United States: Funds Earmarked By Section 363 Purchaser To Pay Creditors Need Not Be Distributed In Accordance With Bankruptcy Code's Priority Scheme

A ruling recently handed down by the U.S. Court of Appeals for the Third Circuit may provide significant flexibility to debtors in that circuit who are implementing sales of substantially all of their assets. In In re LCI Holding Company, Inc., 2015 BL 295784 (3d Cir. Sept. 14, 2015), the court of appeals ruled that funds provided by a secured lender which purchased a debtor's assets by means of a credit bid, pursuant to section 363(b) of the Bankruptcy Code, for the payment of administrative fees, wind-down costs, and unsecured claims need not be distributed in accordance with the Bankruptcy Code's priority rules because the funds were not property of the debtor's estate.

The Bankruptcy Code's Priority Scheme

Secured claims have the highest priority under the Bankruptcy Code, to the extent of the value of the secured claimant's collateral. A claim is secured only to the extent that the value of the underlying collateral is equal to or greater than the face amount of the indebtedness. If this is not the case, the creditor will hold a secured claim in the amount of the collateral value and an unsecured claim for the deficiency. Applicable nonbankruptcy law and any agreements between and among the debtor and its secured creditors generally determine the relative priority of secured claims. However, if certain requirements are met, the Bankruptcy Code provides for the creation of priming liens superior even to pre-existing liens in connection with financing extended to a debtor during a bankruptcy case.

The order of priority of unsecured claims is specified in section 507(a) of the Bankruptcy Code. Priorities are afforded to a wide variety of unsecured claims, including, among others, specified categories and (in some cases) amounts of domestic support obligations, administrative expenses, employee wages, taxes, and certain wrongful death damages awards.

In a chapter 7 case, the order of distribution of unencumbered bankruptcy estate assets is determined by section 726 of the Bankruptcy Code. This order ranges from payments on claims in the order of priority specified in section 507(a), which have the highest ranking, to payment of any residual assets to the debtor, which has the lowest. Distributions are to be made pro rata to claimants of equal ranking within each of the six categories of claims specified in section 726. If claimants in a higher category of distribution do not receive full payment of their claims, no distributions can be made to lower category claimants.

In a chapter 11 case, the plan determines the treatment of secured and unsecured claims (as well as equity interests) in accordance with the provisions of the Bankruptcy Code. If a creditor does not consent to "impairment" of its claim under a plan—such as by agreeing to receive less than payment in full—and votes to reject the plan, the plan can be confirmed only under certain specified conditions. Among these are the following: (i) the creditor must receive at least as much under the plan as it would receive in a chapter 7 case (section 1129(a)(7)), a requirement that incorporates the priority and distribution schemes delineated in sections 507(a) and 726; and (ii) the plan must be "fair and equitable." Section 1129(b)(2) of the Bankruptcy Code provides that a plan is "fair and equitable" with respect to a dissenting impaired class of unsecured claims if the creditors in the class receive or retain property of a value equal to the allowed amount of their claims or, failing that, if no creditor or equity holder of lesser priority receives any distribution under the plan. This requirement is sometimes referred to as the "absolute priority rule."

Senior-Class "Gifting" Under Chapter 11 Plans

A matter of considerable debate concerning section 1129(b)(2) is whether the provision allows a class of senior creditors voluntarily to cede, or "gift," a portion of its recovery under a chapter 11 plan to a junior class of creditors or equity holders, while an intermediate class does not receive payment in full.

In approving senior-class "gifting," some courts rely on the First Circuit's ruling in Official Unsecured Creditors' Comm. v. Stern (In re SPM Manufacturing Corp.), 984 F.2d 1305 (1st Cir. 1993). In SPM, a secured lender holding a first-priority security interest in substantially all of a chapter 11 debtor's assets, in an amount exceeding the value of the assets, entered into a "sharing agreement" with general unsecured creditors to divide the proceeds that would result from the reorganization, presumably as a way to obtain their cooperation in the case. After the case was converted to a chapter 7 liquidation—in which section 1129(b)(2) does not apply—the secured lender and the unsecured creditors tried to force the chapter 7 trustee to distribute the proceeds from the sale of the bankruptcy estate's assets in accordance with the sharing agreement. The agreement, however, contravened the Bankruptcy Code's distribution scheme because it provided for distributions to general unsecured creditors before payment of priority tax claims. The bankruptcy court ordered the trustee to ignore the sharing agreement and to distribute the proceeds of the sale in accordance with the statutory distribution scheme. The district court upheld that determination on appeal.

The First Circuit reversed, reasoning that, as a first-priority secured lien holder, the lender was entitled to the entire amount of any proceeds of the sale of the debtor's assets, whether or not there was a sharing agreement. According to the court, "While the debtor and the trustee are not allowed to pay nonpriority creditors ahead of priority creditors . . . , creditors are generally free to do whatever they wish with the bankruptcy dividends they receive, including to share them with other creditors."

Even though SPM was a chapter 7 case, some courts have cited the ruling as authority for confirming a nonconsensual chapter 11 plan in which a senior secured creditor assigns a portion of its recovery to creditors (or shareholders) who would otherwise receive nothing by operation of section 1129(b)(2) and the Bankruptcy Code's priority scheme. See, e.g., In re MCorp. Financial, Inc., 160 B.R. 941 (S.D. Tex. 1993); In re Journal Register Co., 407 B.R. 520 (Bankr. S.D.N.Y. 2009); In re World Health Alternatives, Inc., 344 B.R. 291 (Bankr. D. Del. 2006); In re Union Fin. Servs. Grp., 303 B.R. 390 (Bankr. E.D. Mo. 2003); In re Genesis Health Ventures, Inc., 266 B.R. 591 (Bankr. D. Del. 2001). However, other courts have rejected SPM and the gifting doctrine as being contrary to both the Bankruptcy Code and notions of fairness. See, e.g., DISH Network Corp. v. DBSD N. Am., Inc. (In re DBSD N. Am., Inc.), 634 F.3d 79 (2d Cir. 2011) (ruling that a class-skipping gift made by an undersecured creditor to equity under a plan violated the absolute priority rule, but declining to determine whether the creditor, after receiving a distribution under the plan, could in turn distribute a portion of that recovery to old equity "outside the plan").

In In re Armstrong World Indus., Inc., 432 F.3d 507 (3d Cir. 2005), the Third Circuit affirmed an order denying confirmation of a chapter 11 plan under which equity holders would receive warrants to purchase new common stock even though unsecured creditors were not paid in full. According to the Third Circuit, if the distribution scheme proposed in the debtor's plan were permitted, it "would encourage parties to impermissibly sidestep the carefully crafted strictures of the Bankruptcy Code, and would undermine Congress's intention to give unsecured creditors bargaining power in this context." However, the Third Circuit did not categorically reject the gifting doctrine. Rather, as noted by the court in World Health Alternatives, 344 B.R. at 299, "Armstrong distinguished, but did not disapprove of," the gifting doctrine because it left open the possibility that give-ups by a senior class under a plan might pass muster under other circumstances.

Finally, some courts have refused to condone gifting when the practice is used for an ulterior, improper purpose. For example, in In re Scott Cable Commc'ns, Inc., 227 B.R. 596 (Bankr. D. Conn. 1998), a debtor proposed a liquidating chapter 11 plan that provided for payment of administrative, priority, and unsecured claims from recoveries which were otherwise payable to secured creditors but did not provide for payment of capital gains taxes arising from the sale of the debtor's assets. The bankruptcy court refused to confirm the plan, ruling that its principal purpose was to avoid taxes, which is expressly prohibited by section 1129(d). The court ruled that reliance on SPM as authority for the proposed gifting was misplaced, given the different circumstances involved in that chapter 7 case (e.g., the inapplicability of section 1129).

Do the Priority Rules Apply to Bankruptcy Settlements?

Most rulings construing the "fair and equitable" requirement in section 1129(b) involve proposals under a chapter 11 plan providing for the distribution of value to junior creditors without paying senior creditors in full. Even so, the dictates of the absolute priority rule must be considered in other related contexts as well. For example, in Motorola, Inc. v. Official Comm. of Unsecured Creditors (In re Iridium Operating LLC), 478 F.3d 452 (2d Cir. 2007), the Second Circuit ruled that the most important consideration in determining whether a pre-chapter 11 plan settlement of disputed claims should be approved as being "fair and equitable" is whether the terms of the settlement comply with the Bankruptcy Code's distribution scheme. In remanding a proposed "gifting" settlement to the bankruptcy court for further factual findings, the Second Circuit reserved the question of whether the doctrine "could ever apply to Chapter 11 settlements," but it rejected a per se rule invalidating the practice, as adopted by the Fifth Circuit in United States v. AWECO, Inc. (In re AWECO, Inc.), 725 F.2d 293 (5th Cir. 1984).

In Official Comm. of Unsecured Creditors v. CIT Grp./Business Credit Inc. (In re Jevic Holding Corp.), 787 F.3d 173 (3d Cir. 2015), the Third Circuit ruled that "bankruptcy courts may approve settlements that deviate from the priority scheme of [the Bankruptcy Code]," but only if the court has "specific and credible grounds" to justify the departure. In Jevic Holding, the Third Circuit concluded that the bankruptcy court, as part of a structured dismissal of a chapter 11 case, had sufficient reason to approve a settlement whereby general unsecured creditors would receive a distribution even though priority administrative wage claimants would receive nothing. According to the Third Circuit, "This disposition, unsatisfying as it was, remained the least bad alternative since there was 'no prospect' of a plan being confirmed and conversion to Chapter 7 would have resulted in the secured creditors taking all that remained of the estate in 'short order.' " A more detailed discussion of Jevic Holding can be found here.

In LCI Holding, the Third Circuit considered whether any payments by the purchaser of a debtor's assets in a sale under section 363 of the Bankruptcy Code must be distributed "according to the Bankruptcy Code's creditor-payment hierarchy."

LCI Holding

LifeCare Holdings, Inc. ("LifeCare"), once a leading operator of long-term acute care hospitals, filed for chapter 11 protection in the District of Delaware in December 2012. The filing occurred shortly after the financially struggling company signed an asset purchase agreement with its secured lender whereby an acquisition entity formed by the lender would acquire substantially all of LifeCare's assets in a sale under section 363 by means of a $320 million credit bid. In addition to the credit bid, the purchaser agreed to pay the legal and accounting fees of LifeCare and the official committee of unsecured creditors appointed in the chapter 11 case, as well as LifeCare's wind-down costs. The purchaser funded escrow accounts for that purpose. Any proceeds remaining in the escrow accounts after payment of those fees and costs were to be returned to the purchaser.

After an auction, the bankruptcy court determined that the secured lender entity's credit bid was the most attractive offer for LifeCare's assets. The creditors' committee and the federal government objected to the sale. According to those parties, neither unsecured creditors nor the government, which claimed that it was entitled to a $24 million administrative expense priority claim for capital gains taxes arising from the sale, would recover anything in respect of their claims if the sale were approved. The committee argued, among other things, that the sale was a "veiled foreclosure" which benefited only the secured lender and would leave the bankruptcy estate administratively insolvent.

The committee later reached a deal with the secured lender, which agreed to deposit $3.5 million in trust for the benefit of general unsecured creditors in accordance with the terms of a settlement agreement subject to court approval.

The bankruptcy court approved the sale in April 2013. Characterizing LifeCare as a "melting ice cube," the court found that the sale was the only alternative to liquidation and was also the best opportunity to realize the full value of LifeCare's assets. It also concluded that the secured lender's offer was the "best and only one" and that a chapter 11 plan of reorganization would not have yielded as favorable an economic result. The court overruled the government's objection, holding that the funds placed into escrow by the purchaser were not property of LifeCare's bankruptcy estate and were therefore not available for general distribution to LifeCare's creditors.

In a later ruling, the court approved the settlement agreement as being "fair and equitable" under the four-factor test articulated in In re Martin, 91 F.3d 389 (3d Cir. 1996), which mandates that a court weigh: (i) the probability of success in litigation; (ii) any likely difficulties in collecting on a judgment; (iii) the complexity of the litigation and its attendant expense, inconvenience, and delay; and (iv) the overriding interest of creditors. The bankruptcy court rejected the government's argument that the settlement violated the absolute priority rule because it would distribute estate property to junior creditors over the objection of a senior creditor. According to the court, because the settlement agreement contemplated a distribution directly to the unsecured creditors from the purchaser, the funds were not estate property, so the absolute priority rule did not apply. The court approved the settlement, noting that the committee's objection to the sale had a very small chance of success, and thus, the $3.5 million distribution was an excellent outcome for unsecured creditors.

Both the bankruptcy court and the district court denied the government's request for a stay of the orders approving the sale and the settlement pending appeal. Like the bankruptcy court, the district court ruled that the government was unlikely to prevail on the merits because the funds were not property of LifeCare's bankruptcy estate, and therefore, the distributions need not comply with the absolute priority rule. The government appealed to the Third Circuit.

The Third Circuit's Ruling

A three-judge panel of the Third Circuit affirmed the rulings below.

Writing for the panel, circuit judge Thomas L. Ambro explained at the outset that the appeals were not moot: (i) constitutionally, because the government's prospect of a recovery in respect of its administrative claim, although remote, still existed even though the purchaser retained a $35 million first-priority lien on LifeCare's assets after applying its credit bid; (ii) statutorily, because section 363(m) of the Bankruptcy Code, which moots any challenge to an asset sale to a good-faith purchaser absent a stay pending appeal, "stamps out only those challenges that would claw back the sale from a good faith purchaser . . . [and] does not moot 'every term that might be included in a sale agreement' " (quoting the government's brief); or (iii) equitably, because "[o]utside the plan context, we have yet to hold that equitable mootness would cut off our authority to hear an appeal, and do not do so here."

The court ruled that neither the settlement funds nor the escrowed funds were property of LifeCare's bankruptcy estate because the funds were not "proceeds . . . of or property of the estate" as required by section 541(a)(6) of the Bankruptcy Code.

The Third Circuit rejected the government's contention that the secured lender's $3.5 million deposit in a trust for the benefit of unsecured creditors was in substance an increased bid for LifeCare's assets and that the funds should therefore be deemed estate property. Looking for guidance to a factually similar case, In re TSIC, 393 B.R. 71 (Bankr. D. Del. 2008), as well as the Third Circuit's ruling in Armstrong, Judge Ambro concluded that "the settlement sums paid by the purchaser 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." The judge characterized as "form over substance" the government's argument that the committee conceded in its settlement approval motion that the parties' compromise "represents an agreement between the Buyer, the Lenders and the Committee to allocate proceeds derived from the sale."

The Third Circuit conceded that whether the escrowed funds earmarked for professional fees and wind-down expenses were estate property "is a more difficult question." Judge Ambro noted that the funds were listed as "consideration" for LifeCare's assets in the asset purchase agreement. Even so, he wrote that "we cannot ignore the economic reality of what actually occurred." The purchaser, he explained, acquired LifeCare's assets with a $320 million credit bid, after which "there technically was no more estate property."

According to the court, the government's argument "presumes that any residual cash from the sale—namely, the monies earmarked for fees and wind-down costs—would become property of LifeCare." Judge Ambro characterized this eventuality as "impossible" because LifeCare agreed to surrender all of its cash under the asset purchase agreement, and any residual funds in the professional fee and wind-down expense escrows belonged to the purchaser. "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," the judge wrote, "it was really 'to facilitate . . . a smooth . . . transfer of the assets from [LifeCare's estate] to the [secured lenders]' by resolving objections to that transfer." The court accordingly held that "as a matter of substance, we cannot conclude that the escrowed funds were estate property."

In dicta, Judge Ambro noted that, had the government contended that the escrowed funds represented "an ordinary carve-out" from the secured lender's collateral and were therefore estate property, that argument would have failed as well. According to the Third Circuit, "We are not dealing with collateral (if we were, this would suggest it was LifeCare's property), but with the purchaser's property because the payments by the purchaser were of its own funds and not LifeCare's bankruptcy estate."

Outlook

With LCI Holding and its ruling earlier this year in Jevic Holding, the Third Circuit has provided debtors flexibility to utilize section 363 sales or settlements outside the plan content to expedite the resolution of chapter 11 cases. This flexible approach will be desirable to certain stakeholders in cases where confirmation of a nonconsensual plan is not a viable alternative; however, if utilized improperly, it has the potential to contravene the creditor and shareholder protections built into chapter 11.

In the aftermath of LCI Holding, instead of resorting to collateral carve-outs or plan gifting to junior classes as a means of achieving confirmation of a plan, secured creditors in cases pending in the Third Circuit may fund escrows for the payment of certain classes of creditors or shareholders in connection with section 363 sales of their collateral—leaving other creditors and shareholders with little or no recovery. As the committee's initial objection to the sale in LCI Holding indicated, this case will further fuel the ongoing debate over whether bankruptcy is being improperly used by secured creditors as a more efficient and less costly alternative to foreclosure.

Interestingly, in LCI Holding, the government appears not to have argued that the section 363 sale transaction represented a sub rosa chapter 11 plan that impermissibly circumvented the plan confirmation requirements in the Bankruptcy Code (such as the requirement for administrative claims to be paid in full as a condition to confirmation). However, the Third Circuit may not have been receptive to this line of attack. Without the secured creditor's agreement to fund professional fees, wind-down costs, and a partial recovery to unsecured creditors, the only viable alternatives under the circumstances apparently were dismissal or conversion to chapter 7.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Mark G. Douglas
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