United States: FLYi, Inc. — Important Application Of Owens Corning Standard For Substantive Consolidation By Delaware Bankruptcy Court

On March 15, 2007, with Jones Day’s assistance as bankruptcy counsel, FLY i, Inc. ("FLY i"), Independence Air, Inc. ("Independence"), and their affiliated debtors (collectively, the "Debtors") obtained confirmation of their chapter 11 plan under the "cramdown" provisions of the Bankruptcy Code. The plan, which became effective on March 30, 2007, will distribute approximately $150 million to unsecured creditors. In ruling on confirmation of the plan, the U.S. Bankruptcy Court for the District of Delaware was required to make one of its first applications of the Third Circuit’s decision in Owens Corning on the doctrine of substantive consolidation. In the ruling, Judge Mary Walrath affirmed that substantive consolidation is a "rare" remedy that should not be used as a sword to improve recoveries for a specific group of creditors at the expense of other creditors.

In the FLY i case, the two main debtors were FLY i, a holding company, and Independence, the FLY i subsidiary that conducted the Debtors’ airline operations. The other debtors were affiliated companies with few or no assets or creditors. After operating as a regional carrier for major airlines, including United Airlines, for 12 years and as an independent, low-fare carrier under the name "Independence Air" for approximately a year and a half, the Debtors suffered increasing operating losses that led them to file for protection under chapter 11 of the Bankruptcy Code on November 7, 2005.

At the outset of the chapter 11 filings, the Debtors obtained authority from the bankruptcy court to attempt to sell their business as a going concern or to find an investor to provide additional capital. No potential bidder or investor, however, offered a transactional alternative that was more favorable to the value of the Debtors’ estates than the value that would be obtained by discontinuing operations and conducting an orderly liquidation. Accordingly, on January 5, 2006, the Debtors obtained authority to cease business operations and begin the process of liquidating their assets and winding down their affairs. To that end, the Debtors rejected their remaining aircraft leases and abandoned their remaining owned aircraft.

The largest claims in the Debtors’ chapter 11 cases were the hundreds of millions of dollars in claims held by lessors whose aircraft leases were rejected by Independence and the undersecured deficiency claims of creditors that made loans to Independence secured by abandoned aircraft. In most cases, Independence’s lease or loan obligations were guaranteed by FLY i. These creditors therefore generally had claims against both FLY i and Independence. As a result, there were three categories of unsecured creditors in the case — FLY i-only creditors, Independence-only creditors, and "crossover" creditors, which consisted in the main of the aircraft-related creditors with primary claims against Independence and guaranties from FLY i. The largest group of FLY i-only creditors consisted of the holders of the approximately $125 million in FLY i’s 6% convertible notes (the "Convertible Notes"). QVT Financial LP ("QVT "), a multibillion-dollar hedge fund, purchased approximately 60% of the Convertible Notes after the filing of the bankruptcy cases. The Independence-only creditors consisted generally of nonaircraft contract-rejection claimants, general trade creditors, and International Lease Finance Corporation ("IL FC"), which had leased aircraft to Independence without requiring a guaranty from FLY i.

The Debtors’ largest asset was a contract-rejection claim in the chapter 11 bankruptcy case of United Airlines. In that bankruptcy, United rejected its code-sharing agreements with the Debtors pursuant to which Independence Air’s predecessor, Atlantic Coast Airlines, had operated as a regional carrier or United. After a contested hearing, the judge in the United bankruptcy allowed the Debtors’ claim for $500 million. United, the United creditors’ committee, and FLY i all appealed the ruling. With Jones Day’s assistance, the Debtors negotiated a settlement of that claim, and of Independence’s unfair-competition claim against United, in the total amount of $750 million. The $750 million claim was worth approximately $150 million in reorganized United stock under United’s bankruptcy plan.

After negotiations with the creditors’ committee, the Debtors and the committee reached an agreement regarding the terms of the Debtors’ chapter 1 1 plan. The agreed-upon plan did not provide for the substantive consolidation of the estates of FLY i and Independence. Instead, the plan separately classified claims against FLY i and Independence, respectively, and treated the assets of FLY i and Independence as separate. The decision not to pursue a plan predicated upon substantive consolidation was informed by the Third Circuit’s decision in In re Owens Corning, 419 F.3d 195 (3d Cir. 2005), in which the Third Circuit held that substantive consolidation is an "extreme" remedy to be used "sparingly."

In addition, the plan included a release by the Debtors of their estates’ pre-petition claims against the Debtors’ present and former officers, their directors, and certain other parties (collectively, the "Debtor Parties"). The Debtors, with Jones Day’s assistance, had reached an agreement with the creditors’ committee on a protocol by which the committee would conduct an investigation of those pre-petition claims against the Debtor Parties. The plan provided that the Debtors would release all causes of action arising prior to bankruptcy that they might have had against the Debtor Parties. The protocol set a deadline of April 11, 2007, for the committee to assert any such causes of action. After its investigation, the committee determined not to pursue any such actions.

Nonconsolidation of the estates of FLY i and Independence left open two significant issues between the two companies: (i) the allocation of the proceeds of the $750 million settlement with United Airlines; and (ii) the treatment of FLY i’s net pre-petition intercompany claim against Independence (the "Intercompany Claim"), which was on the Debtors’ books and records in the amount of approximately $285.5 million. The creditors’ committee requested that the United settlement be allocated 50% to FLY i and 50% to Independence and that the Debtors make such other adjustments as determined equitable. The Debtors believed, however, that it was likely that FLY i would receive substantially less than 50% of the settlement if the allocation were to be litigated, and they also believed that a significant amount of the Intercompany Claim likely would not be treated as valid if litigated. The ultimate compromise embodied in the plan allocated the United settlement 50/50 between FLY i and Independence creditors and provided for no consideration to be paid on account of the Intercompany Claim.

The Debtors’ plan was overwhelmingly accepted by all classes of voting creditors except the class of holders of Convertible Notes controlled by QVT . The only creditors to file material objections to the plan were QVT , which as noted above was a FLY i-only creditor, and IL FC, an Independenceonly creditor. Among their objections, QVT and IL FC argued that the FLY i and Independence estates should have been substantively consolidated or, at a minimum, that the recoveries to the holders of guaranty claims, or crossover creditors, should have been reduced to account for the risk of substantive consolidation. Substantive consolidation would have materially increased the recovery to QVT and IL FC by vitiating the guaranties.

Judge Walrath ultimately concluded that substantive consolidation was inappropriate under the circumstances, following the Third Circuit’s ruling in Owens Corning, because that ruling expressly prohibited the use of substantive consolidation for the type of "affirmative" purpose sought by the objectors: that is, to reduce unilaterally the recoveries of a specific group of creditors—the crossover creditors—so that other creditors, including the objectors, could obtain greater recoveries under the plan. The bankruptcy court’s ruling underscores the principle that separate legal entities are presumed to remain separate in chapter 11 unless the "extreme remedy" of substantive consolidation is warranted by compelling circumstances.

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