Second Circuit confirms use of third-party releases in Chapter 11 Bankruptcy Plans – Circuit split remains

On May 30, 2023, the United States Court of Appeals for the Second Circuit issued an order affirming a Chapter 11 Bankruptcy Plan that included nonconsensual third-party claim releases in In Re: Purdue Pharma L.P. et al. v. The City of Grande Prairie et al. While the order clarified the views of the Second Circuit regarding third-party releases – confirmed the approval of such releases, the authority of the bankruptcy court to permit such releases and set up a seven-part test for evaluating and approving these releases – it also further highlighted a split among circuit courts regarding the use and validity of third-party releases in Chapter 11 bankruptcy cases.

Chapter 11 Third-Party Release Overview

Chapter 11 bankruptcy plans are unique in that they are generally tailored to a debtor’s particular needs so that the debtor can emerge from the bankruptcy and continue operating. Because of this, Chapter 11 plans are creatively negotiated and frequently include release provisions. Many times, these releases extend to third parties – meaning those that have not filed for bankruptcy but still have potential liability for certain actions underlying the bankruptcy.

Third-party releases in Chapter 11 bankruptcies are controversial. Since they permit non-debtor third parties to be released upon confirmation of the bankruptcy plan, parties who never actually agreed to the release of the non-debtors become bound to the terms and lose any opportunity to present a claim against the released third-party. There is no opt-out provision.

On the other hand, in many cases, third-party releases work to fund the bankruptcy plan with a contribution of capital, without which the plan would not be feasible. The non-debtors make a payment into the plan in exchange for the release, increasing the recovery available to injured parties.

Under the express language of the Bankruptcy Code, only a debtor may be discharged in a bankruptcy proceeding. However, the Code is silent regarding whether non-party debtors may be released. As such, jurisdictions are split on the issue of whether these releases are permissible.

As of May 2023, the Second, Third, Fourth, Sixth, Seventh, and Eleventh circuits allow third-party releases in Chapter 11 bankruptcy plans. The Fifth, Ninth, and Tenth circuits expressly disallow third-party releases. The First and Eighth circuits have not directly addressed the matter, but underlying district court decisions indicate they would allow the releases – at least under certain circumstances.

The circumstances that permit these releases, however, are generally undefined in all courts that allow them, leading to a lack of uniformity and predictability both among and within the circuit courts.

Purdue Pharma Decision

The Sackler family purchased Purdue Pharma LP (“Purdue”) in the 1950s and, in 1995, developed OxyContin, a controlled release semisynthetic opioid analgesic that was approved by the FDA. Around 2000, state governments began to alert Purdue regarding the abuse of OxyContin and in 2001, the FDA required Purdue remove from its label that it had a low risk for addiction, which resulted in many lawsuits being filed against Purdue due to it bringing forth one of the largest public health crises. Despite having direct claims for promoting OxyContin, Purdue filed for bankruptcy on September 15, 2019, aiming to resolve thousands of claims arising from its development, manufacturing, marketing and sale of Oxycontin. The Sackler family (“Sacklers”), owners and operators of Purdue, however, did not file for bankruptcy.

During Purdue’s bankruptcy proceeding, the United States Bankruptcy Court for the Southern District of New York issued an order approving a Chapter 11 mediated settlement that included nonconsensual third-party releases of direct claims against non-debtors – in this case, the Sacklers. On December 16, 2021, the United States District Court for the Southern District reversed. On May 30, 2023, the US Court of Appeals for the Second Circuit (“Second Circuit”) confirmed the original order, approving the inclusion of the nonconsensual release of direct claims against the Sacklers in Purdue’s Chapter 11 plan.

At issue before the Second Circuit were the following:

1. Whether the bankruptcy court had the authority to approve the nonconsensual release of direct third-party claims against the Sacklers through the Chapter 11 Plan; and
2. Whether the Bankruptcy Code, factual records, and equitable considerations support the bankruptcy court’s approval of the Chapter 11 Plan.

In relation to the second issue, the Second Circuit reviewed the bankruptcy court’s equitable considerations and concluded that “without the plan, the Sacklers would likely be mired in litigation, but it would also be likely that they could successfully shield much of their estimated $11 billion fortune from creditors through spendthrift trusts and offshore accounts, and broader creditors recovery from Purdue’s estate would be extremely limited”.  In determining whether to approve the plan, the bankruptcy court relied on certain factors highlighted in a prior Second Circuit decision: In re Iridium Operating LLC, 478 F.3d 452 (2d Cir. 2007).[1]

As to the first issue, the Second Circuit confirmed the bankruptcy court’s approval of the plan stating that this approval is to be awarded in certain cases with certain limitations.[2]

In reviewing the bankruptcy court’s authority over the matter, the Court referenced two sections of the Bankruptcy Code, 11 U.S.C. §§ 105(a), and 1123(b)(6), which it found jointly provide the statutory basis for the bankruptcy court’s authority to approve a plan that includes a nonconsensual release of third-party claims against non-debtors. The Court also noted that in specific circumstances, such as in the Purdue case, “bankruptcy courts are permitted to approve of restricting plans that include such release.” Thus, the US Bankruptcy Court’s approval of Purdue’s mediated plan was permissible under both the Bankruptcy Code and prior Second Circuit case law.

Ultimately, the Second Circuit established a seven-factor test to determine the approval of third-party releases in Chapter 11 bankruptcy plans – noting that the factors are not necessarily sufficient to approve a release and extensive discovery into the facts surrounding the claims will be required. The factors are as follows:

1. Whether there is an identity of interests between the debtors and released third parties, including indemnification relationships, 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. Whether claims against the debtor and non-debtor are factually and legally intertwined, including whether the debtors and released parties share common defenses, insurance coverage, or levels of culpability;
3. Whether the breadth of the release is necessary to the plan;
4. Whether the release is essential to the reorganization, in that the debtor needs the claims to be settled in order for the res to be allocated (and not because the released party is somehow manipulating the process to its own advantage);
5. Whether the non-debtor contributed substantial assets to the reorganization;
6. Whether the impacted class of creditors overwhelmingly voted in support of the plan; and
7. Whether the plan provides for fair payment of enjoined claims, with a focus on the fairness of the payment and not the final amount of the payment.

The Second Circuit ultimately concluded that the above factors were met, and that the bankruptcy court did not err in approving the plan.

COMMENT

The decision in Purdue was not a surprise given the trajectory of cases in the Second Circuit. However, the decision only binds the Second Circuit. The split in circuits remains and the validity of third-party releases in Chapter 11 Bankruptcy plans is still unresolved nationwide. Nevertheless, the Purdue decision may serve as persuasive authority in other courts – especially considering the seven-factor test established by the court. Additionally, the decision may encourage businesses to use bankruptcy to address mass tort litigation – much like the Purdue opioid litigation – specifically seeking protection in the Second Circuit.

However, the continued circuit split regarding these third-party releases is constitutionally troublesome. As Judge Wesley noted in his concurrence in Purdue, Article I of the Constitution requires the establishment of “uniform Laws on the subject of Bankruptcies throughout the United States” and the circuit split inevitably leads to results that are far from uniform. Judge Wesley suggests that either Congress or the Supreme Court should address the validity of these third-party releases in order to prevent inconsistent and constitutionally problematic results that are solely “a function of geography.” Moving forward, the Purdue decision could be appealed.  Or Congress may choose to act. Or perhaps more courts adopt the newly established Purdue seven factor test. Regardless, the issues regarding third-party releases in Chapter 11 Bankruptcy plans are far from settled.

[1] These factors include:

1. The probability of success, should the issues be litigated vs. the present and future benefits of the settlement;
2. The likelihood of complex and protracted litigation if the settlement is not approved, with its attendant expense, inconvenience and delay, including the difficulty of collecting on a judgment;
3. The interests of the creditors, including the degree to which creditors support the proposed settlement;
4. Whether other interested parties support the settlement;
5. The competence and expenses of counsel supporting, and the experience and knowledge of the court in reviewing, the settlement;
6. The nature and breadth of the releases to be obtained by officers and directors or other insiders; and
7. The extent to which the settlement is the product of arm’s length bargaining.

[2] In approving the plan, the bankruptcy court determined that the following factors should be considered when determining whether third-party releases are appropriate:

1. The third-party releases were narrowly tailored;
2. Monetary contributions were critical to the plan;
3. The success of the plan hinged on the third-party releases;
4. The affected class or classes overwhelmingly accepted the plan;
5. The amount being paid under the plan was substantial; and
6. Claimants would be compensated fairly under the plan.