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Not so Stern: Delaware Bankruptcy Court Finds Authority To Approve Non-Consensual Third Party Releases; Stern Not Applicable

 

12 October 2017

On remand from an appeal to the United States District Court for the District of Delaware, Bankruptcy Judge Laurie Selber Silverstein penned a resounding and thoroughly reasoned sixty-nine page opinion1 holding that the Bankruptcy Court had constitutional authority to confirm a chapter 11 plan that contains a non-consensual third party release of non-bankruptcy claims2 On October 3, 2017, in In re Millennium Lab Holdings II, LLC, Judge Silverstein rejected the application of the U.S. Supreme Court’s 2011 Stern v. Marshall3 decision in which the Court held that non-Article III courts, such as the Bankruptcy Court, lack constitutional authority under Article III of the United States Constitution to enter final judgments on certain state law counterclaims, despite the express statutory authority provided by Congress under 28 U.S.C. § 157(b)(2)(C).

While we do not expect that Judge Silverstein’s decision will be the final word in the debate over the limits of bankruptcy court authority, in the wake of Stern v. Marshall, her decision stands as a full-throated defense of the power of U.S. Bankruptcy Courts to preside over and resolve complex and contentious chapter 11 cases through the confirmation of a plan, even where the plan would adversely affect a party’s non-bankruptcy claims against non-debtors.  

Procedural Background

Commencement of the Case

Millennium Lab Holdings II, LLC and its affiliates (collectively, “Millennium”) provided laboratory-based diagnostic testing services, and sought relief under chapter 11 of the Bankruptcy Code on November 10, 2015. Millennium filed a pre-packaged joint plan of reorganization (the “Plan”) that proposed a restructuring of the company’s $1.7 billion term loan, and a settlement between Millennium and certain federal and state agencies to resolve numerous claims in exchange for a payment of approximately $256 million. Further, the Plan called for the release of both debtor and non-debtor claims against certain of Millennium’s non-debtor equity holders (the “Releases”). In exchange for the Releases, the released equity holders (the “Non-Debtor Equity Holders”) would pay $325 million to fund the company’s settlement with the government and the reorganized company’s initial working capital needs.

Bankruptcy Court Confirms Plan and Releases, Over Creditor Objections

The Releases included a release of potential federal RICO and state law claims held by certain lenders under the term loan (the “Opt-Out Lenders”) against the Non-Debtor Equity Holders for fraudulent inducement, aiding and abetting fraud, and civil conspiracy. The Plan solicitation process and ballots however did not provide affected creditors with an option to elect to opt-out of the Releases and retain their claims against the Non-Debtor Equity Holders. Indeed, Millennium represented to the Bankruptcy Court that absent confirmation of the Plan and approval of the Releases, the company would be forced to liquidate.

The Opt-Out Lenders voted to reject the Plan and objected to confirmation on the basis that, inter alia, the Bankruptcy Court lacked subject matter jurisdiction to approve the proposed Releases. Further, to crystalize their RICO and common law fraud claims, the Opt-Out Lenders filed a complaint against the Non-Debtor Equity Holders in the District Court (the “RICO Lawsuit”). The Bankruptcy Court nonetheless entered an order confirming the Plan over the objections of the Opt-Out Lenders.

Appeal of the Plan Confirmation Order and Remand

The Opt-Out Lenders appealed the Bankruptcy Court’s confirmation order to the District Court. On appeal, the Opt-Out Lenders argued, among other things, that the Bankruptcy Court did not have the constitutional authority to enter the confirmation order which would give effect to the Releases. In opposition, Millennium sought dismissal of the appeal as being “equitably moot” and countered that the Bankruptcy Court had the constitutional authority to enter a final order confirming the Plan with the Releases.

The District Court first observed that Millennium’s equitable mootness arguments were “persuasive.”4 However, the District Court concluded that it could not dismiss the appeal for mootness without first determining whether the Bankruptcy Court had the constitutional authority to enter an order confirming the Plan with the offending Releases. The District Court found that, while the Bankruptcy Court had subject matter jurisdiction, it was not clear that the Bankruptcy Court had squarely ruled on the question of its constitutional authority to approve such Releases, referring to the Supreme Court’s 2011 Stern v Marshall decision (as the issue was not fully briefed and argued before the Bankruptcy Court).5 Accordingly, the District Court remanded to the Bankruptcy Court with express instructions to issue a reasoned decision on that issue or otherwise to strike the Releases from the Plan.6 In so doing, the District Court notably referred to the “seeming merits” of the Opt-Out Lenders constitutional objections.7 

Stern and the Constitutional Arguments Made by the Opt-Out Lenders on Remand

On remand, in their supplemental briefing, the Opt-Out Lenders argued that the Bankruptcy Court lacked constitutional authority to confirm the Plan containing the Release, relying primarily on Stern v. Marshall. In Stern, the Supreme Court considered whether a bankruptcy court had the constitutional authority to enter a final judgment on a state law governed counterclaim made by a debtor in bankruptcy court against a claimant.8 The Court held that the bankruptcy court, as a non-Article III court,9 did not have such authority because the claim at issue: (i) did not stem from the bankruptcy itself or (ii) would not be necessarily resolved in the bankruptcy claims allowance process.10 The Supreme Court suggested that bankruptcy courts were constrained only to issue proposed “findings of fact and conclusions of law” with respect to non-bankruptcy counterclaims, which findings could either be adopted or denied by the district court.11 The Court reasoned:  

Congress may not bypass Article III simply because a proceeding may have some bearing on a bankruptcy case; the question is whether [i] the action at issue stems from the bankruptcy itself or [ii] would necessarily be resolved in the claims allowance process.12 

The above two-prong test has been dubbed by some courts as the “Disjunctive Test.”13

In the wake of Stern, certain bankruptcy courts (including a majority of Delaware courts) have interpreted Stern narrowly and only apply the Disjunctive Test to consider whether they have authority to determine a debtor’s state law counterclaims (the “Narrow Interpretation”).14 Other courts have taken a broad interpretation of Stern and apply the Disjunctive Test when determining any common law or state law cause of action, including state law counterclaims (the “Broad Interpretation”).15 Additionally, at least one court interpreted Stern as a basis to apply a constitutional analysis test to a core bankruptcy proceeding that concerned underlying non-bankruptcy claims (the “Broadest Interpretation”).16

Distinct from the above approaches, the Opt-Out Lenders’ main argument on remand was the preclusive effect that the Releases would have on the continued prosecution of the RICO Lawsuit, which they argued should be the focal point of the Bankruptcy Court’s Stern analysis.17 Because the Releases effectively foreclosed the RICO Lawsuit, the Opt-Out Lenders argued that the Bankruptcy Court’s confirmation of the Plan is tantamount to adjudicating the RICO Lawsuit.18 Under this theory, the Opt-Out Lenders posited that the Bankruptcy Court should have applied the Disjunctive Test to the RICO Lawsuit itself, rather than with respect to the confirmation of the Plan. The Opt-Out Lenders asserted that the standard cannot be met because the suit does not stem from the bankruptcy and would not be resolved in the claims allowance process. Accordingly, the lenders argued that the Bankruptcy Court did not have the constitutional authority to confirm the Plan with the Releases.19

The Bankruptcy Court’s Remand Opinion

The Bankruptcy Court began its Opinion with a discussion of bankruptcy court jurisdiction and reasoned that “there has never been any doubt” with respect to the constitutional authority of a bankruptcy court to confirm a plan of reorganization.20 The Bankruptcy Court next considered whether it had the constitutional authority to enter a final order confirming the Plan with the Releases.21  In doing so, the Bankruptcy Court rejected the Opt-Out Lenders’ Stern analysis and argument that the focus of the analysis should be on the RICO Lawsuit. The Bankruptcy Court noted, “[the Opt-Out Lenders do] not point to anything in Stern, or in any case interpreting Stern, suggesting that the ‘action at issue’ should be anything other than the operative proceeding before the bankruptcy judge.”22 To the contrary, the Bankruptcy Court found that the operative proceeding before it was the confirmation of the Plan and cited to a number of cases, both pre- and post-Stern, where courts concluded that they had constitutional authority to approve plans containing non-consensual third party releases.23

Finding that the operative proceeding was the confirmation of the Plan, the Bankruptcy Court reasoned that under both a Broad and Narrow Interpretation of Stern, the Disjunctive Test should not be applied. The Bankruptcy Court found that confirmation of a plan is not a state or common law claim of any type, nor does it have a state or common law analogue.24 Confirmation of a plan instead depends on the Bankruptcy Court’s application of, and determination under, federal bankruptcy law. Thus, the Bankruptcy Court also held that even under the Broadest Interpretation of Stern, the court would still have the constitutional authority to confirm the Plan.25 The Bankruptcy Court bolstered its holding by noting that even if it did apply the Disjunctive Test, it would find that confirmation of the Plan would satisfy both prongs (confirmation of a plan stems from bankruptcy and the Releases would necessarily be resolved in the confirmation process):26 

The Bankruptcy Court also rejected the argument that the Plan and the Releases would effectively preclude their RICO Lawsuit and so confirmation would be tantamount to a final determination or adjudication of the RICO Lawsuit.27The Bankruptcy Court acknowledged that its confirmation order “surely impacted” the RICO Lawsuit, but held that, based on prevailing case law, a bankruptcy judge’s final order on a core issue that may have a preclusive effect on non-bankruptcy rights does not violate Stern.28 The Bankruptcy Court explained, a bankruptcy judge may enter a final order in a core matter that impacts or even precludes a state law action between two non-debtors.29

Finally, the Bankruptcy Court emphasized that adopting the Opt-Out Lenders’ interpretation of Stern would “dramatically change the division of labor between the bankruptcy and district courts” because it would deprive bankruptcy courts of the power to make various final orders.30 The Bankruptcy Court noted seven instances where the division of labor between the district court and bankruptcy court would undergo a “dramatic change”, including, for example, “virtually every sale of assets” under section 363 of the Bankruptcy Code as such sales inevitably involve a purchaser seeking a release from successor liability.31

Conclusion

In Millennium Lab Holdings II, the Bankruptcy Court issued a thorough and well-reasoned opinion to support the contention that the Bankruptcy Court has the required constitutional authority to confirm a plan that contains a non-consensual third party release. The Bankruptcy Court’s decision is based on fundamental principles of bankruptcy court jurisdiction and how such jurisdiction does not preclude bankruptcy courts from ordering relief, including non-consensual third party releases that could adversely affect, and even preclude, a party’s otherwise valid non-bankruptcy right. Significantly, the Opinion clarifies the bounds of bankruptcy court authority which has been distorted following Stern. The Millennium Lab Holdings II decision supports a narrow reading of Stern and stays true to Chief Justice Robert’s remark that the Supreme Court’s decision in Stern “did not change all that much” when it comes to bankruptcy court constitutional authority. Few now have explained that as thoroughly as Bankruptcy Judge Laurie Selber Silverstein.

Whether the Opt-Out Lenders will pursue a further appeal remains unclear, but it is worth noting that Judge Silverstein also held that the Opt-Out Lenders’ waived their right to raise the Stern-based argument on appeal, which would present an additional hurdle for the Opt-Out Lenders to overcome if they pursue further appeal.32 What is clear is that the District Court will have its work cut out in any appeal if it were inclined to undo the Bankruptcy Court’s well-reasoned opinion. We will keep you apprised of further developments in this litigation. 


1 Complete with a total of 199 footnotes.

2 Millennium Lab Holdings II, LLC et. al., Case No. 15-12284 (LSS) (Bankr. Del. October 3, 2017) [Dkt. 476]  hereinafter “the Opinion.”

3 131 S. Ct. 2594 (2011).

4 Opt-Out Lenders, No.16-00100 [Dkt..48, p.22-23].

5 The District Court held that the Bankruptcy Court properly found that it had subject matter jurisdiction to enter the confirmation order because the released claims involved contractual indemnification obligations that could affect the Millennium debtors. By contrast, the Bankruptcy Court for the District of Colorado in Midway Gold US, Inc., recently issued an opinion holding that it lacked subject matter jurisdiction to approve a reorganization plan containing a third party release because the “disputes subject to [the releases]” would not have an affect on the estate. Case No. 15-16835, Opinion at 54-57 (Bankr. Col. 2015) [Dkt. 1322] (“[T]he Court cannot find it has ‘arising in’ jurisdiction over the proceedings simply because the releases are included within a proposed Chapter 11 plan.”).

6 Id. at 27.

7 Id.

8 Stern, 131 S. Ct. at 2620.

9 Article III of the U.S. Constitution provides that “[t]he judicial Power of the United States, shall be vested in one supreme Court, and in such inferior Courts as the Congress may from time to time ordain and establish.” Article III courts are the U.S. Supreme Court, the 13 U.S. Courts of Appeals, and the 94 U.S. District Courts, each of which is composed of judges that enjoy the protections specifically afforded by Article III of the Constitution: life tenure and pay that cannot be reduced by Congress.  U.S. Bankruptcy Courts, by contrast, are not Article III courts but rather courts established pursuant to Congress’ authority under Article I of the Constitution to assist the U.S. District Courts in the administration of cases under the Bankruptcy Code. Unlike judges on Article III courts, bankruptcy court judges serve 14-year terms and do not enjoy the salary protections afforded to Article III court judges.

10 Id. at 2618.

11 Id. at 2620.

12 Id.

13 Opinion at 20.

14 See Opinion at 23-26 citing In re USDigital Inc., 461 B.R. 276, 292 (Bankr. D. Del. 2011) (Sontchi, J.); Burtch v. Seaport   Capital, LLC (In  re Direct  Response Media, Inc.); 466 B.R. 626, 644 (Bankr. D. Del. 2012) (Gross, J.); Zazzali v. 1031 Exch. Grp. (In re DBSI), 467 B.R. 767, 772 (Bankr. D. Del. 2012) (Walsh, J.); In re WCI Cmtys., Inc., No. 09-52250, 2012 WL 1981713 n.14 (Bankr. D. Del. June 1, 2012) (Carey, J.).

15 Opinion at 24.

16 Id. at 25 citing In re Wash. Mut., Inc., 461 B.R. 200 (Bankr. D. Del. 2011), vacated in part, No. 08-12229, 2012 WL 1563880 (Bankr. D. Del. Feb. 23, 2012) (“WaMu”). Utilizing the Broadest Interpretation, the WaMu court did not apply the Disjunctive Test, but ultimately found that because the matter before it was within a bankruptcy court’s core jurisdiction, did not adjudicate the merits of an underlying state law claim, and dealt with the property of the estate, the court had the constitutional authority to make a final judgment on the matter.  Opinion at 26 citing WaMu, 461 B.R. at 215-16.

17 Opinion at 8-9.

18 Id.

19 Id.

20 See Opinion at 12.

21 Opinion at 27(“[i]n this matter, the operative proceeding for purposes of a constitutional analysis is confirmation of a plan.”).

22 Opinion at 31.

23 Opinion at 15-16 citing In re AOV Industries, Inc., 792 F.2d 1140, 1145-46 (D.C. Cir. 1986) (“Although the bankruptcy’s court’s decision may have an impact on claims outside the scope of the immediate proceedings, we do not read Marathon and its progeny to prohibit all bankruptcy court decisions that may have tangential effects”); Opinion at 22 citing Charles Street African Methodist Episcopal Church of Boston, 499 B.R. 66 (Bankr. D. Mass. 2013) (finding confirmation of a plan was a “public right” and approval of the release in the plan was not tantamount to adjudicating the obligations to be released), and citing MPM Silicones, LLC, No. 14-25503 (RDD), 2014 WL 4436335, at *34 (Bankr. S.D.N.Y. Sept. 9, 2014).

24 The Bankruptcy Court concluded that “[a]dopting the Narrow Interpretation, Stern is inapplicable as a confirmation of a plan is not ‘a state law counterclaim’ . . . . Adopting the Broad Interpretation, the same is true . . . . Under both of these interpretations, then, my constitutional analysis stops.” Opinion at 27-28. The Bankruptcy Court further noted that confirmation of a plan is not a state law claim commenced by the debtor, as is typically the case where Stern applies. Id. at 31-34.

25 Id. at 28. Namely, the Bankruptcy Court found that confirmation of a plan is a core proceeding, is a goal of chapter 11 cases, is unique to bankruptcy cases, and with respect to a plan containing non-consensual third party releases, it doesn’t involve the adjudication of the underlying merits of any claims subject to the release.

26 Opinion at 33. The Bankruptcy Court also discussed that even if it were to utilize the Opt-Out Lenders’ interpretation of Stern, whereby the Disjunctive Test would be applied to the RICO Lawsuit, the Bankruptcy Court would find that the second prong of the test was met. Specifically, it would find that because the Plan involved a settlement “global in nature”—providing for, among other things, the allowance of claims necessarily conditioned on the Releases—and because the Opt-Out Lenders were provided with an allowed claim pursuant to the Plan, the RICO Lawsuit was necessarily resolved in the claims allowance process. Opinion at 34.

27 Opinion at 44.

28 Opinion at 34-39 citing e.g.; Linear Electric Company, Inc., 852 F.3d 313 (3d Cir. 2017) (finding Stern did not prevent bankruptcy court from entering a final order finding construction liens filed by a non-debtor supplier against real property owned by a  non-debtor void ab initio for violating the automatic stay); In re Lazy Days’ RV Center Inc., 724 F.3d 418, 423 (3d Cir. 2012); Hart v. S Heritage Bank (In re Hart), 564 F. App’x 773 (6th Cir. 2014) (finding Stern did not prevent bankruptcy court from entering judgment, finding creditor’s loans nondischargeable under the Bankruptcy Code and entering judgment as to the amount of each nondischargeable loan despite debtor’s objection that such judgment would affect its state law action pending against the creditor); In re Fischer Island Investments, Inc., 778 F.3d 1172, 1192 (11th Cir. 2015) (finding that bankruptcy court had constitutional authority to resolve ownership dispute with respect to two debtors subject of involuntary proceedings and that Stern was a “narrow holding . . . wholly inapplicable”). The Opinion, at note 139,  cites other reported decisions in which courts have held that a bankruptcy judge has constitutional adjudicatory authority post-Stern to issue an order in a core proceeding that impacts state law claims including: (i) In re Safety Harbor Resort and Spa, 456 B.R. 703 (Bankr. M.D. Fla. 2011) (finding that a bankruptcy judge has constitutional adjudicatory authority to impose creditor suggested “lock up”  restrictions on the reorganized debtor’s business operations and non-debtor guarantors’ assets as condition to confirming plan containing third party releases; lock up restrictions were an integral part of the order confirming the plan and confirmation of a plan is core); (ii) In re Catholic Bishop of N. Alaska, 525 B.R. 723, 730 (D. Alaska 2015) (over Stern objection, holding that bankruptcy judge had authority to determine state law adverse possession property rights in context of non-debtor/purchaser’s motion to enforce § 363 sale order because it “was necessary for the proper administration of the bankruptcy estate”); In re Owner Mgmt. Serv., LLC Trustee Corps., 530 B.R. 711 (Bankr. C.D. Cal 2015) (holding that post-Stern, bankruptcy judges can continue to enter final orders on substantive consolidation) (citing In re LLS America, 2011WL 4005477 (Bankr. E.D. Wash. Sept. 8, 2011)) aff’d In re LLS Am., LLC, 2012 WL 2042503 (9th Cir. BAP June 5, 2012); In re Land Resource, LLC, 505 B.R. 571, 581-82 (M.D. Fla. 2014) (holding the bankruptcy court had constitutional adjudicatory authority to enter order approving settlement that contained permanent injunction and bar order permanently enjoining non-debtors from pursuing claims against other non­debtors, and that Stern is inapposite and should not be extended beyond its narrow holding).

29 Opinion at 34-39.

30 Id. at 50-51.

31 Id.

32 See Opinion at 53-69.

 

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