Southern District of New York and Eastern District of Virginia Curtail the Use of Non-Consensual Third-Party Releases in Plans of Reorganization

In recent months, two courts expressed disapproval of the use of non-consensual third-party releases in plans of reorganization: (i) the Southern District of New York, in In re Purdue Pharma, L.P., and (ii) Eastern District of Virginia, in Patterson v. Mahwah Bergen Retail Group, Inc. These decisions represent a significant shift towards curtailment of the use of non-consensual third-party releases in plans of reorganization. Non-consensual third-party releases arise in Chapter 11 plans and are an uncommon tool in bankruptcy proceedings. Instead of voluntary releases—which are the typical, and preferred, tool in Chapter 11 plans—a non-consensual third-party release is generally sought when the claim(s) against the third party must be released because the third party has a substantial and essential economic contribution that makes such release vital to the plan.

The Southern District of New York's Decision in in re Purdue Pharma L.P.

On December 16, 2021, Judge McMahon of the Southern District of New York reversed the Bankruptcy Court’s confirmation of the Debtors’ plan of reorganization because of the non-consensual third-party release provisions in the plan. In her decision, Judge McMahon analyzed whether Section 105(a), 1123(a)(5), 1123(b)(6), or 1129 of the Bankruptcy Code authorizes the Bankruptcy Court’s approval of non-consensual third-party releases. Judge McMahon concluded that none of those statutory sections confer authority on the Bankruptcy Court to grant non-consensual third-party releases.

After concluding that the Bankruptcy Code does not expressly authorize the approval of the third-party releases at issue, Judge McMahon considered the Debtors’ argument that the Bankruptcy Court could approve the non-consensual third-party releases because of the lack of any statutory prohibition prohibiting them. Judge McMahon rejected the Debtors’ argument, finding that Congress’s silence on the issue does not mean that the Bankruptcy Court has authority to approve non-consensual third-party releases. In contrast, as Judge McMahon noted, Congress has expressly authorized such releases, assuming certain conditions are met, in asbestos-related cases.

The Eastern District of Virginia's decision in Patterson v. Mahwah Bergen Retail Group, Inc.

Following on the heels of the Judge McMahon’s decision in In re Purdue Pharma, Judge Novak of the Eastern District of Virginia similarly disapproved of the use of non-consensual third-party releases in a plan of reorganization in his January 13, 2022 decision. In the underlying bankruptcy case, the Bankruptcy Court approved broad non-debtor releases of—among other claims—securities-fraud claims against the Debtors’ insiders as part of the Bankruptcy Court’s confirmation of the Debtors’ plan of reorganization. Finding the third-party release provisions void and unenforceable, Judge Novak labeled the breadth of the release provisions as “shocking” and cautioned that third-party releases are a “device that lends itself to abuse.”

In reaching his decision, Judge Novak expressed significant concern with the due process implications of non-consensual third-party releases, explaining that the “third-party releases strike at the heart of these fundamental rights.” As the third-party releases would release the claims of—at a minimum—hundreds of third parties without their consent, Judge Novak held that the third-party releases “offended the most fundamental precepts of due process.”

In addition, Judge Novak held that the Bankruptcy Court lacked jurisdiction to approve the broad, third-party releases at issue. Analyzing whether the Bankruptcy Court has constitutional authority to release the claims of third parties under the Supreme Court’s decision in Stern v. Marshall, Judge Novak found that the Bankruptcy Court:

1. failed to identify whether it had jurisdiction over the released claims; and
2. lacked jurisdiction over many of the released claims because such claims included claims between non-debtors that have little to no connection to the bankruptcy estate or the administration of the bankruptcy case.

Conclusions & Takeaways

The In re Purdue Pharma and Mahwah Bergen Retail Group decisions add to the growing uncertainty regarding the use of third-party non-consensual releases in a plan of reorganization. Even prior to the In re Purdue Pharma and Mahwah Bergen Retail Group decisions, courts had been split on the issue of third-party non-consensual releases. Judge McMahon’s and Judge Novak’s decisions add to the increasing body of case law that either disfavors or expressly prohibits the use of broad, non-consensual third-party releases. In the wake of these decisions and until the uncertainty regarding the use of third-party of releases is resolved, debtors will have to proceed cautiously before seeking approval of broad, non-consensual third-party release provisions in a plan of reorganization.