An increasingly common aspect of Chapter 11 plans is non-consensual third party releases, which are often a vital tool required to obtain global peace among competing constituencies whose support is often needed for a debtor to obtain confirmation of a Chapter 11 plan. However, the parameters of a bankruptcy court’s Constitutional authority to approve such non-consensual releases has, to date, been unclear. Clarity, however, has been provided by the recent decision by the United States Bankruptcy Court for the District of Delaware In re Millennium Lab Holdings II, LLC,[1] where the Court concluded that it had constitutional authority to confirm a restructuring plan that released third parties from liability to certain creditors, even though those creditors had not consented to the releases.  The Bankruptcy Court’s ruling will be of interest to potential debtors and other potential releasees who may seek to employ or benefit from non-consensual third party releases as well as to lenders and other creditors who may find themselves bound by non-consensual release contained in a Chapter 11 plan.

Debtor Millennium Lab Holdings II, LLC and certain affiliates commenced their Chapter 11 Cases in 2015 following a settlement with the United States federal government and certain states relating to alleged violations of the Anti-Kickback Statute, the False Claims Act, and the Stark Act (which relates to physician referrals for Medicare and Medicaid services). In December 2015, the Bankruptcy Court confirmed a Plan of Reorganization which contained settlements with certain equity holders (the “Non-Debtor Equity Holders”), who contributed $325 million to the estate and received third party releases.  Immediately prior to the confirmation hearing, certain dissenting creditors (the “Opt-Out Lenders”) commenced a lawsuit asserting common law fraud and RICO claims against the Non-Debtor Equity Holders.  The Opt-Out Lenders also filed an objection to the non-consensual third party releases in the proposed Plan.  The Opt-Out Lenders argued that the Plan’s non-consensual releases went beyond the scope of the Bankruptcy Court’s authority.[2]

The Bankruptcy Court overruled the Opt-Out Lenders’ arguments and confirmed the Plan in a bench ruling on December 11, 2015. Thereafter, in a January 12, 2016 written opinion, the Bankruptcy Court certified an appeal directly to the Third Circuit on the following question: “Do Bankruptcy Courts have the authority to release a non-debtor’s direct claims against other non-debtors for fraud and other willful misconduct without the consent of the releasing non-debtor?”[3]  The Third Circuit denied the petition for permission to appeal, and the appeal was docketed with the Delaware District Court.[4]

In the District Court, the Opt-Out Lenders principally pursued an argument based on the Supreme Court’s decision in Stern v. Marshall.[5]  According to the Opt-Out Lenders, the Bankruptcy Court lacked constitutional authority to enter a final order releasing direct, non-bankruptcy claims against non-debtors.  The District Court remanded the case to the Bankruptcy Court to decide that issue.  In doing so, however, the District Court provided its own view of the merits and voiced agreement with the Opt-Out Lenders’ Stern argument.  The District Court stated that it was “persuaded by [the Opt-Out Lenders’] argument that the Plan’s release, which permanently extinguished [the Opt-Out Lenders’] claims, is tantamount to resolution of those claims on the merits” and that it believed that “[i]f Article III prevents the Bankruptcy Court from entering a final order disposing of a non-bankruptcy claim against a nondebtor outside of the proof of claim process, it follows that this prohibition should be applied regardless of the proceeding (i.e., adversary proceeding, contested matter, plan confirmation).”[6]

On remand, the Bankruptcy Court concluded that it did have the authority to grant the release of the Opt-Out Lenders’ claims via confirmation of the Plan.  In its analysis, the Bankruptcy Court laid out a continuum of interpretations of Stern.  On one end of the continuum, the narrow interpretation reads Stern only as prohibiting a bankruptcy court from entering a “final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor’s proof of claim.”[7] Next, a relatively broad interpretation of Stern would prohibit a bankruptcy court from entering a final judgment on “all state law claims, all common law causes of action or all causes of action under state law.”[8] Finally, the broadest view of Stern holds “that bankruptcy judges should examine their ability to enter final orders in all enumerated or unenumerated core proceedings.”[9]

The Bankruptcy Court held that it possessed constitutional authority to confirm the Plan under both the narrow and broad views of Stern because confirmation of a plan is neither a state law counterclaim nor a state law claim of any kind.[10] Furthermore, even under the broadest interpretation of Stern, the Bankruptcy Court maintained constitutional authority to confirm the plan because (1) confirmation is at the core of a bankruptcy judge’s power, (2) confirmation applies a “federal standard,” and (3) the confirmation of the Plan met the Third Circuit’s “standard of fairness and necessity to the reorganization.”[11]

The Bankruptcy Court also rejected the Opt-Out Lenders’ interpretation of Stern. The Opt-Out Lenders argued that confirmation would violate Stern’s statement that “the question is whether the action at issue stems from the bankruptcy itself or would necessarily be resolved in the claims allowance process.” The Bankruptcy Court questioned whether that disjunctive test was the appropriate measure of the constitutionality of a restructuring plan, and further held that confirmation of the Plan was constitutional because the Plan stemmed from the Chapter 11 Cases and “the releases were integral to confirmation and thus integral to the restructuring of the debtor-creditor relationship.”[12]

The Bankruptcy Court also dismissed the Opt-Out Lenders’ functionalist argument that, because confirmation had the effect of extinguishing their RICO lawsuit, the confirmation constituted an “impermissible adjudication of the litigation being released.” Relying on pre-Stern Third Circuit precedent,[13] the Bankruptcy Court concluded that a confirmation order can permissibly impact and even extinguish lawsuits in non-core proceedings. The Bankruptcy Court went on to note that, if taken to its logical conclusion, the Opt-Out Lenders’ interpretation of Stern would apply to an eye-popping range of core bankruptcy matters, including substantive consolidation, recharacterization and subordination of debts, and practically every section 363 sale.

In short, the Bankruptcy Court held that, regardless of Stern, bankruptcy courts have constitutional authority to confirm restructuring plans that include non-consensual releases of claims against third parties. Furthermore, Stern does not extend to core proceedings concerning federal law that implicate state law rights.

Although Stern is now nearly eight years old, its meaning remains a source of controversy and litigation in bankruptcy courts. The range of possible interpretations of Stern described by the Bankruptcy Court—as well as the differing view offered by the District Court—show that courts have not yet settled how Stern affects even routine and fundamental bankruptcy court business. Perhaps not surprisingly in light of the long history of the dispute and the District Court’s decision, the Opt-Out Lenders have filed a notice of appeal of the Bankruptcy Court’s decision. Stay tuned to the HHR Bankruptcy Report to stay apprised of further developments.

* James Henseler assisted with the preparation of this post.

[1].      In re Millennium Lab Holdings II, LLC, No. 15-12284, 2017 WL 4417562 (Bankr. D. Del. October 3, 2017).

[2].      According to the Bankruptcy Court, the Opt-Out Lenders raised four objections to the releases: (i) the court lacked subject matter jurisdiction to grant nonconsensual third party releases, (ii) the releases were impermissible, (iii) the Plan impermissibly did not allow parties to opt-out of the releases, and (iv) the releases were inconsistent with the Third Circuit’s holding in Gillman v. Continental Airlines (In re Continental Airlines), 203 F.3d 203 (3d Cir. 2000).

[3].      In re Millennium Lab Holdings II, LLC, 543 B.R. 703, 711 (Bankr. D. Del. 2016).

[4].      In re Millennium Lab Holdings II, LLC, 242 F. Supp. 3d 322, 335 (D. Del. 2017).

[5].      Stern v. Marshall, 564 U.S. 462 (2011).

[6].      In re Millennium Lab Holdings II, LLC, 242 F. Supp. 3d 322, 339 (D. Del. 2017).

[7].      2017 WL 4417562, at *12 (quoting Stern, 564 U.S. at 503).

[8].      Id.

[9].      Id. at *13 (emphasis removed).

[10].    Id. at *14 (internal quotation marks omitted).

[11].    Id. at *15 (citing In re Cont’l Airlines, 203 F.3d 203, 214 (3d Cir. 2000)).

[12].    2017 WL 4417562, at *18.

[13].    CoreStates Bank, N.A. v. Huls Am., Inc., 176 F.3d 187 (3d Cir. 1999).

In the beginning of the opinion he wrote for Stern v. Marshall, Chief Justice Roberts referenced Charles Dickens’ Bleak House, in which Dickens gives a grim description of a lawsuit litigated in a foggy courtroom.[1] In resolving the tumultuous Stern dispute, the Supreme Court created a new fogginess in bankruptcy courtrooms as to the exact contours and scope of a bankruptcy courts’ authority. As our readers are aware, the Supreme Court and the various Circuit Courts have issued a number of opinions in the wake of Stern to clarify the exact parameters of a bankruptcy court powers and the recent opinion by the Fourth Circuit in In re Lewis addressing the specific power of a bankruptcy court to discipline attorneys further helps clear the proverbial fog surrounding the bankruptcy courts’ powers.[2]

In In re Lewis, Mr. Lewis was the attorney to a debtor in bankruptcy.[3] The Bankruptcy Administrator observed several discrepancies in Mr. Lewis’ representation, prompting the Bankruptcy Court to sanction and temporarily suspend Mr. Lewis from further proceedings.[4] On appeal, Mr. Lewis contended that the court did not have the authority, as an Article I tribunal, to suspend his bar privileges or to sanction him.[5] Relying on Stern, he argued that the court did not possess the authority to rule on disciplinary matters against him.[6] The Fourth Circuit disagreed.[7]

The Court of Appeals explained that the Bankruptcy Court appropriately exercised its authority to sanction Lewis for his misconduct.[8] Bankruptcy courts have inherent power, “‘incidental to all courts’ to ‘discipline attorneys who appear before it,’”[9] including “issu[ing] any order, process, or judgment that is necessary or appropriate to carry out the provisions of [Title 11] or to prevent an abuse of power”[10] and suspending or disbarring attorneys from their court.[11] So, despite any Constitutional restrictions prescribed upon Article I courts, all courts may admonish and discipline those who appear before them.

[1] Stern v. Marshall, 131 S. Ct. 2594 (2011)

[2] In re Lewis, 2015 WL 3561277 (E.D. N.C. June 9, 2015).

[3] In re Lewis, 2015 WL 3561277 at *1.

[4] Id.

[5] Id. at *2.

[6] Id.

[7] Id.

[8] Id.

[9] Id. (quoting Chambers v. NASCO, Inc., 501 US 32, 43 (1991).

[10] Id. (quoting 11 USC § 105(a)).

[11] Id. (citing In re Snyder, 472 U.S. 634, 643 (1985)).

In Wellness International Network v. Sharif, the Supreme Court recently weighed in again on the scope of a bankruptcy court’s jurisdiction, holding in a 6-3 opinion that Article III authorizes bankruptcy judges to exercise judicial power over Stern claims (claims that challenge a bankruptcy court’s power to enter final judgment on a case) when the parties consent to such adjudication.

As previously reported, the Wellness case arises out a complaint filed in bankruptcy court by Wellness International Network against Sharif, a chapter 7 debtor. Wellness claimed that Sharif administered a trust fund that was actually his personal property and part of his bankruptcy estate. Later, the bankruptcy court found that Sharif violated the court’s discovery order, and subsequently entered a default judgment against him, treating the property from the trust fund as part of his bankruptcy estate. Upon appeal to the Seventh Circuit, the court ruled that, following Stern, the Bankruptcy Court did not have constitutional authority to enter final judgment and the parties could not consent to waive jurisdictional issues. The Supreme Court granted certiorari and decided the following issue:

“[W]hether Article III allows bankruptcy judges to adjudicate [Stern] claims with the parties’ consent.” Wellness Int’l Network v. Sharif, No. 13-935, slip op., at 2 (2015).

In Stern, the Court decided that Article III disallows bankruptcy courts from implementing final judgments on claims that “seek only to ‘augment’ the bankruptcy estate . . .” Wellness, slip op. at 2. That standard now has an exception as held in Wellness, which permits bankruptcy courts to implement final judgments on claims, even if they are only augmenting a bankruptcy estate, as long as the parties consented to adjudication in bankruptcy court. The Court noted, “[A]llowing Article I adjudicators to decide claims submitted to them by consent does not offend the separation of powers so long as Article III courts retain supervisory authority over the process,” which was the case in Wellness. Wellness,slip op. at 12.

Furthermore, as mentioned by the Court, such consent need not be express. However, it must be knowing and voluntary. That is, “the key inquiry is whether ‘the litigant or counsel was made aware of the need for consent and the right to refuse it, and still voluntarily appeared to try the case’ before the non-Article III adjudicator,” such as a bankruptcy court, which is an Article I adjudicator. Wellness, slip op. at 19 (quoting Roell v. Withrow, 538 U.S. 580, 590 (2003)).

Thus, in holding that Article III permits bankruptcy courts to decide Stern claims to which the litigants consented, the Court remanded the case to the Seventh Circuit to decide whether Sharif’s actions had the requisite “knowing and voluntary consent” to litigate the case in bankruptcy court. Chief Justice Roberts—the author of the Stern decision limiting bankruptcy court jurisdiction—wrote a 20-page dissent criticizing the majority decision as establishing precedent to allow Congress to strip the judiciary of other powers.

The Impact of Wellness

After Stern, bankruptcy courts could not enter a final judgment on a case that could “exis[t] without any bankruptcy proceeding.” However, as the Court in Wellness noted, that ruling hinged on the fact that a litigant in the case “did not truly consent to” adjudication in bankruptcy court. Thus, what Stern decided was that non-consent is a bar to the bankruptcy court’s entering a final judgment—it did not decide the inverse situation, whether consent allows the court to enter a final judgment. Wellness answers this latter question, confirming that consent—both express and implied—are sufficient for the bankruptcy court to enter a final judgment on the case. That is, while Stern was premised on non-consent to adjudication in a bankruptcy court as a “constitutional bar” on a bankruptcy court’s ability to hear the case, Wellness was premised on consent to adjudication in bankruptcy court as authorizing the court to exercise judicial power over the case and waiving the litigants’ right to litigate in an Article III court. What is left unclear, however, is what exactly amounts to “consent,” but as this case gets remanded to the Seventh Circuit to determine whether Sharif consented to adjudication in bankruptcy court, and as future courts provide their interpretations on the scope of consent, Wellness’s implications will become clearer.

In a unanimous opinion written by Justice Clarence Thomas, the Supreme Court today upheld a Ninth Circuit decision allowing a bankruptcy court to issue proposed findings of fact and conclusions of law on issues outside their constitutional jurisdiction for de novo review by the district court.  As previously reported here, the Supreme Court was presented with two questions: (i) whether Article III permits the exercise of the judicial power of the United States by bankruptcy courts on the basis of litigant consent, and, if so, whether “implied consent” based on a litigant’s conduct, where the statutory scheme provides the litigant no notice that its consent is required, is sufficient to satisfy Article III; and (ii) whether a bankruptcy judge may submit proposed findings of fact and conclusions of law for de novo review by a district court in a “core” proceeding under 28 U.S.C. § 157(b).

In reaching its decision, the Court relied on the reasoning set forth in Stern v. Marshall, a landmark bankruptcy decision on the constitutional limitations of bankruptcy judges’ power arising from the legal dispute between Anna Nicole Smith and the heirs of her former husband, the late J. Howard Marshall II.  In Stern, the Supreme Court held that, notwithstanding statutory authority granted by Congress, a bankruptcy court lacked constitutional authority to finally adjudicate certain claims reserved for Article III judges.  But, because the statute only explicitly allowed bankruptcy courts to issue findings of fact and conclusions of law on issues defined by the statute as “non-core,” the lower courts found a “statutory gap” in the treatment of claims defined by the statute as “core” that were outside of the scope of the bankruptcy court’s constitutional jurisdiction under Stern.  Applying the severability clause of the statute, the Court concluded:

We hold today that when, under Stern’s reasoning, the Constitution does not permit a bankruptcy court to enter final judgment on a bankruptcy related claim, the relevant statute nevertheless permits a bankruptcy court to issue proposed findings of fact and conclusions of law to be reviewed de novo by the district court.

Because it was not necessary to reach the first question presented, the Court “reserve[d] . . . for another day” the question of whether a party can consent to the Bankruptcy Court’s adjudication of a Stern claim.