clause.
Judge Novak remanded the case to another bankruptcy judge with instructions to redraft the exculpation clause and “then to proceed with confirmation of the Plan without the voided Third-Party Releases.”
Another Appeal?
It is unclear whether Judge Novak’s ruling is a final order appealable to the Fourth Circuit. Does the remand call for merely ministerial actions by the bankruptcy court that would allow an appeal?
The parties may not appeal again if they decide they can live without the broad releases that Judge Novak voided.
Judge-Shopping Curtailed in the E.D. of Va.
Like the Southern District of New York, the Eastern District of Virginia has adopted a local order that goes into effect on February 15: For chapter 11 debtors with more than $100 million in liabilities, the cases will be assigned randomly to a bankruptcy judge in the district without regard to the division in which the petition was filed.
In a scorching opinion, a district judge in Richmond, Va., set aside confirmation of a chapter 11 plan that contained “extremely broad third-party (non-debtor) releases.”
District Judge David J. Novak said that the releases in the appeal before him “represent the worst of this all-too-common practice, as they have no bounds.” He described the releases as barring the claims
of at least hundreds of thousands of potential plaintiffs not involved in the bankruptcy . . . , shielding an incalculable number of individuals associated with the Debtors . . . for an unspecified time period stretching back to time immemorial . . . .” [Emphasis in original.]
Judge Novak said that the bankruptcy court “exceeded the constitutional limits of its authority . . . , ignored the mandates of the Fourth Circuit . . . , and offended the most fundamental precepts of due process.”