Southern District of New York Holds That Bankruptcy Court Lacks Statutory Authority to Approve Non-Consensual Third-Party Releases

In a December 16, 2021, decision,¹ Judge Colleen McMahon of the US District Court for the Southern District of New York reversed the bankruptcy court order confirming the Chapter 11 plan of Purdue Pharma, L.P. and its affiliated debtors, holding that the Bankruptcy Code did not authorize the plan’s non-consensual third-party releases. Judge McMahon’s decision is now the subject of an expedited appeals process² whose outcome has the potential to substantially affect the ability of shareholders and other third parties to obtain releases in a Chapter 11 case.

BACKGROUND

As the district court explained and has been widely reported, the Purdue Pharma case arose in the context of the opioid epidemic in the United States, which has been traced largely to the over-prescription of addictive medications, including Purdue Pharma’s proprietary drug, OxyContin.³ By 2019, Purdue Pharma was facing thousands of lawsuits by people who had become addicted to OxyContin and the estates of people who had died of overdoses. The company also faced numerous claims by federal, state and local governmental entities and in 2020 pled guilty to criminal charges brought by the US Department of Justice.⁴

Faced with thousands of lawsuits in jurisdictions around the country, Purdue Pharma filed a voluntary Chapter 11 bankruptcy petition in September 2019. Shortly after the filing, which automatically stayed litigation against Purdue Pharma itself, the bankruptcy court entered a stay of litigation against various non-debtors affiliated with Purdue Pharma, primarily members of the Sackler family, who for years owned and controlled the company and were defendants in many of the pending lawsuits. Over the following two years, various classes of creditors then negotiated a plan of reorganization with Purdue Pharma and the Sackler family that was ultimately approved by the bankruptcy court and which Judge McMahon subsequently reversed.

THE SHAREHOLDER RELEASES

A central provision of Purdue Pharma’s plan of reorganization was a broad release of claims in favor of the “Shareholder Released Parties,” i.e., the Sackler family and various related people and entities. The provision included a release of direct claims of the “Releasing Parties”—which included all holders of claims against Purdue Pharma—against the Shareholder Released Parties, relating to, among other things, Purdue Pharma’s OxyContin-related activities “as to which any conduct, omission or liability of any Debtor or any Estate is the legal cause or is otherwise a legally relevant factor.”⁵ The release provision was non-consensual, meaning that it was binding not only on those who consented to it but on objecting parties, as well.⁶ In exchange, pursuant to settlements that were incorporated into Purdue Pharma’s Chapter 11 plan, the Shareholder Released Parties agreed to contribute a total of $4.325 billion to a trust, over the course of nine to ten years, that would be used to resolve public and private opioid-related civil claims and civil and criminal settlements with the federal government.⁷ The plan also provided for the channeling of enjoined claims against the Shareholder Released Parties to nine creditor trusts for treatment according to the trust documents for each trust.⁸

The plan was overwhelmingly accepted by the members of each class of creditors entitled to vote. However, eight states, the District of Columbia and various other parties objected to the releases of the Shareholder Released Parties and argued, among other things, that (1) the releases of their direct claims against the Shareholder Released Parties were not permitted under the Bankruptcy Code; and (2) the bankruptcy court lacked constitutional, statutory and equitable authority to approve the releases.⁹ The bankruptcy court confirmed the plan over these objections.

BANKRUPTCY COURT’S FINDINGS

In confirming the plan, the bankruptcy court made three core findings with respect to the Sackler settlements that incorporated the releases of the Shareholder Released Parties.¹⁰

Necessary to the Plan

First, the bankruptcy court found that the settlements were necessary to the plan. Specifically, a number of other settlements that were essential to the plan would fail for lack of funding if the Sacklers did not make the promised $4.325 billion contribution, and that contribution was conditioned on the Sacklers receiving the releases.

Fair and Reasonable

Second, the bankruptcy court found that the settlements, in which the Sacklers agreed to pay $4.325 billion in exchange for the releases, were fair and reasonable. In that regard, the bankruptcy court made various findings, including that: (1) the settlements were the product of arms-length negotiations in separate mediations that were preceded by production of almost 100 million pages of documents through which interested parties could learn of potential claims against the Shareholder Released Parties; (2) the settlements were negotiated by highly competent counsel; (3) Purdue Pharma’s creditors voted overwhelmingly in support of the plan that incorporated the settlements; (4) failure to approve the settlements would likely result in protracted and expensive litigation, while the settlements offered significant and immediate benefits to the estate and its creditors; (5) any judgments that might be obtained against the Sacklers would be difficult to collect for several reasons, including that the Sacklers’ assets were held principally in “purportedly” spendthrift trusts and that many Sackler family members lived abroad; and (6) the unraveling of the other settlements incorporated into the plan that were dependent on the primary settlements with the Sacklers would inevitably result in a Chapter 7 liquidation that would result in no recovery for personal injury plaintiffs.¹¹

Releases Authorized by the Bankruptcy Code

Third, the bankruptcy court held that it had statutory authority to approve the third-party releases in favor of the Shareholder Released Parties, even though such parties were not debtors in Purdue Pharma’s case, based on certain sections of the Bankruptcy Code:¹²

• Section 105(a), which authorizes the court to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions” of the Bankruptcy Code;¹³
• Section 1123(a)(5), which requires that a Chapter 11 plan of reorganization “provide adequate means for [its] implementation;”¹⁴
• Section 1123(b)(6), which provides that a Chapter 11 plan may “include any other appropriate provision not inconsistent with the applicable provisions of this title;”¹⁵ and
• Section 1129(a)(1) of the Bankruptcy Code, which provides in pertinent part that a bankruptcy court “shall confirm a plan only if . . . the plan complies with the applicable provisions of this title.”¹⁶

The bankruptcy court concluded that when read together, these provisions permitted the releases if such releases were necessary for a workable reorganization plan.

As additional support, the bankruptcy court pointed to:

• the absence of an express prohibition in the Bankruptcy Code against granting third-party releases;¹⁷
• its authority to release non-derivative, direct claims of third parties insofar as they were “premised as a legal matter on a meaningful overlap with the debtor’s conduct;”¹⁸ and
• case law holding that there is “residual authority” under the Bankruptcy Code to release third parties from liability if appropriate and not inconsistent with the Bankruptcy Code.¹⁹

DISTRICT COURT’S HOLDING

The district court disagreed with the bankruptcy court’s analysis, holding that the Bankruptcy Code provisions relied on by the bankruptcy court only confer “the power to enter orders that carry out other, substantive provisions of the Bankruptcy Code. None of them creates any substantive right; neither do they create some sort of ‘residual authority’ that authorizes the action taken by the Bankruptcy Court:”²⁰

• As to Section 105(a), the district court explained that that section does not authorize actions inconsistent with other provisions of the Bankruptcy Code and does not confer any substantive right authorizing a third-party release. In that regard, the district court relied on prior US Supreme Court decisions interpreting Section 105(a), albeit decisions that did not address third-party releases expressly.²¹
• As to Section 1123(a)(5), the district court noted that that section enumerated various actions that may be taken to implement a plan, such as providing for the debtor to retain or transfer property. However, those actions could only be taken with the debtor’s assets, not the assets of third parties.²² The district court further reasoned that Section 1123(a)(5) did not authorize injunctions against the prosecution of third-party claims against non-debtors or the release of such claims.²³
• As to Section 1123(b)(6), the district court held that the release of the Shareholder Released Parties in Purdue Pharma’s plan was in fact “inconsistent with the applicable provisions” of the Bankruptcy Code because the releases would discharge the Sacklers of debts that could not otherwise be discharged even if they filed their own bankruptcy petitions, such as debts for fraud and non-dischargeable civil penalties payable to governmental units.²⁴
• As to Section 1129(a)(1), the district court concluded that Section 1129(a)(1)’s pronouncement that a plan should only be confirmed if it complies with the applicable provisions of the Bankruptcy Code conferred no substantive right that could be used to support the non-consensual release of third-party claims.²⁵

The district court also rejected the bankruptcy court’s reasoning that the Bankruptcy Code authorized the releases because it contained no provision expressly prohibiting them.²⁶ In particular, the district court noted that the Bankruptcy Code did expressly authorize the release of third-party claims against non-debtors but only in the limited case of asbestos litigation, pursuant to Sections 524(g) and (h).²⁷ By permitting third-party releases in that limited context, while remaining silent in other contexts, the district court found that Congress intended those provisions to “preempt the field where non-debtor releases were concerned,”²⁸ i.e., such releases are allowed in the asbestos context but nowhere else.

Finally, the district court held that even if bankruptcy courts hold some “residual authority” to take actions not otherwise inconsistent with the Bankruptcy Code, that authority is not so broad so as to allow a bankruptcy court “to insert a right that does not appear in the Bankruptcy Code in order to achieve a bankruptcy objective.”²⁹ Instead, “whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code.”³⁰

In holding that there was no statutory authority under the Bankruptcy Code authorizing the non-consensual release of direct third-party claims against the Shareholder Released Parties, the district court declined to consider the other arguments raised by the parties including those based on constitutional concerns and those unique to the facts of the Purdue Pharma case.³¹

TAKEAWAYS

The district court’s opinion in Purdue Pharma is currently subject to an expedited appeal before the US Court of Appeals for the Second Circuit, and the bankruptcy court has also ordered the parties to further mediate their disputes in an attempt to reach an agreed modification of Purdue Pharma’s Chapter 11 plan that will allow the plan to become effective. As this mediation and the appeal progress, it also bears monitoring to what extent the district court’s decision will influence other cases. Indeed, on January 13, 2022, the US District Court for the Eastern District of Virginia issued a decision striking third-party releases in the Chapter 11 plan of Mahwah Bergen Retail Group and in doing so relied in part on the district court’s decision in Purdue Pharma.³² It also remains to be seen whether the district court’s decision will impact draft legislation that has been proposed in Congress that is intended to prohibit non-consensual third-party releases.³³

¹ In re Purdue Pharma, L.P., 2021 WL 5979108 (S.D.N.Y. Dec. 16, 2021).

² On January 27, 2022, the US Court of Appeals for the Second Circuit entered an order granting the petitions for leave to appeal the district court’s decision and has ordered the parties to address “any and all issues bearing on the legal authority of the bankruptcy court—constitutional, statutory, or otherwise—to authorize the non-consensual releases of third-party direct claims against non-debtors.” See Purdue Pharma, L.P. v. State of Washington, No. 22-85(L), Jan. 27, 2022 (ECF No. 220). Briefing will occur in February and March, and oral argument will be scheduled during the week of April 25, 2022, or as soon thereafter as possible. Id.

³ Purdue Pharma, 2021 WL 5979108, at *1.

⁴ Id.

⁵ The bankruptcy court required this specific language as an express condition to confirmation of Purdue Pharma’s plan. Purdue Pharma, 2021 WL 5979108, at *27; Plan, § 10.7(b). The plan also released the Sacklers of derivative claims that could be brought on behalf of Purdue Pharma’s bankruptcy estate to recover for injury caused to Purdue Pharma itself. See Purdue Pharma, 2021 WL 5979108, at *48. On appeal to the district court, no party disputed the bankruptcy court’s authority to approve a release of derivative claims. Id.

⁶ Purdue Pharma, 2021 WL 5979108, at *29; Plan, § 10.7(b).

⁷ Purdue Pharma, 2021 WL 5979108, at *32; Plan, at 38, § 5.2(g).

⁸ However, the district court concluded that because the trust documents provided that distributions from the trusts would only be determined with consideration to claims held against Purdue Pharma, and not with consideration to claims held against non-debtor parties, the claims against the Shareholder Released Parties “are effectively being extinguished for nothing.” Purdue Pharma, 2021 WL 5979108, at *29.

⁹ Purdue Pharma, 2021 WL 5979108, at *30.

¹⁰ The plan included two settlements with the Sacklers and their related entities. The first provided for the settlement of claims of Purdue Pharma’s bankruptcy estate. The second provided for settlement of third-party claims (i.e., claims that could be asserted by others). In re Purdue Pharma L.P., 633 B.R. 53, 83 (Bankr. S.D.N.Y. 2021).

¹¹ The bankruptcy court also weighed the potential legal risks of the bankruptcy estates’ claims against the Sacklers versus the benefits of settlement, including that Purdue Pharma may not have been insolvent when most of the transfers from Purdue Pharma to the Sacklers were made, that most of the Sackler family members had nothing to do with Purdue Pharma’s operations and that no action had been taken in their capacity as passive shareholders that would make them liable on alter ego, veil-piercing and breach of fiduciary duty claims. Id. at *33. However, the issue on appeal ultimately was not whether the bankruptcy estates’ claims against the Sacklers could be released (which nobody disputed) but whether direct claims of creditors—that is, “claims that are not derivative of Purdue’s liability, but are based on the Sacklers’ own, individual liability, predicated on their own alleged misconduct and the breach of duties owed to claimants other than Purdue”—could be released. Id. at *36, 48.

¹² Id. at *35.

¹³ 11 U.S.C. § 105(a).

¹⁴ 11 U.S.C. § 1123(a)(5).

¹⁵11 U.S.C. § 1123(b)(6).

¹⁶ 11 U.S.C. § 1129(a)(1).

¹⁷ See Purdue Pharma, 2021 WL 5979108, at *35; see Purdue Pharma, 633 B.R. at 101. In particular, the bankruptcy court held that Section 524(e) of the Bankruptcy Code—which provides that the discharge of a debtor does not affect the liability of third parties—was not an impediment to third-party releases because while it explains the effect of a debtor’s discharge, it does not affirmatively prohibit the release of a non-debtor.

¹⁸ Purdue Pharma, 2021 WL 5979108, at *35.

¹⁹ Purdue Pharma, 633 B.R. at 102-03 (citing In re Airadigm Communications, Inc., 519 F.3d 640 (7th Cir. 2008)).

²⁰ Id. at *61-62.

²¹ Id. at *51-52, *61-62 (citing Law v. Siegel, 571 U.S. 415 (2014)).

²² Id. at *63-64.

²³ Id. at *64.

²⁴ Id. at *62 (citing 11 U.S.C. §§ 523(a)(2), (4), (6), (7)). The district court noted that some of the claims asserted by the objecting states sought relief in the nature of non-dischargeable civil penalties, thus implicating the exception to discharge under Section 523(a)(7) of the Bankruptcy Code.

²⁵ Id. at *65.

²⁶ Id. at *65.

²⁷ Id. at *66.

²⁸ Id.

²⁹ Id.

³⁰ Id. at *68 (quoting Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1988)).

³¹ Id. at *38.

³² See Patterson v. Mahwah Bergen Retail Group, Inc., 2022 WL 135398 (E.D. Va. Jan. 13, 2022). The grounds for the decision included that the bankruptcy court lacked constitutional authority to grant the releases and that the bankruptcy court failed to make findings that the releases were authorized under governing precedent of the US Court of Appeals for the Fourth Circuit that sets forth the factors to be considered for approving non-consensual third-party releases (including that the bankruptcy court made no finding that the individuals who received releases had made any contribution to the reorganization).

³³ Various members of the US House of Representatives have sponsored the Nondebtor Release Prohibition Act of 2021 (H.R.4777), and analogous legislation has been proposed in the US Senate (S.2497).