The Restructuring Report

Court watchers have kept a close eye on the In re: Purdue Pharma LP chapter 11 bankruptcy case, and for good reason. It is one of the largest cases to test a question that has divided the Circuit Courts of Appeals: can a debtor in its chapter 11 plan include releases from liability for non-debtor third parties over the objection of creditors? Although the debate over the answer has been stewing for some time now, a December 2021 decision from the Southern District of New York may finally cause the pot to boil over. As many readers may be aware at this point, the district court vacated the much anticipated and highly contested chapter 11 plan in In re: Purdue Pharma LP that contained nonconsensual releases of non-debtor Purdue affiliates and members of Purdue’s founding family, the Sacklers.

The Background on Nonconsensual Third-Party Releases

Before discussing Purdue Pharma, just what is a third-party release in this context? A third-party release is a provision in a chapter 11 plan of reorganization that releases claims—quite often a wide swath of them—against a non-debtor third party. They are often used in situations in which an entity and its affiliates face large tort liability; the entity files for bankruptcy and then seeks releases of claims against non-debtor third-party affiliates on the grounds that such releases are necessary for the successful plan of reorganization. In return for the release, the non-debtor third party contributes assets to the reorganization. Section 524(g) of the Bankruptcy Code explicitly permits third-party releases in asbestos cases, as long as certain requirements are met, but the Bankruptcy Code is silent as to third-party releases in other types of cases. Courts have allowed releases in non-asbestos cases even over the objection of part of the impacted class(es) of creditors—hence the term nonconsensual third-party release. Debtors facing large tort liability—including several Catholic dioceses—have turned to nonconsensual third-party releases as a tool in their chapter 11 toolbox in recent years.

Courts of Appeals are split over whether nonconsensual third-party releases in non-asbestos cases are constitutional and allowed under the Bankruptcy Code. The First, Second, Third, Fourth, Sixth, Seventh, Eleventh, and D.C. Circuits have all either left the door open to the allowance of nonconsensual third-party releases, or they have held that the Bankruptcy Code allows such releases in certain circumstances. In doing so, these courts most often relied on § 1123(b)(6), which states that a plan may “include any other appropriate provision not inconsistent with the applicable provisions of this title,” and the broad grant of authority to “issue any order, process or judgment that is necessary or appropriate to carry out the provisions of” the Bankruptcy Code in § 105. Under the factors set forth in Class Five Nev. Claimants v. Dow Corning Corp. (In re Dow Corning Corp.), 280 F.3d 648, 658 (6th Cir. 2002), which many courts have adopted, third-party nonconsensual releases may be appropriate when there is an identity of interests between the debtor and the third party, usually an indemnity relationship, and when the following factors are satisfied:

1. there is an identity of interests 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 release is essential to reorganization, namely, the reorganization hinges on the debtor being free from indirect suits against parties who would have indemnity or contribution claims against the debtor;
4. the impacted class, or classes, has overwhelmingly voted to accept the plan;
5. the plan provides a mechanism to pay for all, or substantially all, of the class or classes affected by the injunction; and
6. the plan provides an opportunity for those claimants who choose not to settle to recover in full.

The Fifth, Ninth and Tenth Circuits have come down on the other side, holding that nonconsensual third-party releases are not permitted under the Bankruptcy Code. In support, those Courts often cite § 524(e)’s statement that the “discharge of a debt of the debtor does not affect the liability of any other entity on . . . such debt.”

The Southern District of New York Holds Nonconsensual Third-Party Releases Are Unconstitutional

In September 2021, after two years of negotiations and a six-day hearing on the matter, the Bankruptcy Court for the Southern District of New York confirmed Purdue Pharma’s chapter 11 plan of reorganization. The plan, over the objection of some creditors, included the release of direct claims against members of the Sackler family and some of Purdue’s non-debtor affiliates. In exchange, these non-debtor third parties agreed to contribute $4.5 billion toward the plan of reorganization. The Bankruptcy Court relied on six different bases for its authority to grant such releases. First, the Bankruptcy Court held that sections 105(a), 1123(a)(5), 1123(b)(6) and 1129(a)(1) of the Bankruptcy Code, in various combinations with each other, allowed the Court to grant nonconsensual third-party releases. Next, the Bankruptcy Court turned to the Bankruptcy Code’s silence on the issue, determining that this silence meant that such releases are not prohibited. Finally, the Bankruptcy Court looked to its “residual power” to enforce orders to effect the chapter 11 plan that are not inconsistent with the Bankruptcy Code.

On appeal, the Southern District of New York rejected in turn each of these grounds for the Bankruptcy Court’s purported authority to grant nonconsensual third-party releases and vacated the order confirming Purdue Pharma’s chapter 11 plan. Addressing the specific Bankruptcy Code provisions that the Bankruptcy Court relied on, the District Court held that none provide the independent authority to grant nonconsensual third-party releases. And contrary to the Bankruptcy Code being silent on the matter of third-party releases, the District Court noted that § 524(g) and (h) expressly provide for third-party releases in asbestos cases. Thus, by expressly allowing third-party releases in the asbestos context, but not more generally, Congress was creating an exception to the default Bankruptcy Code structure. Finally, the District Court rejected the Bankruptcy Court’s determination that it had residual authority to grant such releases because any exercise of residual authority in this context was in fact inconsistent with various provisions of the Bankruptcy Code.

What’s Next for Purdue Pharma and the Future of Nonconsensual Third-Party Releases?

So after over two years, it seemed as if Purdue Pharma was heading back to the drawing board. But then, in January 2022, the District Court granted Purdue’s request to immediately appeal the vacatur of the plan to the Second Circuit. The Second Circuit, despite having left the door open to the idea of nonconsensual third-party releases in prior cases, has in the past shown great skepticism regarding the propriety of nonconsensual third-party releases outside of exceedingly rare circumstances. Given the in-depth and thorough District Court decision, the Second Circuit will have ample opportunity to address head-on the question of whether such releases are constitutional.

Perhaps strengthening the position of those opposing nonconsensual third-party releases, the opinion in In re: Purdue Pharma is not the only recent decision to address this issue. In an opinion released on January 18, the Eastern District of Virginia also vacated the portion of Ascena Retail’s chapter 11 plan containing nonconsensual third-party releases on constitutional grounds, calling them “the worst of this all-too-common practice, as they have no bounds,” and noting that the “sheer breadth of the releases [at issue] can only be described as shocking.” In this same edition, Clint Cutler writes about the recent decision in the Ascena Retail case. Congress is also considering legislation to curb nonconsensual third-party releases. With all the attention on nonconsensual third-party releases, whether Congress or the United States Supreme Court will address the issue first is an open question.

Given the rising ubiquity of nonconsensual third-party releases and the lynchpin-role they often play in chapter 11 plans, you can bet it will be more than just your avid court watchers keeping an eye out for the Second Circuit’s decision in In re: Purdue Pharma.