In Brief: Delaware and New York District Courts Affirm Constitutional Authority to Grant Nonconsensual Releases in Chapter 11 Plan

by Jones Day
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Jones Day

On September 21, 2018, the U.S. District Court for the District of Delaware affirmed a bankruptcy court's ruling that it had the constitutional authority to grant nonconsensual third-party releases in an order confirming the chapter 11 plan of laboratory testing company Millennium Lab Holdings II, LLC ("Millennium"). See Opt-Out Lenders v. Millennium Lab Holdings II, LLC (In re Millennium Lab Holdings II, LLC), 2018 WL 4521941 (D. Del. Sept. 21, 2018). In so ruling, the court rejected an argument made by a group of creditors that a provision in Millennium's plan releasing racketeering claims against the debtor's former shareholders was prohibited by the U.S. Supreme Court's 2011 ruling in Stern v. Marshall, 564 U.S. 462 (2011), which limited claims that can be finally adjudicated by a bankruptcy judge. The court concluded that Stern does not apply because the "operative proceeding" before the court was a chapter 11 plan confirmation proceeding rather than litigation of the racketeering claims.

Less than three weeks afterward, the U.S. District Court for the Southern District of New York reached the same conclusion in Lynch v. Lapidem Ltd. (In re Kirwan Offices SARL), 2018 WL 5095675 (S.D.N.Y. Oct. 10, 2018). In affirming an order confirming a cramdown chapter 11 plan that enjoined arbitration of claims over whether the bankruptcy filing was authorized, the court ruled that "[a] bankruptcy court acts pursuant to its core jurisdiction when it considers the involuntary release of claims against a third-party, non-debtor in connection with the confirmation of a proposed plan of reorganization, which is a statutorily defined core proceeding."

Millennium

The bankruptcy court confirmed Millennium's chapter 11 plan in December 2015. The plan released claims against various nondebtor entities, including Millennium's former shareholders, who contributed $325 million to the estate, in part to fund a settlement with federal regulators.

A group of creditors led by Voya Investment Management ("Voya"), which asserted racketeering claims against the shareholders, objected to confirmation. Voya contended, among other things, that the court did not have subject matter jurisdiction to grant nonconsensual third-party releases and that the plan releases did not satisfy the test set forth in the Third Circuit's decision in Gillman v. Continental Airlines (In re Continental Airlines), 203 F.3d 203 (3d Cir. 2000). That decision requires specific factual findings that proposed releases are fair and necessary to a reorganization.

The court overruled the objections, and Voya appealed the confirmation order. It argued on appeal, among other things, that the bankruptcy court lacked authority to grant the releases under Stern because barring the racketeering claims was tantamount to adjudicating them, which is outside a bankruptcy court's constitutional jurisdiction. Persuaded that releasing Voya's claims might be tantamount to adjudicating them and that Stern's constitutional limitations should apply as much to plan confirmation as to any other bankruptcy-related proceeding, the district court remanded the constitutionality issue to the bankruptcy court.

The Bankruptcy Court's Ruling on Remand

On remand, the bankruptcy court rejected Voya's "expansive reading of Stern, which not only applies Stern outside of the narrow context in which it was made, but far beyond the holding of any court." In Stern, the Supreme Court articulated a "disjunctive test" for whether a bankruptcy court can enter a final order on a trustee's counterclaim: "Congress may not bypass Article III [of the U.S. Constitution] simply because a proceeding may have some bearing on a bankruptcy case; the question is whether the action at issue stems from the bankruptcy itself or would necessarily be resolved in the claims allowance process." Stern, 564 U.S. at 499 (emphasis added). The Court ruled that a bankruptcy court cannot enter a final judgment on a state law counterclaim of the bankruptcy estate that is not resolved in the process of ruling on a creditor's proof of claim.

According to the bankruptcy court on remand in Millennium:

Stern did not hold, as Voya suggests, that regardless of which articulated (or unarticulated) core proceeding is before the court, the bankruptcy judge cannot, consistent with the Constitution, enter a final order in that proceeding if that order affects a party's entitlement to have a debtor's or trustee's state law claim heard by an Article III court.

The court also stated that Voya's Stern-based argument was misplaced because, among other reasons, the racketeering claims were federal and, although the releases undeniably "impacted" the racketeering claims, they did not actually adjudicate them, but were part of a settlement that would give the shareholders an affirmative defense in any racketeering litigation.

In addition, the bankruptcy court ruled that, even if it were to apply Stern's disjunctive test to a plan confirmation proceeding, the test would be satisfied because: (i) the chapter 11 plan and the releases "stem from the bankruptcy case"; and (ii) the releases were integral to confirmation and integral to the restructuring of the debtor-creditor relationship, thus being "necessarily resolved" in the confirmation process, the process of restructuring the debtor-creditor relationship, and the claims allowance process.

The bankruptcy court emphasized that Voya's interpretation of Stern would "dramatically change the division of labor between the bankruptcy and district courts." It explained that, without consent, which could be withheld as leverage, district courts would be compelled to enter final orders approving a wide range of relief traditionally granted by bankruptcy courts, including orders approving free-and-clear asset sales under section 363 of the Bankruptcy Code, substantive consolidation, and the recharacterization or subordination of claims.

Voya appealed the ruling.

The District Court's Ruling in Millennium

The district court affirmed. It agreed with the bankruptcy court that Stern did not address any context other than counterclaims or "announce a broad holding addressing every facet of the bankruptcy process." The district court also agreed that plan confirmation was the "operative proceeding" and that Stern does not require application of the disjunctive test in that context.

Finally, the district court did not fault the bankruptcy court's conclusion that approval of the chapter 11 plan releases did not amount to adjudication on the merits of Voya's racketeering claims. Like the bankruptcy court, the district court noted that Voya's position was at best "a substantive argument against third party releases, not an argument that confirmation orders containing releases must be entered by a district court."

Kirwan

Kirwan Offices S.a.r.l. ("Kirwan") is a Luxembourg entity established as a special investment vehicle for the purpose of acquiring a subsidiary of Yukos Oil Company. In 2016, Kirwan's majority shareholders (who were also creditors) filed an involuntary chapter 11 petition against Kirwan in the U.S. Bankruptcy Court for the Southern District of New York.

A minority shareholder opposed the filing. He argued that the court should dismiss or abstain from hearing the case so that he could pursue arbitration in London of a dispute over the majority shareholders' rights under a shareholders' agreement to file the involuntary bankruptcy case. The bankruptcy court ruled that majority shareholders had the authority to file the case in their capacity as creditors and that dismissal or abstention was not warranted because the dispute regarding the alleged breach of the shareholders' agreement was within the court's "core" jurisdiction. The minority shareholder did not appeal.

In 2017, the bankruptcy court confirmed a chapter 11 plan for Kirwan proposed by the majority shareholders. The plan included a nonconsensual, third-party release prohibiting the minority shareholder from initiating arbitration in London for the purpose of establishing that the majority shareholders breached the shareholders' agreement by filing Kirwan's chapter 11 case.

The minority shareholder did not object to the plan. However, he appealed the confirmation order, arguing that the bankruptcy court lacked jurisdiction and the constitutional power to enjoin subsequent litigation of nonbankruptcy claims under the shareholders' agreement.

The District Court's Ruling in Kirwan

The district court affirmed. Initially, the court noted that "involuntary releases of third-party, non-debtor claims that are entered by bankruptcy courts are subject to considerable scrutiny," but that a majority of circuit courts—including the U.S. Court of Appeals for the Second Circuit—"permit them, but only if they meet certain conditions."

In addition, the district court observed that there "is no consensus among the courts holding the majority view" about the jurisdictional basis for third-party releases. Some courts, the district court explained, including the Third and Fifth Circuit Courts of Appeals, "posit that the only jurisdictional basis for a bankruptcy court to extinguish third-party claims permanently is through an exercise of non-core jurisdiction." Other courts, including the U.S. Court of Appeals for the D.C. Circuit and the district court in Millennium, have concluded that "when involuntary third-party releases are considered in connection with confirmation proceedings, bankruptcy courts act pursuant to their core jurisdiction."

The Kirwan district court sided with the latter view. It ruled that "[a] bankruptcy court acts pursuant to its core jurisdiction when it considers the involuntary release of claims against a third-party, non-debtor in connection with the confirmation of a proposed plan of reorganization, which is a statutorily defined core proceeding. 28 U.S.C. § 157(b)(2)(L)."

Like the district court in Millennium, the Kirwan district court concluded that approving a nonconsensual, third-party release "does not address the merits of the claims being released." The court 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." Instead, the court wrote, 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 of the Bankruptcy Code.

The district court rejected the argument that third-party injunctions would give bankruptcy courts a "blank check" to exercise "infinite jurisdiction." It would be constitutionally improper, the court noted, to confirm a plan with third-party releases that were "unrelated (or even tangentially related) to the debtor or the bankruptcy case." Instead, a nonconsensual third-party release "must be sufficiently related to the issues before the bankruptcy court in order for core jurisdiction to cover an order extinguishing that claim."

Approval of the injunction as part of Kirwan's chapter 11 plan, the district court emphasized, was within the bankruptcy court's core jurisdiction because it prevented the minority shareholder from collaterally attacking the confirmation order through arbitration in London.

The district court also held that res judicata precluded the minority shareholder from attacking the plan releases because the minority shareholder did not appeal the bankruptcy court's earlier ruling that the dispute regarding the shareholders' agreement was core and therefore within the final adjudicatory power of the bankruptcy court.

Finally, the district court ruled that, even if approval of the plan releases was not within the bankruptcy court's core jurisdiction, the minority shareholder impliedly consented to final adjudication by the bankruptcy court by participating in the proceedings below without raising the constitutional issue.

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