David Bass and Mark Tsukerman
David Bass and Mark Tsukerman ()

Two long-standing controversial areas of bankruptcy law have recently intersected in a bankruptcy case out of the District of Delaware: (1) a bankruptcy court’s adjudicative authority consistent with Article III of the Constitution, and (2) the propriety of what are referred to in bankruptcy parlance as “third-party releases.” Independently, both topics have been the subject of extensive debate by courts and commentators. Until recently in Opt-Out Lenders v. Millennium Lab Holdings II (In re Millennium Lab Holdings II), Civ. No. 16-110-LPS, 2017 WL 1032992 (D. Del. March 17, 2017), however, few courts have questioned the bankruptcy court’s constitutional authority to approve third-party releases in a Chapter 11 plan. The issues raised in the Millennium decision have caught the attention of the bankruptcy community and have potentially wide-reaching implications on the use of third-party releases and the prosecution of Chapter 11 plans. For the non-bankruptcy practitioner, this article will provide a brief introduction to the two topics of adjudicative authority and third-party releases to give context to the issues raised in Millennium. The article will then briefly summarize the Millennium decision and its potential implications to current bankruptcy practice.

Bankruptcy Court’s Authority

A bankruptcy court’s adjudicative authority is the subject of controversy because bankruptcy court judges, unlike federal district court judges, are not appointed under Article III of the Constitution. Yet, as U.S. Supreme Court precedent makes clear, Article III imposes a structural limitation on the power of an Article I court to assert the “judicial power of the United States.” Also, parties have a constitutional right to have certain claims adjudicated by an Article III judge who enjoys the Article III protections of life tenure and undiminished pay. To put the issue into perspective, some historical context is helpful.

Prior to 1978, bankruptcy courts were specialized forums of rather limited jurisdiction. Federal district courts could refer matters within the traditional “summary jurisdiction” of bankruptcy courts to bankruptcy referees. Generally speaking, summary jurisdiction covered claims regarding the apportionment of the bankruptcy estate among creditors. Proceedings to augment the bankruptcy estate, on the other hand, implicated the district court’s or the applicable state court’s “plenary jurisdiction,” and were not referred to the bankruptcy courts unless the parties consented. Eventually, Congress perceived a need to modernize the country’s then-existing bankruptcy laws, which were designed in 1898 in “the horse and buggy era of consumer and commercial credit.”

In 1978, Congress enacted a comprehensive revision of the country’s bankruptcy laws (1978 act), which eliminated the distinction between “summary” and “plenary” jurisdiction and vastly expanded the bankruptcy court’s jurisdiction, but bankruptcy judges were not afforded the protections of Article III. In 1982, the Supreme Court in N. Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982) struck down parts of the 1978 act as unconstitutional. The court held that a bankruptcy court lacked constitutional authority to adjudicate a debtor’s state law-based contract claim against a defendant that did not file a proof of claim in the debtor’s bankruptcy case. The court recognized there was a historically accepted category of cases involving “public rights” that could constitutionally be assigned to Article I legislative courts. But, resolution of the debtor’s contract claim in Marathon did not fall within that exception. The court distinguished between “the restructuring of debtor-creditor relations, which is at the core of the federal bankruptcy power,” and “the adjudication of state-created private rights, such as the right to recover contract damages[.]” Id. at 71 (emphasis added).

Congress responded to Marathon with the Bankruptcy Amendments and Federal Judgeship Act of 1984 (BAFJA), which sets forth the current bankruptcy jurisdictional scheme. Under BAFJA, the federal district courts retain original jurisdiction over bankruptcy cases and related proceedings. Bankruptcy jurisdiction extends to three types of proceedings: those “arising under” the Bankruptcy Code or “arising in” or “related to” the bankruptcy case, the latter representing the broadest path to bankruptcy jurisdiction. The federal district courts, in turn, may “refer” any or all bankruptcy cases or proceedings to the bankruptcy judges within their district. Bankruptcy judges constitute a “unit” of the district court known as the bankruptcy court. They are appointed to 14-year terms by the courts of appeals and are subject to removal for cause.

Under BAFJA, the bankruptcy court’s adjudicative authority depends on whether the proceeding is classified as “core”, apparently borrowing the term from the Marathon court’s reference to core bankruptcy powers. By design, the statutory definition of “core proceedings” corresponds with that of “arising under” and “arising in” bankruptcy jurisdiction. “Non-core proceedings” correspond with “related to” jurisdiction. Congress also designated as “core” a nonexclusive list of 16 types of proceedings in which it thought bankruptcy courts could constitutionally enter judgment. Congress gave bankruptcy courts the power to “hear and determine” core proceedings and to “enter appropriate orders and judgments,” subject to appellate review by the district court under a clearly erroneous standard. On the other hand, a bankruptcy court may “hear” a non-core proceeding and “enter appropriate orders and judgments” only “with the consent of all the parties to the proceeding.” Absent consent, bankruptcy courts in non-core proceedings may only “submit proposed findings of fact and conclusions of law” to the district for review under a de novo standard.

In 2011, the Supreme Court issued its decision in Stern v. Marshall, 564 U.S. 462 (2011) and once again found that Congress improperly allocated adjudicative authority to the bankruptcy court, but this time in “one isolated respect.” In Stern, the debtor brought a common law counterclaim alleging tortious interference against a creditor who filed a proof of claim for defamation against the debtor’s estate. Notably, “[c]ounterclaims by the estate against persons filing claims against the estate” is a proceeding identified as core in the statute. Nevertheless, the Supreme Court held that, absent the defendant’s consent, the bankruptcy court could not, consistent with Article III of the constitution, adjudicate the counterclaim. The court likened the debtor’s counterclaim to the contract claim in Marathon—both were common law based claims that were brought to augment the bankruptcy estate. That the defendant filed a proof of claim in the bankruptcy case did not alter this conclusion because it was not necessary to resolve the counterclaim as part of the process of allowing or disallowing the creditor’s proof of claim.

Stern has made clear that while a proceeding may be statutorily core (i.e., labeled as core by Congress in the statute), that does not mean it is constitutionally core. Thus, as a practical matter, the focus of courts and practitioners today when making core/non-core determinations is on the constitutional analysis under Stern. Stern also made clear that the issue of adjudicative authority is not jurisdictional. “Section 157 allocates the authority to enter final judgment between the bankruptcy court and the district court … . That allocation does not implicate questions of subject matter jurisdiction.” Stern, 546 U.S. at 480. Later, in Exec. Benefits Ins. Agency v. Arkinson, 134 S. Ct. 2165 (2014), the Supreme Court confirmed that a bankruptcy court’s issuance of a final order or judgment based upon an improper core determination, may be cured by the district court’s de novo review and affirmance of the matter.

‘Third-Party Releases’

One of the main features of U.S. bankruptcy law is the grant of a “discharge” of a debtor’s pre-bankruptcy debt. In Chapter 11 cases, a discharge is achieved by confirmation a Chapter 11 plan of reorganization, which requires the Chapter 11 debtor to satisfy a host of procedural due process and substantive requirements imposed by the Bankruptcy Code to ensure fairness and safeguard the rights of the debtor’s creditors and parties in interest, among other reasons. Often, however, the plan proponent will attempt to extend releases to certain affiliated non-debtor parties, not only from claims belonging to the debtor, but from the claims of non-debtor third-parties too. The latter type of release is what is referred to as a “third-party release.” Such releases, in essence, allow non-debtors to reap the benefits of a bankruptcy discharge without having to pass through the bankruptcy gauntlet. Hence the controversy.

Two circuits (the Ninth and Tenth) have adopted a strict view of third-party releases to hold that third-party releases are not permitted under the Bankruptcy Code, with the limited exception of asbestos liability cases, which are statutorily permitted. The majority of jurisdictions (including the Second and Third Circuits), however, are willing to consider and approve third-party releases under appropriate circumstances, though the courts differ on the standards for their approval. Approval of a third-party release will generally require a two-part inquiry. First, the court must find that is has subject matter jurisdiction to issue the release. The court must, at the very least, conclude that is has “related to” bankruptcy jurisdiction over the third-party claims to be released. “Related to” jurisdiction is the broadest category of bankruptcy jurisdiction, and as discussed, proceedings that are premised on “related to” jurisdiction are non-core. Next, assuming there is jurisdiction, a court must determine whether the third-party release is proper under applicable circuit precedent. Generally speaking, courts will undertake a fact-intensive inquiry and consider a number of factors based on applicable precedent, such as whether the release is consensual, the role and contributions of the proposed release beneficiaries, the importance of the third-party release to the debtor’s plan, and the protections afforded by the plan for third parties bound by the releases.

In contesting third-party releases, litigants typically focus on the court’s subject matter jurisdiction and application of circuit precedent on the permissibility of third-party releases under the circumstances. Absent constitutional challenge, bankruptcy courts have assumed or concluded, without analysis, that they have authority to grant the release if warranted under the substantive case law. Notably, the “confirmation of plans” are statutorily core, 28 U.S.C. §157(b)(2)(L), and plan confirmation was certainly within the bankruptcy referee’s “summary jurisdiction” prior to the 1978 act. While nobody would dispute a bankruptcy court’s constitutional authority to confirm a Chapter 11 plan, the notable issues, as raised in the Millennium case discussed below, are (a) whether approval of a third-party release, which is arguably an adverse adjudication of the third-party releasor’s claim, may be bootstrapped to the bankruptcy court’s plan confirmation authority; and (b) if it cannot not be, whether the district court should be able to cure any Article III infirmity by conducting a de novo review of the bankruptcy court’s findings and conclusions with respect to the releases.

‘Millennium’

In Millennium, the debtor companies filed a plan of reorganization that was premised on the contribution by the debtors’ non-debtor equity holders (the shareholders) of $325 million. The plan contribution would be used to settle certain claims, to secure plan support from certain creditor constituents, and to fund the debtors’ post-confirmation operations. In exchange for the contribution, the plan provided the shareholders with broad releases of all claims against them, including, as discussed below, the claims of the certain prepetition lenders (the lenders) to the debtors. The plan provided no provision for dissenting parties to “opt-out” of the third-party releases, meaning they would be granted upon confirmation of the plan regardless of whether a creditor consented.

Prior to the confirmation hearing, the lenders commenced an action against the shareholders. They asserted fraud claims, alleging that the shareholders misrepresented the company’s financials, failed to disclose material information, and fraudulently induced them to make the loan which they unjustly benefited from. The lenders raised a litany of objections to confirmation of the plan, including that the court lacked subject matter jurisdiction to approve the releases, and even if such jurisdiction existed, the releases were impermissible under applicable law and could not be approved absent the lenders’ consent. In their objections, however, the lenders “did no more than touch upon” the issue of the bankruptcy court’s adjudicative authority to approve the third-party releases.

The bankruptcy court overruled the lenders’ objections and confirmed the plan. The court found that it had “related to” jurisdiction over the lenders’ claims. After analyzing applicable Third Circuit precedent as applied to the facts of the case, the court also concluded that the releases were permissible and could be approved notwithstanding the lenders’ lack of consent. The bankruptcy court did not, however, rule on whether it had constitutional authority to approve the plan releases.

On appeal to the district court, the lenders refocused their arguments on the bankruptcy court’s alleged lack of adjudicative authority to release their claims without their consent. The parties did not dispute that the lenders’ claims against the shareholders were non-core. The lenders argued the confirmation order violated Article III of the Constitution and was inconsistent with the Supreme Court’s holding in Stern. Conversely, the debtors argued that Stern left intact the bankruptcy court’s authority to confirm a plan of reorganization, including any third-party releases contained therein. Furthermore, they argued that the plan release did not run afoul of Stern because it is not an “adjudication” of claims. Moreover, even if the bankruptcy court lacked constitutional authority to approve the releases the district court’s review and approval of the confirmation order would cure the infirmity.

The Millennium court agreed with the bankruptcy court that “related to” subject matter jurisdiction existed over the lenders’ claims, and that Stern does change that conclusion. However, the court agreed with the lenders that under Stern the bankruptcy court was required to address its constitutional authority to issue the releases. The district court remanded the case to the bankruptcy court to address in the first instance whether it had constitutional authority to approve the non-consensual third-party releases in the plan. In doing so, however, the Millennium court took the opportunity to make several findings and observations regarding the merits of the lenders’ position. The court stated that the lenders’ claims were non-core and, under Stern, the lenders appeared to be entitled to Article III adjudication of their claims. Furthermore, the court was persuaded that the plan’s release, which permanently extinguished the lenders’ claims, “is tantamount to resolution of those claims on the merits” against the lenders. Also, the court rejected the debtors’ argument that any Article III violation may be cured and mooted by the district court’s de novo review. The court reasoned that its de novo review was not a cure “because there has been no adjudication on the merits of the actions released by the Plan.” Accordingly, the Millennium court held, it could not resolve the constitutional concerns set forth in Stern through de novo review.

The Millennium court’s conclusion that it could not cure the Article III violation by de novo review is questionable and potentially troublesome. The apparent basis for its conclusion, that there was no adjudication the lenders’ claims, appears to directly contradict its prior conclusion, that the third-party release was tantamount to an adverse adjudication of the lenders’ claim. Further, the conclusion is inconsistent with Stern’s clear mandate that the core/non-core distinction is not jurisdictional, but merely involves the division of labor between the district and bankruptcy courts. If the Millennium plan releases were substantively proper under Third Circuit precedent, as the bankruptcy court had determined, then the district court should be equally positioned to review the bankruptcy court findings and conclusions and either uphold or reject the releases based on that same precedent and the record that was before the bankruptcy court.

Conclusion

The Millennium issue is pending in the bankruptcy court as of the writing of this article. The case and issue has already been widely reported and commented on in the bankruptcy community. To be sure, the case adds uncertainty and complexity to two already muddled and highly litigated areas of bankruptcy law. It may take time for any controlling precedent to develop. In the meanwhile, litigants adversary affected by proposed third-party releases in plans will surely add to their arsenal of objections the challenge to the bankruptcy court’s constitutional authority to approve the releases. The practical effect of such a challenge, however, remains to be seen. Despite the Millennium court’s questionable position on this issue, if third-party releases are constitutionally non-core, the traditional remedy is for the bankruptcy court to issue proposed findings of fact and conclusions of law in respect any third-party releases in the plan and to allow the district court to issue the final order approving (or rejecting) them after de novo review. If that procedure were required, it could have significant consequences to current bankruptcy practices, both administratively—in respect to the division of labor between district and bankruptcy courts in confirming Chapter 11 plans containing third-party releases—and substantively—for example, there are different appellate rights and procedures for core versus non-core matters. Furthermore, while parties may try to structure around Millennium by requiring consent of the affected party, the standard for consent to a third-party release (which is often procured by plan voting mechanism) may diverge from the standard of consent required for a party to waive the right to Article III adjudication.