Category: Absolute Priority Rule

Third Circuit Approves Payment by Creditor/High Bidder to Unsecured Creditors and Bankruptcy Professionals – Leaving Government in the Cold

by Nicole Leonard

In In re ICL Holding Co., Inc.[i], the Third Circuit Court of Appeals (the “Court”) addressed whether a bankruptcy sale and related settlement that resulted in (1) paying some administrative claimants (i.e. the case professionals) and not others (i.e. the government) and (2) paying unsecured creditors, while not paying creditors higher on the priority scheme, violated the Bankruptcy Code’s distribution requirements.  The Court found that following the sale and related settlement (neither of which the government was successful in staying), the government’s arguments against distribution were neither constitutionally, statutorily nor equitably moot.  Nevertheless, the Court affirmed the decisions of the lower courts approving distributions to both administrative creditors at the same priority as the government and junior creditors–while not paying the government – because such transfers were not made from property of the bankruptcy estate and were thus not subject to the Code’s distribution scheme.

Facts:

Debtor LifeCare Holdings, Inc. (“LifeCare” or “Debtor”) was in the business of operating long term acute care hospitals.  Following devastation of some its facilities after Hurricane Katrina, a post-Katrina environment of increased regulation and a debt load that thwarted obtaining new capital, LifeCare explored a sale of its assets.  After LifeCare entered into an asset purchase agreement with its secured lenders (the “Lender Group”), LifeCare and its 34 subsidiaries filed for chapter 11 protection.  The asset purchase agreement involved a credit bid by the Lender Group of about 90% of the debt owed to it   for the transfer of all of the Debtor’s assets and cash.  The agreement further provided that the Lender Group would pay for the legal and accounting costs of the Debtor and the (to-be-formed) unsecured creditors’ committee  (the “Committee”) as well as Debtor’s wind down costs.  These funds were to be held in escrow and any remaining funds after the aforementioned payments were made would go back to the Lender Group.

Following initial sale approval and an auction, the Lender Group bid was determined best.  But, the Committee and the government objected.   The Committee argued that the transaction was really a “veiled foreclosure” that would leave the estate administratively insolvent.  The government argued that the sale improperly provided for payment to certain administrative creditors, namely the case professionals, but did not provide for payment of the government’s administrative claim – described as an approximately $24 million capital gains tax claim resulting from the sale.

The Lender Group and the Committee worked out a deal that would provide $3.5 million to unsecured creditors and the Committee would thus withdraw its objection.  But removal of the Committee’s objection added to the government’s objection since the settlement resulted in unsecured creditors junior in priority to the government’s tax claim being paid ahead of (and instead of) the tax claim.  Despite the government’s objections, the settlement and the sale were approved in separate hearings. The government appealed both decisions and sought a stay pending appeal which was denied.  The district court affirmed denial of the stay and dismissed the government appeal.  The Third Circuit affirmed.

The Lender Group credit bid $320 million which was 90% of its $355 million secured claim. Following the credit bid, the Lender Group had an approximately $35 million remaining secured claim against any property of the estate.  The Debtor and Committee argued that the government’s claim for a $24 million tax liability was moot.  However, the Court disagreed and found that (a) the government’s claim, though remote, was not impossible and therefore not constitutionally moot; (b) Section 363(m) did not bar review so the claim was not statutorily moot; and (c) since the matter was not being addressed in the plan context it was not equitably moot.  Having determined the government’s claims were not moot, the Court turned to whether the funds escrowed for case professionals and placed in trust for the unsecured creditors were paid from property of the Debtor’s estate.

Settlement Payment to Unsecured Creditors

The Court found that “the settlement sums paid by the purchaser [Lender Group] were not proceeds from its liens, did not at any time belong to LifeCare’s estate, and will not become part of its estate even as a pass-through.”[ii] Further, the Court was not persuaded that language in the motion seeking approval of the Committee settlement, which described the settlement as an allocation of the “proceeds of the sale”, was evidence that the settlement proceeds served as consideration for the purchased assets.[iii]

Payment to Case Professionals

The Court found more difficult the analysis of whether the funds set aside for payment to professionals were property of the estate.  The asset purchase agreement described the funds as part of the purchase price for the Debtor’s assets.  Despite that description, the Court found it could not “ignore the economic reality of what actually occurred.”[iv] The Court explained that in the sale the Lender Group took all of the Debtor’s assets, including their cash, “[t]hus, once the sale closed, there technically was no more estate property.”[v] Further, any residual funds in the escrow account set aside for professionals would be returned to the Lender Group. The Court acknowledged the following:

All that said, we recognize that, in the abstract, it may seem strange for a creditor to claim ownership of cash that it parted with in exchange for something. . But in this context it makes sense. Though the sale agreement gives the impression that the secured lender group agreed to pay the enumerated liabilities as partial consideration for LifeCare’s assets, it was really “to facilitate … a smooth … transfer of the assets from the debtors’ estates to [the secured lenders]” by resolving objections to that transfer. …. To assure that no funds reached LifeCare’s estate, the secured lenders agreed to pay cash for services and expenses through escrow arrangements.[vi]

The Court distinguished this arrangement from a standard carve-out from a secured creditor’s cash collateral because in that circumstance, the cash collateral used for the carve-out is property of the estate where, as here, the funds escrowed were property of the Lender Group.

Key Take Aways:

  • This sale involved the Lender Group credit bidding part of its claim for all of the Debtor’s assets, including cash. Thus, the sale effectively removed all property from the estate. An important distinction made by the Court was that the funds to be distributed to the case professionals and unsecured creditors were not “cash collateral” and arguably part of the Debtor’s estate, but were rather funds of the Lender Group.       If the sale did not go through, the funds would not go to the Debtor but back to the Lender group.       Thus – this opinion does not address the distribution scheme in a typical carve-out scenario. However, this case does give a very useful roadmap on how to provide value for professionals and unsecured creditors outside of the plan context – although such value may come at the expense of other creditors similarly situated or even superior to those receiving the value.
  • This Court read substance over form in terms of the language in the sale documents even though the funds in question were specifically described as part of the purchase price. But, attention should be paid to drafting motions and asset purchase agreements in case another court is less inclined to divine the substance from the form.
  • An issue raised but not determined by the Court is whether the priority requirements apply in the 363 sale context “even if textually most (save for § 507) are limited to the plan context.”[vii] The Court found that “ even assuming the rules forbidding equal-ranked creditors from receiving unequal payouts and lower-ranked creditors from being paid before higher ranking creditors apply in the § 363 context, neither was violated here.”[viii] Thus the issue as to whether the priority scheme applies in the 363 context is left open.

[i] In re ICL Holding Co., Inc., No. 14–2709,  2015 WL 5315604 (Sept. 14, 2015 3d Cir.)

[ii] Id. at *7.

[iii] Id.

[iv] Id. at *8.

[v] Id.

[vi] Id. (internal citation omitted).

[vii] Id. at *6.

[viii] Id. at *9.

THIRD CIRCUIT APPROVES STRUCTURED DISMISSAL OF CHAPTER 11 DESPITE NONCOMPLIANCE WITH ABSOLUTE PRIORITY RULE

by Jason Angelo

In re Jevic Holding Corp., 2015 WL 2403443, __ F.3d __ (3d Cir. May 21, 2015)

Section 507’s Absolute Priority Rule always applies – or does it? After last month’s precedential opinion issued by the Third Circuit Court of Appeals, apparently that isn’t always the case. In a matter of first impression within the Third Circuit, the Court determined that the Absolute Priority Rule is not necessarily implicated outside the context of plan confirmations. At the same time, the court became the first circuit court to determine that bankruptcy courts have the discretion to approve structured dismissals in connection with a Rule 9019 settlement, so long as the ultimate result does not evade the safeguards of the plan confirmation or conversion process.

Background

Jevic, a former New Jersey trucking company, was acquired in a 2006 LBO by Sun Capital Partners (“Sun Cap”) and financed by a group of lenders headed by CIT Group. In May 2008, Jevic ceased operations, notified its employees of their imminent termination, and filed a voluntary Chapter 11 petition in the Bankruptcy Court for the District of Delaware.

In the meantime, a group of former Jevic employees (the “WARN claimants”) initiated a class action lawsuit against Jevic and Sun Cap, alleging violations of the federal Worker Adjustment and Retraining Notification (“WARN”) Act and its New Jersey analogue. At the same time, the Official Committee of Unsecured Creditors brought a fraudulent conveyance action against Sun Cap and CIT in connection with the LBO.

The key players soon reached a settlement that provided for a release of claims between and among the Committee, Jevic, CIT, and Sun Cap in exchange for dismissal of the fraudulent conveyance action; for CIT to pay $2 million into an account to pay legal fees and other administrative expenses; for Sun Cap to assign its lien on the bankruptcy estate’s cash to a trust to pay tax, administrative, and general unsecured creditors; and for dismissal of the Chapter 11 case. The WARN claimants, however, were left out of the settlement, as Sun Cap refused to pay them as long as they maintained their WARN action. The WARN claimants and the U.S. Trustee objected to the settlement, arguing that it called for distribution of property of the estate to lower priority creditors under section 507’s distribution scheme; that the Bankruptcy Code does not permit structured dismissals; and that the Committee breached its fiduciary duties to the estate by leaving the WARN claimants out of the settlement.

In an oral opinion, Chief Judge Brendan L. Shannon approved the settlement and dismissal, concluding that the “dire circumstances” of the case– specifically, the lack of any realistic prospect of a distribution to any unsecured creditors if the settlement was not approved –mandated approval. Moreover, the Bankruptcy Court determined that there was no chance of approval of a Chapter 11 plan, and that conversion to Chapter 7 was impracticable both in terms of cost and the settling parties’ willingness to participate in a settlement in that context. The Bankruptcy Court also concluded that no fiduciary duties had been violated, that the settlements under Rule 9019 need not comply with the Absolute Priority Rule, and that the settlement was fair and equitable under the factors established by In re Martin, 91 F.3d 389 (3d Cir. 1996).

The WARN claimants appealed to the District Court, which rejected their contentions, holding that the Bankruptcy Court had correctly applied the Martin factors and had correctly ruled regarding the fiduciary duties and absolute priority rule issues. The District Court noted that even had the Bankruptcy Court erred, however, the WARN claimants’ appeal was equitably moot because the settlement had been “substantially consummated.” See Jevic Holding Corp., 2014 WL 2688613, at *2 (D.Del. Jan. 24, 2014). The WARN claimants appealed to the Third Circuit, with the U.S. Trustee joining in the appeal as amicus curiae.

Analysis

In a 2-1 panel split, the Third Circuit upheld the District Court’s order and the panel rejected the WARN claimants’ contention that structured dismissals are never permissible and must always comply with Section 507’s priority scheme. See In re Jevic Holding Corp., 2015 WL 2403443 (3d Cir. May 21, 2015).

Noting that the Code does not explicitly permit structured dismissals and that the only statutory ways out of a Chapter 11 case are plan confirmation, conversion to Chapter 7, or reversion to the status quo ante via dismissal “with no strings attached,” the panel stated that “structured dismissals are simply dismissals that are preceded by other orders . . . that remain in effect after dismissal.” Further, the Code, per Section 349, explicitly authorizes Bankruptcy Courts “to alter the effect of dismissal ‘for cause,’” such that “a hard reset” as contemplated by the WARN claimants was unnecessary. At bottom, bankruptcy courts have discretion to approve structured dismissals unless they are effectively sub rosa plans – that is, they are “contrived to evade the procedural protections and safeguards of the plan confirmation or conversion process.”

The Court next discussed whether settlements approved in the context of structured dismissals may ever disregard the Absolute Priority Rule by skipping a class of objecting creditors in favor of less senior creditors. Agreeing with the Second Circuit’s opinion in In re Iridium Operating LLC, 478 F.3d 452 (2d Cir. 2007), the panel noted that in determining whether a proposed settlement is “fair and equitable,” compliance with the Absolute Priority Rule will “usually be dispositive” because the policy behind the rule, “evenhanded and predictable treatment of creditors,” applies with equal force to both settlements and plans. The panel gave bankruptcy courts some leeway, however, to exercise their discretion depending on the facts of each case, by holding that they may approve settlements that do not follow the Absolute Priority Rule “’only if they have specific and credible grounds to justify [the] deviation.’”

The panel went on to conclude that the Bankruptcy Court had “sufficient reason” to approve the settlement and dismissal in this case because it was the “least bad alternative” – that is, there was no prospect of a confirmable plan and conversion would have resulted in the secured creditors taking what was left in the Estate. Outside of the settlement, there was no chance of the unsecured creditors receiving a meaningful distribution. Faced with the Hobson’s choice of accepting a settlement that strayed from the Code’s priority scheme or allowing the WARN claimants’ lawsuit to deplete the Estate, the Bankruptcy Court made a judgment call within its discretion in approving the settlement and dismissal.

Key Takeaways

This decision is significant for a number of reasons, especially considering the relative dearth of case law from courts of all levels across the nation addressing the issues discussed. The Third Circuit is the first circuit court to explicitly acknowledge that structured dismissals are permitted in some cases. Of particular note is the panel’s refusal to adopt a hard and fast rule that such structured dismissals are disallowed per se.

In the rare case where the traditional routes out of a Chapter 11 are closed off and a settlement will best serve the interests of the estate and its creditors as a whole, structured dismissals that deviate from the Absolute Priority Rule are justifiable. The Third Circuit’s decision grants further discretion to bankruptcy courts to approve alternatives to plan confirmation, conversion, or plain dismissal when the unique circumstances of a case justify such a decision.

Jason D. Angelo is an Associate in McElroy, Deutsch, Mulvaney & Carpenter, LLP’s Bankruptcy Practice Group and is admitted to practice in Delaware and New Jersey.