(Bloomberg) -- The surprise rejection of Purdue Pharma LP’s sweeping opioid settlement is already reverberating through the rest of the bankruptcy system. 

Ascena Retail Group, the former owner of women’s fashion brands including Ann Taylor and Lane Bryant, is the latest company to see a bankruptcy deal fall apart over its use of so-called third-party releases. The federal judge who struck down the deal last week called back to Purdue in his decision, citing U.S. District Judge Colleen McMahon’s rejection of the opioid maker’s proposed settlement.

The latest ruling shows how third-party releases, a long-controversial legal tool that can protect a bankrupt company’s executives and owners from lawsuits, are coming under increased scrutiny. Federal courts are split on whether the releases are legal, and now once-permissive jurisdictions are increasingly questioning such maneuvers. Other large companies including opioid maker Mallinckrodt Plc are also seeing their use of releases come under fire. 

“Judges have been holding their noses on this issue for a while,” David Skeel, a law professor at the University of Pennsylvania, said in an interview. “It seems like the Purdue decision, at least in the short run, has opened the floodgates -- courts feel like they’ve been given an invitation to be skeptical.”

The fresh scrutiny of releases, which are a part of virtually every large insolvency case, threatens to alter the way big-time corporate bankruptcies work in the U.S., and could strengthen the hand of individual investors by protecting their right to sue insiders and others liable for a company’s failure.

Ascena Question

Ascena’s bankruptcy was essentially wrapped up. The company, which was among the largest to seek court protection in 2020, sold off its brands for about $650 million and got approval for a plan to divvy up the proceeds to creditors in early 2021. 

The deal contained liability releases for almost everyone involved with the company, including consultants and low-level employees, and was approved despite objections from the U.S. Department of Justice and the Securities Exchange Commission. That was a mistake, according to U.S. District Judge David Novak, who handled an appeal of the plan.

“The sheer breadth of the releases can only be described as shocking,” Novak wrote in a decision last week that struck down the plan. “They release the claims of at least hundreds of thousands of potential plaintiffs not involved in the bankruptcy, shielding an incalculable number of individuals associated with the Debtors in some form, from every conceivable claim -- both federal and state claims -- for an unspecified period stretching back to time immemorial.” 

Lawyers for Ascena, now called Mahwah Bergen Retail Group, did not immediately respond to a request for comment Wednesday.

Novak sent the plan back to bankruptcy court for revision. Like Purdue’s Judge McMahon, he also ruled that bankruptcy judges don’t have authority to force certain kinds releases on unwilling parties.

“There are non-silly arguments that judges do not have the power to be granting these releases,” Skeel said. If third-party releases become unacceptable or are drastically diminished, it could make it more difficult for some companies to reorganize, he said. They may have to more narrowly tailor releases for parties related to a bankruptcy, or otherwise find some kind of workaround. 

The bankruptcy world’s attention is now on Mallinckrodt, which had the legality of the releases in its Chapter 11 exit plan openly questioned by its bankruptcy judge. After a lengthy trial, he has yet to rule on whether to approve the deal.

Purdue Aflame

Releases, a typically esoteric aspect of bankruptcy law, drew widespread scrutiny last year when it became clear that members of the billionaire Sackler family that own Purdue Pharma would get sweeping legal protections as part of the company’s opioid settlement.

After the deal won approval, a handful of states and an arm of the Justice Department appealed the decision. The states wanted to continue pressing civil suits against the Sacklers, with or without a bankruptcy plan. 

McMahon, a relative outsider to bankruptcy law, questioned whether Purdue’s owners abused the court protection system and whether the company’s bankruptcy judge had authority to grant the releases at all. While finding that he doesn’t, she warned that the conflict was far from over. 

“This issue has hovered over bankruptcy law for thirty-five years,” McMahon said in her ruling. “This opinion will not be the last word on the subject, nor should it be.”

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