The practice of granting third party releases in bankruptcy was recently dealt another blow by the District Court for the Eastern District of Virginia. In Patterson et. al. v. Mahwah Bergen Retail Group, Inc., Civil No. 3:21cv167 (DJN), the District Court found that the lower bankruptcy court lacked the constitutional authority to both rule on certain of the claims covered by the third-party releases at issue and, it follows, to confirm the debtors’ plan of reorganization.  The District Court went so far as to sever the third-party releases from the plan, vacating the plan and remanding the matter for consideration of the plan without the releases.  But the District Court didn’t stop there. The District Court further ordered that the case be reassigned to a different bankruptcy judge in a different regional division (that is not known for consistently granting third-party releases), adding that the Chief Judge could “assign it to himself if he believes the interests of justice so warrant.”  Doc. 79 at 86.

This appeal arose out of the chapter 11 cases of Mahwah Bergen Retail Group, Inc. and certain of its affiliates (the “Debtors”). The Debtors’ plan of reorganization contained broad releases of a wide-range of non-debtor third parties, a practice that is common in large chapter 11 cases. The plan included a common opt-out mechanism, excluding from the “releasing parties” all holders of claims and interests that timely opted out of, or objected to, the releases. Notice of the plan and releases were delivered to, among others, approximately 300,000 current and former shareholders – members of putative class action against the Debtors and certain of their officers. Of those, approximately 600 had effectively opted-out shortly before the confirmation hearing. Given the limited response, the lead plaintiffs sought to exercise the opt-out on behalf of all putative members but their efforts were rebuffed. The plan was confirmed on February 25, 2021.

The lead plaintiffs and the US Trustee appealed and the matter was heard by District Court in mid-December 2021. According to the District Court, the releases at issue “represent the worst of this all-too-common practice, as they have no bounds. The sheer breadth of the releases can only be described as shocking. They release the claims of at least hundreds of thousands of potential plaintiffs not involved in the bankruptcy, shielding an incalculable number of individuals associated with Debtors in some form, from every conceivable claim – both federal and state claims – for an unspecified time period stretching back to time immemorial.” Id. at 5. As interpreted by the court, the releases “cover any type of claim that existed or could have been brought against anyone associated with Debtors as of the effective date of the plan.” Id. at 11. The District Court expressed concern that the Bankruptcy Court, when considering the effect of the proposed releases, had only focused on the putative class in its analysis, and did not address a myriad of other claims that would be released. Concerned with due process, the court noted that many of the “releasing parties,” including current and former employees, received no notice or opt-out forms. According to the court, “[t]his tunnel vision proves fatal to any notions of proper notice (as well as consent) in this case.”  Id. at 12.

The District Court engaged in a lengthy analysis regarding constitutionality of the Bankruptcy Court’s ruling and found that under Stern v. Marshall, 564 U.S. 471 (2011), the Bankruptcy Court had no jurisdiction over the underlying claims or to grant the releases. It provided guidance for future determinations – “[d]ue to the substantial constitutional issues at play with the use of this perilous tool, it seems preferrable for a bankruptcy court to submit any third-party releases to the district court for approval via a Report and Recommendation in the rare and exceptional case that warrants the use of third-party releases. The Report and Recommendation should identify with specificity the claims and individuals released and provide detailed proposed findings of fact and conclusions of law to ensure that the released claims are truly integral to the reorganization.”  Id. at 40. A burdensome feat to be sure, and perhaps impossible in many cases.

The District Court further considered whether the releases were consensual and met the standards for third-party releases in the Fourth Circuit. While consent may, in some cases, obviate the need for an analysis of the applicable factors, the court explained that the opt-out notice in the instant case does not satisfy the standards for consent.  See Id. at 52.  The District Court implied that, in order to find consent, proper notice must at a minimum (i) describe the released claims or the rights given up and (ii) identify consideration to the releasing party (i.e., a mutual release). The notices at issue did neither. Coupled with the lack of representation, the purported class members were not afforded due process. See Id. at 59. The District Court emphasized that notice was entirely absent for potential claimants outside the purported class. Accordingly, an analysis of the applicable factors was demanded, but not conducted, by the bankruptcy court. After conducting its own high-level review of the applicable factors, the District Court determined that the third-party releases were not appropriate. Indeed, it took the extraordinary action of severing the releases from the plan, finding that doing so would not “upset the viability of the plan.”  See Id. at 71. That decision was made easier due to the nature of the underlying case.  The Debtors had sold substantially all of their assets prior to confirmation, with only distribution of proceeds remaining — severing the releases would not upset this from proceeding according to the court (and there was consistent testimony at trial). See Id.

With the recent challenges to third-party releases in the Second Circuit, debtors will seemingly face an increasing burden to justify broad releases of third parties proposed in their plans of reorganization.