Bad News for Non-Debtors Seeking Chapter 11 Releases



In January, we wrote about the mega-bankruptcy of Purdue Pharma. A United States District Court in New York struck down Purdue Pharma’s confirmed Chapter 11 plan, finding it inappropriate for the plan to contain non-consensual releases of direct claims held by third parties against nondebtors. The district court specifically disapproved of the discharges granted to members of the Sackler family, who had not filed for personal bankruptcy protection. You can read the entire article here.

Less than a month later, a United States District Court in Virginia issued a similar decision. The district court’s blunt ruling ruled that in the Fourth Circuit (which includes North Carolina’s federal courts), third-party releases are disadvantaged because they can lead to abuse and should be granted cautiously and infrequently.

The decision came during the bankruptcy of Mahwah Bergen Retail Group. Mahwah and several affiliates owned and operated over 2,800 retail clothing stores under the Ann Taylor, LOFT and Lane Bryant brands. Debtors had approximately $1.6 billion in secured debt and $800 million in unsecured debt. In Chapter 11, they liquidated the company for over $650 million, then came up with a plan to pay certain secured creditors and set aside $7.25 million for pro-rata payments to unsecured creditors. The bankruptcy court upheld the plan over objections from the United States trustee, the Securities and Exchange Commission and plaintiffs in a securities fraud case.

Prior to the bankruptcy, a group of plaintiffs had filed a securities fraud lawsuit against the debtors, their CEO and CFO, and others. The lawsuit alleged that the defendants engaged in a deceptive, false and deceptive scheme to artificially inflate the price of their common stock. The plaintiffs were seeking class action status when bankruptcy put the case on hold.

The plan contained convoluted and general statements. Basically, if you had a claim against a person or entity associated with the debtors, you released everything if you did not object or withdraw in a timely manner. In rejecting the plan, the district court said the releases closed the doors of the courthouse to potential plaintiffs while protecting company insiders. The Court interpreted the waivers as barring the claims of hundreds of thousands of potential plaintiffs uninvolved in the bankruptcy, protecting countless individuals associated with the debtors for an indefinite period of time going back forever. The releases effectively killed the securities fraud lawsuit.

The district court recognized that there was no absolute ban on third-party broadcasts in the Fourth Circuit. A bankruptcy court may approve non-consensual, non-debt discharges after considering these factors:

  1. Is there an identity of interest between the debtor and the third party?

  2. Did the non-debtor contribute substantial assets to the reorganization?

  3. Is liberation essential to reorganization?

  4. Did the affected classes vote overwhelmingly to accept the plan?

  5. Does the plan include a mechanism to pay the classes affected by the release?

  6. Does the plan provide an opportunity for applicants who choose not to settle to fully recover?

But the bar is almost insurmountable and all factors must be supported by precise, detailed and rigorous factual findings.

A key thing to remember is that parties whose claims will be extinguished must be given proper notice and due process, the opportunity to negotiate, and some value for their release. The district court found that the notification process was insufficient. The debtors sent notices and opt-out forms to 300,000 potential class members and published notices in two national newspapers. Less than half of the 1% withdrew. The debtors had no record of who actually received the forms. The debtors argued that since the parties could opt out of the proposed plan if they did not, there was implied consent to the plan. The district court rejected this argument. There must be real and not tacit consent.

The back-to-back decisions in Purdue Pharma and Mahwah highlight contentious issues with third-party non-consensual releases in bankruptcy. These decisions are not the final word, and we will continue to monitor them on appeal.

© 2022 Ward and Smith, Pennsylvania. All rights reserved.National Law Review, Volume XII, Number 40



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