Relevant Documents:
Opinion
Remand Order
Order Requiring Submission of Fees to District Court
U.S. District Judge David Novak has vacated confirmation of the Ascena Retail debtors’
liquidating plan and invalidated the plan’s third-party releases, concluding that the bankruptcy court “plainly lacked the constitutional power to adjudicate” many claims covered by the releases. In an opinion issued Thursday night, Jan. 13, the judge also voids the plan’s exculpation provision as overly broad. The Eastern District of Virginia’s opinion is the second landmark ruling on third-party releases in recent months, coming on the heels of the Southern District of New York’s decision in
Purdue.
While striking down the third-party releases, Judge Novak also finds them to be severable and severs them from Ascena’s plan. He remands the case to the bankruptcy court - but
not the same court as before, as discussed below - saying that once the exculpation is “redraft[ed]” on a narrower basis, the bankruptcy court can then “proceed with confirmation of the Plan without the voided Third-Party Releases.”
Judge Novak previewed that he would invalidate the releases during the
oral arguments on Dec. 20. The U.S. Trustee and two securities fraud plaintiffs challenged the Ascena plan’s release and exculpation provisions in their consolidated
appeals of the confirmation order.
Thursday’s opinion says that the third-party releases at the heart of the plan appeals “represent the worst of this all-too-common practice, as they have no bounds. The sheer breadth of the releases can only be described as shocking.” The releases would extinguish the claims of “
at least hundreds of thousands of potential plaintiffs not involved in the bankruptcy.” At the same time, they would shield “an incalculable number of individuals associated with Debtors in some form, from every conceivable claim,” including “corporate insiders who had no role in the reorganization of the company.”
Judge Novak concludes that the bankruptcy court, “acting with its limited Article I powers,” “extinguished” the released claims “with little or no analysis.” This exceeded the constitutional limits of the bankruptcy court’s authority under the Supreme Court’s 2011
Stern v. Marshall decision, the opinion continues, while “ignor[ing] the mandates” of the Fourth Circuit’s 2011
Behrmann decision and “offend[ing] the most fundamental precepts of due process.”
Judge Novak rejects the debtors’ argument that the third-party release did not implicate
Stern because releasing parties consented to providing the third-party release and to the jurisdiction of the bankruptcy court as a non-Article III court. The releasing parties here did not affirmatively assent and the release was not consensual, the court emphasizes. Under the plan, parties that did not affirmatively return an “opt-out” of the release were included in the release.
The judge also sides with the UST against the debtors’ argument that the third-party releases cannot be severed because the plan is not viable without them. “The Court will not allow parties who gifted themselves a release in the Plan to hold this appeal hostage with a Nonseverability Provision,” the opinion remarks.
In addition, Judge Novak denies the debtors’ request to dismiss the appeal as equitably moot, describing the argument as an effort to dodge judicial review. The judge calls the debtors’ attempt to “invoke an equitable principle designed to promote a fair outcome” the “height of irony.”
In the order remanding the case to the bankruptcy court, the district court directs that the case be reassigned to another bankruptcy judge in the Eastern District of Virginia outside of the Richmond Division, where the case was filed and the plan confirmed. The judge writes, “the practice of regularly approving third-party releases and the related concerns about forum shopping call into question public confidence in the manner that these cases are being handled by the Bankruptcy Court in the Richmond Division.”
As the opinion puts it, “The ubiquity of third-party releases in the Richmond Division demands even greater scrutiny” of the releases at issue here. Judge Novak continues, “their prevalence also undermines assertions that they are integral to the success of this particular reorganization plan.” Quoting U.S. District Judge Colleen McMahon’s Purdue decision, Judge Novak comments: “When every case is unique, none is unique.”
Opinion
As an initial matter, the court finds that although the U.S. Trustee has standing to bring the appeal, the securities litigation plaintiffs do not. With respect to the UST, the court notes that the Bankruptcy Code gives the UST standing to “appear and be heard on any issue in any [bankruptcy] case.”
The court finds that the securities plaintiffs have no individual standing because they opted out of the releases and can pursue their individual claims. Judge Novak is unpersuaded by the plaintiffs’ argument that they were “aggrieved parties” because the plan’s death trap provision required them to either opt out of the release and risk a challenge to their standing, or decline to opt out (and waive significant rights). The judge remarks that although he is “sympathetic to the conundrum in which they were placed, tough strategic decisions do not confer standing.”
Bankruptcy Court’s Constitutional Authority and Stern v. Marshall
Judge Novak discusses the constitutional implications of the third-party releases and finds that the bankruptcy courts do not have authority under the U.S. Constitution to approve them. Citing the seminal U.S. Supreme Court
Stern v. Marshall decision, Judge Novak says that bankruptcy courts only have the authority to issue final orders with respect to “constitutionally core” proceedings - claims that “stem from the bankruptcy itself or would necessarily be resolved in the claims allowance process.” More specifically, he says that a matter is constitutionally core “‘when it shares common questions of fact and law with the creditor's claims and when it seeks to directly reduce or recoup the amount claimed.’” He further notes that this constitutional limitation even applies to claims over which Congress has granted the bankruptcy court statutory authority.
Applying this constitutional limitation to the Ascena plan’s third-party releases, Judge Novak concludes that the bankruptcy court failed to exercise its “responsibility” and “took no steps” to determine whether it had jurisdiction over the released claims. In fact, Judge Novak finds that the “only extinguished claims” that the bankruptcy court considered were securities fraud claims against Ascena’s former CEO David Jaffe and former CFO Robert Giammatteo, while “ignor[ing]” all of the other released claims.
Although the “sheer breadth” of the releases made a determination of whether released claims were core a “Herculean undertaking,” “the enormity of the task does not absolve the Bankruptcy Court of its responsibility to properly identify the content of the claims before it and ensure that it has jurisdiction to rule on each of them.” According to Judge Novak, the size of the task “underscore[d] the constitutional questionability of the Bankruptcy Court’s actions.”
Although Judge Novak says that he will “not speculate” as to the nature of the released claims because “that was the responsibility of the Bankruptcy Court,” he finds that “it only takes a cursory review” of the releases to conclude that the court lacked the authority to adjudicate them. As examples, the court highlights: prepetition claims brought by the securities plaintiffs against former Mahwah officers and directors who had no involvement in the bankruptcy proceeding; employee hostile work environment claims against a former Mahwah employee; a negligence action by a Mahwah employee against a consultant hired to counsel employees on retirement plans; and a slander action by a former employee of Mahwah’s term lenders against a current Mahwah employee.
Judge Novak also rejects the debtors’ argument that the bankruptcy court can approve the releases simply because they were included in the Ascena plan, saying that such an argument would require him to “conclude that only the Plan Confirmation Order constitutes a judgment.” The court concludes that extinguishing the released claims “amounts to adjudication of the claims for
Stern purposes.”
In any event, the debtors’ argument “misses the mark” because the bankruptcy court must rely on its own limited “
in rem jurisdiction over the debtors’ property and the disposition of that property,” says the opinion. However, the bankruptcy court “has no
in rem jurisdiction over third-party claims not against the estate or property of the estate.” “Article III simply does not allow third-party non-debtors to bootstrap any and all of their disputes into a bankruptcy case to obtain relief,” he concludes.
Consent
Judge Novak rejects the debtors’ argument that the releasing parties consented to providing the third-party release and to the jurisdiction of the bankruptcy court (which could sidestep the
Stern issues noted above). The Supreme Court’s standard for valid consent to adjudication by a bankruptcy court requires the litigant to provide “knowing and voluntary” consent, which is absent in this case, writes Judge Novak.
Although the bankruptcy court relied on the fact that the releasing parties received notice and an opportunity to opt out of the release, this does not answer the “threshold question of whether they consented to having the Bankruptcy Court adjudicate the released claims” and it will not support a finding of consent to Article I adjudication for all releasing parties, the judge says. Under Supreme Court precedent, courts cannot conclude that there was consent to the jurisdiction of a non-Article III court “based on inaction,” the opinion emphasizes.
Here, the bankruptcy court “merely relied on the fact that a document was mailed out with the goal of reaching thousands of individuals. Then, without regard to whether those individuals received the document, and without regard as to whether those individuals took any overt actions in response to the document,” the bankruptcy court “determined that they had surrendered their constitutional right to an Article III court.”
Judge Novak adds that “allowing inaction to imply consent” encourages “gamesmanship.” That is, “non-debtors could tuck releases unrelated to a bankruptcy proceeding into bankruptcy plans, then secrete an opt-out opportunity into a convoluted legal document, send the document to non-parties previously unaware of the bankruptcy proceeding and use their non-response to extinguish all of their claims.”
“This type of gamesmanship, aimed at extinguishing claims of unwitting individuals and providing a golden parachute to the parties drafting the plan, cannot be tolerated,” the opinion concludes (emphasis added).
Consequence of a Stern violation
Having determined that the bankruptcy court violated
Stern by exceeding its authority, Judge Novak states that he must vacate the confirmation order and treat it instead as a report and recommendation, which he is required to review
de novo. Because the bankruptcy court’s opinion “lacks any meaningful factfinding,” the district court sets out its own factual findings based on the record from the confirmation hearing.
Judge Novak also makes an “observation about the procedure for the handling of third-party releases by bankruptcy courts going forward.” He writes that
due to the “substantial constitutional issues at play with the use of this perilous tool, it seems preferable” for a bankruptcy court to submit any third-party releases to the district court for approval in a report and recommendation in the “rare and exceptional” case that warrants the use of third-party releases (emphasis added).
Such a report and recommendation should identify with specificity the claims and individuals released and provide detailed proposed findings of fact and conclusions of law to ensure that the released claims are “truly integral” to the reorganization. This procedure would “necessarily avoid any
Stern issues” and would serve as an extra safeguard to ensure that third-party releases are “reserved for the truly appropriate case,” says the ruling.
The Fourth Circuit’s Behrmann Standard
The district court also concludes that the bankruptcy court was incorrect to approve the third-party releases because they did not meet the seven-factor legal standard under the Fourth Circuit’s
Behrmann opinion, which requires:
“(1) There is an identity of interests between the debtor and the third party, usually an indemnity relationship, such that a suit against the non-debtor is, in essence, a suit against the debtor or will deplete the assets of the estate; (2) The non-debtor has contributed substantial assets to the reorganization; (3) The injunction is essential to reorganization,, namely, the reorganization hinges on the debtor being free from indirect suits against parties who would have indemnity or contribution claims against the debtor; (4) The impacted class, or classes, has overwhelmingly voted to accept the plan; (5) The plan provides a mechanism to pay for all, or substantially all, of the class or classes affected by the injunction; (6) The plan provides an opportunity for those claimants who choose not to settle to recover in full and; (7) The bankruptcy court made a record of specific factual findings that support its conclusions.”
Generally,
Stern and
Behrmann have an “interrelationship,” says the opinion, because the Constitution limits bankruptcy courts to adjudicating only matters that are “integral” to a bankruptcy proceeding. In the Fourth Circuit, the
Behrmann factors “task a reviewing court with determining how integral the releases are,” adds Judge Novak.
In this case, the bankruptcy court only “stated in conclusory fashion” that the third-party releases were integral to the plan, basing this finding only “on the fact that the Plan stated as much.” Instead of making detailed factual findings on whether unique circumstances justify nondebtor releases, the bankruptcy court “abdicated this crucial function to the negotiators of the Plan - the very negotiators who stood to benefit from the Releases.” Judge Novak writes that
the bankruptcy court “cannot delegate to private citizens the determination of whether a court has the constitutional power to approve the releases” (emphasis added) and the bankruptcy court’s lack of explanation on this score constitutes clear error.
The opinion also addresses the debtors’ argument that the bankruptcy court did not need to apply the
Behrmann standard because the releasing parties consented. However, failing to opt out does not rise to the level of consent required to eliminate the need for a
Behrmann-type analysis, writes the judge. The third-party releases implicate serious due process concerns and “failure to opt out, without more, cannot form the basis of consent to the release of a claim.”
The opinion then assails the bankruptcy court’s cursory treatment of the
Behrmann factors, saying that the confirmation opinion only addressed them in “a single footnote” incorporating the debtors’ confirmation brief. Judge Novak adds, “It should be obvious that a court may not satisfy its judicial responsibilities by simply incorporating by reference a party's brief.” Judge Novak then discusses each of the
Behrmann factors.
Severability
Having found that the third-party releases are unlawful, the court considers whether it can sever the releases from Ascena’s plan. Judge Novak answers the question in the affirmative, rejecting the debtors’ position that a nonseverability provision in the plan prevents the third-party releases from being severed.
The nonseverability provision states that
before confirmation, the rest of the plan “remains in full effect in the event that the Bankruptcy Court finds any provision unenforceable,” observes Judge Novak. However, following confirmation, “all provisions are integral and only the Debtors can consent to severance of a particular provision,” Judge Novak notes, reasoning that since he found that the bankruptcy court violated
Stern and vacated the confirmation order, the district court is now assessing the plan as proposed findings of fact and conclusions of law.
The plan has now “return[ed] to its pre-confirmation phase” and the district court “steps into the shoes of the Bankruptcy Court before confirmation,” says the opinion (emphasis added).
Although the debtors insist that the third-party releases are so important that the plan cannot survive without them, the “contradictory text and operation” of the nonseverability provision belie this argument, the opinion says. According to the judge, the fact that the plan would have survived if the bankruptcy court had severed the third-party releases just before confirmation, without any further changes, “demonstrates that the Third-Party Releases are not inextricably tied to the rest of the Plan.”
After confirmation, the nonseverability provision states that provisions of the plan could be deleted with the debtors’ consent. “Again, this demonstrates that the Plan could survive in the absence of any particular provision,” says Judge Novak. He states that the debtors have “attempted to reserve for themselves the right to sever provisions of the Plan” without other parties’ consent “while arguing here that the Court lacks the same authority to sever legally unenforceable provisions.”
“This confirms that the Nonseverability Provision amounts to nothing more than a hollow attempt to evade judicial review of the Third-Party Releases,” writes Judge Novak (emphasis added).
The judge finds that the evidence in the Ascena case supports severing the third-party releases. He questions how doing away with the releases would upset the viability of the plan when “the three main sales of the assets had all closed months before the confirmation hearing.” There is “no evidence” that severing the third-party releases would upset the closed sales, require the debtors to return the funds from the sale or disrupt the distribution of cash proceeds, says the opinion.
Although the debtors’ president
Carrie Teffner testified during the confirmation hearing that the plan releases were the product of extensive arm’s length negotiations, the judge states that “this ‘arm’s length’ negotiation occurred without the Releasing Parties having a seat at the negotiating table.” Critically, Teffner “could not offer specific reasons why the Third-Party Releases comprised a necessary part of the Plan,” says the ruling. The judge finds that the record contains no evidence of how the third-party releases induced specific releasing parties to settle or of how severing the releases would threaten the debtors’ ability to emerge.
Equitable Mootness
Judge Novak also refuses to dismiss the appeal on equitable mootness grounds, saying that the court will not “use its equitable powers to ignore the serious errors that have occurred here.” The court remarks that equitable mootness “is all too often invoked to avoid judicial review, as Debtors seek to do here.” He adds that this concern “takes on greater import here with the shockingly broad releases and the including in the Plan of an attempted ‘poison pill’ Nonseverability Provision.”
Judge Novak identifies several threshold issues that he concludes weigh against a finding of equitable mootness. “First and foremost,” he finds that vacating the confirmation order “undercuts” the equitable mootness finding and that “[t]he inquiry could end here.” Second, Judge Novak emphasizes that the appeal was not brought by a private individual seeking a return to the “status quo ante.” Instead, the UST pursued the appeal as a “‘watchdog’” on behalf of “absent individuals” to protect the public interest and to ensure that bankruptcy cases are “conducted according to law.” According to Judge Novak, an equitable mootness finding would prevent the UST from fulfilling these duties.
The court also finds that the
“seriousness of the Bankruptcy Court’s errors” weighs against a finding of equitable mootness (emphasis added). Stating that the bankruptcy court “extinguished the claims of absent and nonconsenting parties without the constitutional authority,” Judge Novak writes, “pragmatism does not outweigh the need to remedy constitutional errors . . . that directly concern the integrity of the bankruptcy process.”
Next, Judge Novak applies the four factors under the equitable mootness test, ultimately concluding that the appeal is not equitably moot. First, he finds that it would not be inequitable to rule on the appeal because the requested relief does not seek to affect creditor recoveries. Moreover, the appellants previously sought and failed to obtain a stay, which “left open the door for Appellants to prevail on the merits.”
Second, the judge says that substantial consummation of the plan is not an obstacle to review because the UST does not seek to undo any plan transaction but only to invalidate releases that “would only prospectively affect the ability of parties to bring suits based on past events.” The requested relief “would require no unwinding,” says Judge Novak. Third, he finds that invalidating the third-party releases would not affect the plan’s success or affect it in “any material way” because it would not impact creditor recoveries and “the Plan itself states that the Third-Party releases can be severed.”
Finally, Judge Novak finds that the fourth factor, the effect on the interests of third parties, weigh in favor of granting relief, since the releases “only apply to claims arising on or before the Effective Date, no post-confirmation transactions with third parties have occurred in reliance on the releases.” As a result, considering the merits of the appeal does not negatively affect any third parties who relied on confirmation of the plan, the judge reasons.
Exculpation
Judge Novak also finds that the bankruptcy court “clearly erred” in approving the plan’s exculpation provisions. While agreeing with the bankruptcy court that the
Behrmann factors do not apply to exculpations, Judge Novak finds the exculpations overly broad because they “extended beyond fiduciaries who have performed necessary and valuable duties,” highlighting that the exculpated parties include “all current and former employees, attorneys, accountants, managers, financial advisors and consultants of every party.” The court also states that the exculpation provision lacks a “gatekeeping function that would allow an avenue into court for some claims.”
However, Judge Novak ultimately concludes that unlike the release provisions, the exculpation provision can be redrafted to comply with the limits on such provisions set forth in Bankruptcy Judge Kevin Huennekens’ 2016
Alpha Natural Resources opinion.