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Stern Requires More Than Subject Matter Jurisdiction, Bankruptcy Court Must Also Have Constitutional Adjudicatory Authority to Approve Nonconsensual Third-Party Releases in a Plan

Opt-Out Lenders v. Millennium Lab Holdings II, LLC, No. 16-110-LPS, — F.Supp.3d —, 2017 WL 1032992 (D. Del. Mar. 17, 2017) corrected and superseded by 2017 WL 1064997 (D. Del. Mar. 20, 2017)

In this Opinion, the United States District Court for the District of Delaware (the “District Court”) examines the bankruptcy court’s authority post-Stern v. Marshall, 131 S. Ct. 2594 (2011), to enter a final order releasing and permanently enjoining a non-debtor’s state law fraud and federal RICO claims against non-debtors absent consent.  Following two recent United States Supreme Court cases—Stern and Wellness Int’l Network, Ltd. v. Sharif, 135 S. Ct. 1932 (2015)—it is clear that parties have a constitutional right to have state law claims adjudicated by an Article III court.  “Despite the District Court’s general referral of bankruptcy matters to the Bankruptcy Court, the extent of the Bankruptcy Court’s adjudicatory authority depends on the type of proceeding before it and is subject to the bounds of [these] constitutional limitations . . . .”  Op. at 3.  For core proceedings (i.e., those that “arise under title 11” or “arise in a case” under title 11), bankruptcy judges can enter final orders.  When a matter is non-core (i.e., “related to” the bankruptcy case), however, absent consent of the parties, bankruptcy judges have authority only to hear the matter and submit proposed findings of fact and conclusions of law to the district court.

The Delaware Bankruptcy Court entered an order (the “Confirmation Order”) confirming the chapter 11 plan of reorganization (the “Plan”) filed by Millennium Lab Holdings II, LLC and its affiliated reorganized debtors (collectively, the “Debtors”) that included nonconsensual third-party releases.  Specifically, the plan gave certain non-debtor equity holders who made a contribution full releases of all claims against them and related parties, including claims brought directly by non-debtors.  There was no option to opt-out of the releases, which were automatically granted upon confirmation regardless of consent.

Prior to confirmation, pre-petition lenders ISL Loan Trust and certain affiliated funds (collectively, “Appellants”) filed a complaint against the non-debtor equity holders and other releasees under the Plan alleging, among other things, state law fraud and federal RICO claims.  Approval of the Plan would permanently enjoin Appellants from prosecuting these claims.  Accordingly, Appellants raised a host of objections to confirmation, arguing that the Bankruptcy Court lacked subject matter jurisdiction to approve the releases, even if the Bankruptcy Court had subject matter jurisdiction, the court lacked statutory authority to approve the releases, and assuming there was an opt-out option, there were no exceptional circumstances to justify the releases.  The Bankruptcy Court overruled Appellant’s objections and “held that it had, at the very least, ‘related to’ subject matter jurisdiction over the claims,” noting that “Stern v. Marshall does not change the conclusion that [it] has jurisdiction.”  Op. at 14.  The Bankruptcy Court did not address whether it lacked adjudicatory authority to enter a final order releasing the claims.

Appellants appealed the Confirmation Order, and the Debtors moved to dismiss the appeal as equitably moot.  Before the District Court could consider whether the appeal should be dismissed on equitable mootness grounds, it had to first decide whether the Bankruptcy Court had constitutional power to act.  On appeal, the District Court considered (i) whether the Bankruptcy Court had subject matter jurisdiction to approve the nonconsensual third-party releases and (ii) whether the Bankruptcy Court had constitutional authority to permanently release the claims post-Stern.

The District Court agreed that the Bankruptcy Court had subject matter jurisdiction, finding that “[t]he permanent release of a non-debtor, third-party’s claim against another non-debtor, third party—whether through a chapter 11 plan or otherwise—is an exercise of the Bankruptcy Court’s ‘related to’ jurisdiction.”  Op. at 4.  However, Stern teaches that subject matter jurisdiction is not enough; the Bankruptcy Court must have constitutional adjudicatory authority as well.  Because the parties paid little attention to the constitutional issue below (conflating it with subject matter jurisdiction), it is unclear whether the Bankruptcy Court had the opportunity to decide if it had adjudicatory authority to enter a final order releasing third-party claims.

While the District Court believed Appellants’ argument to have some merit, it stopped short of ruling on an issue that the Bankruptcy Court did not rule on in the first instance.  The higher court noted that the nonconsensual third-party releases in the Plan permanently extinguished Appellants’ state law fraud and federal RICO claims against the non-debtor equity holders, which essentially resolved the claims on the merits against Appellants.  Because these claims did not involve “public rights” (e.g., claims that “stem[] from the bankruptcy itself or would necessarily be resolved in the claims allowance process”) that could be assigned to the bankruptcy court, Appellants appear to be entitled to Article III adjudication of the claims, and the Bankruptcy Court could not enter a final order releasing the claims absent consent of the parties.  Op. at 6 n.7, 25.  The District Court’s de novo review of the Confirmation Order does not satisfy the constitutional concerns because there has been no adjudication of the claims on the merits by an Article III judge.

In an unusual move, the District Court denied without prejudice the Debtors’ motion and remanded to the Bankruptcy Court to consider whether it has constitutional adjudicatory authority to approve the nonconsensual release of Appellants’ direct non-bankruptcy claims against the non-debtor equity holders.  If the Bankruptcy Court finds that it does not have such authority, it must submit proposed findings of fact and conclusions of law or alternatively, strike the nonconsensual release of Appellants’ claims from the Confirmation Order.  Recognizing that remand one year post-confirmation is “far from ideal”, the District Court nonetheless believed it important for the Bankruptcy Court to rule on the adjudicatory authority issue first given its “experience and expertise”.  Op. at 28.