The Delaware Bankruptcy Court on September 25 issued a ruling in Smallhold that a creditor cannot be presumed to consent to a third-party release in a bankruptcy plan without clear, affirmative consent. This decision rules on what constitutes valid creditor consent to a third-party release, addressing an issue left unresolved by the US Supreme Court’s ruling in Purdue Pharma, which held that nonconsensual third-party releases are not permitted under the Bankruptcy Code.
For more details on Purdue, see our June 28, 2024 LawFlash. In the wake of Smallhold, other bankruptcy courts have weighed in on what constitutes creditor consent for third-party releases, with varying outcomes.
Since Purdue, the question of what constitutes a “consensual” third-party release, and whether “opt-out” releases are permissible, has been a topic of significant discussion and activity in bankruptcy courts. An opt-out release binds creditors to a third-party release unless they actively choose not to be bound, typically by checking a box in a bankruptcy ballot. Alternatively, an “opt-in” release binds creditors only if they explicitly indicate an intent to be bound. Following the Purdue decision, some bankruptcy courts, like the court in Smallhold, have questioned whether a “pure opt-out” release, which binds creditors who take no action at all, can be considered consensual.
BACKGROUND
Smallhold, a mushroom farming company, filed for Chapter 11 bankruptcy under Subchapter V of the Bankruptcy Code. Its main investor, who also provided its debtor-in-possession loan, supported the plan. The key issue in the case was whether the plan could include third-party releases using a modified opt-out mechanism. The plan’s release mechanism provided that impaired creditors who received a ballot and voted on the plan would be bound by the releases unless they affirmatively opted out by checking a box, regardless of whether they voted in favor or against the plan. Impaired creditors who did not vote (i.e., those who did not return a ballot) would not be bound by the release. Unimpaired creditors were deemed to accept the plan, did not receive ballots, and were automatically bound by the release.
The US Trustee objected to the release mechanism, arguing that after Purdue, third-party releases can only be valid if a creditor affirmatively expresses its consent to be bound by the release.
SMALLHOLD OPINION
In Smallhold, Delaware Bankruptcy Judge Craig T. Goldblatt held that creditors cannot be presumed to consent to third-party releases without clear, affirmative action. Accordingly, because unimpaired creditors were not given a chance to vote or opt out, they could not be considered to have consented to the releases. On the other hand, impaired creditors who filled out and submitted a ballot but did not check the opt-out box could be viewed as having affirmatively consented, even if they voted against the plan. The ballot clearly indicated that failure to check the box would result in being bound by the release, regardless of how the creditor voted, and the court found that submitting such a ballot, without checking the box, was sufficient affirmative action to bind voting creditors to the release.
The court rejected the reasoning from post-Purdue cases suggesting that a true opt-out mechanism—where a creditor who fails to act at all could be bound to a release—could be considered consensual. The court held that under contract law, silence or inaction does not typically equate to consent. Rather, creditors must take affirmative steps, such as opting in or, as in Smallhold, submitting a ballot that contains clear instructions about the consequences of not checking the opt-out box. This “limiting principle,” the court stressed, should apply in bankruptcy cases to align with Purdue, especially when it involves releasing claims against third parties.
POST-SMALLHOLD
In the wake of the Smallhold decision, debtors like Basic Fun and SunPower Corp. have modified the release mechanisms in their plans, shifting to a pure opt-in mechanism for third-party releases. However, in other cases—such as FTX and Wheel Pros—pure opt-out and hybrid release mechanisms have been approved.
In FTX, Delaware Chief Bankruptcy Judge John T. Dorsey approved a hybrid approach, combining both opt-in and opt-out mechanics. Creditors or interest holders who voted on the plan had to check a box to opt out of the release. Regardless of how a creditor voted, they would be deemed to have granted the releases if they cast a vote and did not affirmatively opt out by checking the box. Furthermore, creditors who received a ballot and did nothing would also be deemed to have granted the release. Unimpaired creditors deemed to have accepted the plan without voting were automatically treated as agreeing to the releases. However, those creditors that were not asked to vote because they were deemed to have rejected the plan would be bound by the releases only if they actively chose to opt in.
Judge Dorsey approved a similar release mechanism in Wheel Pros. In that case, parties voting to accept the plan were automatically deemed to have granted the third-party releases. Parties voting against the plan were given the option to opt out of the releases, but if they did not affirmatively do so, they would also be deemed to have granted the releases. Creditors who received a ballot and did not return it were also bound to the release. Like FTX, creditors deemed to have rejected the plan and who were not entitled to vote would not be bound by the release, but, unlike FTX, non-voting, rejecting creditors also had no ability to opt in to the release. With overwhelming creditor support for the plan and proper notice of the confirmation hearing, including publication notice, the court found that using an opt-out mechanism, similar to the one in FTX, was justified under the circumstances.
In both cases, Judge Dorsey likened the opt-out mechanism to class action settlements, where class members are bound to a settlement unless they take affirmative action to opt out. The court saw no significant distinction between that process and the opt-out mechanics of a bankruptcy plan, where creditors receive appropriate notice.
KEY TAKEAWAYS
The ultimate fate of opt-out releases after Purdue remains to be determined. Until a higher court weighs in with binding precedent, some bankruptcy judges may reject opt-out releases in any form, while others may allow a hybrid mechanism that requires some affirmative action before creditors will be bound. Other judges may still permit a pure opt-out mechanism that binds a creditor who takes no action, particularly in cases with significant creditor consensus and proper notice. The key takeaway is that the law continues to evolve, and practitioners should closely monitor decisions as they come down.
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