The Bottom Line

After hearing oral argument at confirmation on August 30, 2017, the bankruptcy court for the Western District of Pennsylvania issued a written opinion in In re rue21, inc., et. al., Case No. 17-22045-GLT (Bankr. W.D. Pa. September 8, 2017), Dkt. No. 1082, approving a third party release of the Debtor’s sponsor over the objection of the Committee where the claims that the Committee sought to retain are currently meritless under Third Circuit precedent. The Court determined that the Supreme Court’s grant of certiorari to hear a circuit split which could potentially allow a cause of action that is currently meritless in the Third Circuit to go forward in the future, does not create a colorable claim because as the law exists today, no such cause of action exists. Even though the Supreme Court has granted certiorari to resolve a circuit split on the issue of whether the section 546(e) safe harbor prevents a constructive fraudulent transfer claim where settlement payments are made to or by a financial institution, regardless of whether the financial institution has a beneficial interest in the securities or merely serves as a conduit for payment, stare decisis requires the Court to apply the current ruling of the Third Circuit and since no viable claim currently exists, the Court will not forcibly remove a release where creditors have overwhelmingly voted in favor of the Plan.

What Happened?

Facing an increasingly difficult retail environment and an unsustainable debt burden, rue21 filed for chapter 11 protection on May 15, 2017. At the time of filing, the Debtors had a restructuring support agreement in place which had also been agreed to by the ABL Lenders, Term Lenders and Apax Partners, the equity owners of the Debtors who had acquired the equity interests through an LBO in 2013. Once the Debtors filed for chapter 11, the case moved along quickly. On May 23rd an official committee of unsecured creditors (the “Committee”) was appointed and just two weeks after the petition was filed, the Debtors filed their initial proposed chapter 11 plan of reorganization.

After the Committee objected to the Debtors’ disclosure statement and raised confirmability issues with the Plan, the parties engaged in negotiations and on July 12, 2017, the Debtors filed a revised Plan which had the unanimous support of the Committee’s members. The Court approved the Disclosure Statement and the accompanying materials which included a letter of support from the Committee. The Plan received extremely broad support from creditors with the two impaired classes of creditors overwhelmingly voting in its favor (100% of Term Lenders and 98% in amount and 93% in number of general unsecured creditors voted in favor of the Plan).

Even though the Committee supported the Plan and hoped for the Debtors expeditious exit from chapter 11, the Committee did express concern with, and object to, one aspect of the Plan—releases granted to Apax and affiliates in connection with the LBO. In particular, the Committee believed that the Debtors may have constructive fraudulent transfer claims against Apax and affiliates for amount received in connection with the LBO.

The Debtors disagreed. The Debtors had formed an independent committee of the board of directors to review the potential fraudulent transfer claims and believed that they had no merit. Therefore, the Debtors believed that the Court should defer to their business judgment and overrule the Committee’s objection. The independent committee of the board of directors had retained Reed Smith LLP and in a 79 page report following an investigation, Reed Smith had determined that because all payments in the LBO were either made by or to a financial institution as a settlement payment, the safe harbor of 11 U.S.C. § 546(e) provided a complete defense to any state law avoidance claim or constructive fraudulent transfer claims. Given this fact, as well as other potential defenses that Apax may have, the Debtors believed that their decision to grant the releases constituted a settlement or compromise of claims, which can be effectuated through a plan of reorganization under section 1123(b)(3)(A). The Debtors argued that the appropriate standard for reviewing the releases was therefore akin to that of a 9019 settlement and that the settlement fell above the lowest range of reasonableness and should be approved.

The Committee argued that a more stringent standard of review was called for. The Committee argued that courts in the Third Circuit use the Master Mortgage factors when evaluating the fairness of a debtor’s releases. See in re Master Mortgage Inv. Fund, Inc., 168 B.R. 930 (Bankr. W.D. Mo. 1994). The five Master Mortgage factors include: (1) an identity of interest between the debtor and released party; (2) a substantial contribution to the plan by the released party; (3) the necessity of the release to the reorganization; (4) the overwhelming acceptance of the plan and release by creditors and interest holders; and (5) the payment of all or substantially all of the claims of creditors and interest holders under the plan.

On the issue of the proper standard for determining whether releases are appropriate under a plan, the Court ruled that it depends on whether the releases can be directly traced to the settlement of a claim or are intertwined with the plan as a whole. The Court determined that in this instance, there was insufficient evidence to show that the release directly tied to the settlement of a claim and therefore since the releases are part of the Plan as a whole, the Master Mortgage factors provided the framework for evaluating the propriety of the release. Judge Taddonio added that the Master Mortgage factors merely served as a guideline for the Court’s analysis and are not binding. In light of this, Judge Taddonio added a factor that he believed to be critical under the circumstances. Judge Taddonio determined that the Court must also consider whether the released claims are colorable. The Debtors had already determined not to pursue the claims so in order to proceed another party must step in and attempt to bring them. However, in order to gain standing to do so, the party must show that the claims are colorable because there is no utility in preserving claims that cannot be brought. Therefore, colorability of the claims should be part of the analysis of the propriety of the releases.

The Court analyzed each of the Master Mortgage factors but ultimately made its determination based on whether the claims are colorable. After reviewing the record, the Court determined that the constructive fraudulent transfer claims against Apax had no merit. Based on the Third Circuit Court of Appeals decision in In re Resorts Int’l, Inc., 18 F.3d 505, (3d Cir. 1999), the Section 546(e) safe harbor that prohibits the avoidance of transfers by or to a financial institution that are made in connection with a securities contract or that constitute settlement payments applies to transfers made in connection with a buyout such as the Apax LBO. Under this binding Third Circuit case law, the safe harbor protection is not lost where the financial institution merely serves as a conduit for the transfer. Therefore, any distributions received by Apax are protected under section 546(e) from constructive fraudulent transfer claims.

The Committee tried to argue that the Third Circuit had incorrectly decided the relevant cases and that the better view was the one held by the Seventh Circuit in FTI Consulting, Inc. v. Merit Mgmt. Grp., LP, 830 F.3d 690 (7th Cir. 2016). In Merit, the court held that in order to qualify for the 546(e) safe harbor, the financial institution must have a beneficial interest in the transactions. The Supreme Court had recently granted certiorari in Merit and is set to hear the case on November 6, 2017.

Based on the Supreme Court’s grant of certiorari in Merit, the Committee argued that the appropriate course of action was to remove the Apax release from the Plan and for a liquidating trust to be set up to prosecute the claims if they were to become viable based on a favorable ruling by the Supreme Court. The Court however, squarely rejected this notion, writing that the Committee’s view suffered from a fundamental legal error in that it conflicted with the jurisprudential principle of stare decisis. The Court wrote that it was unquestionably bound by the Third Circuits decision in Resorts Int’l and that the current state of the law prohibited taking the Committee’s approach. The safe harbor provision of section 546(e) in Third Circuit operates as a complete defense to the claims alleged by the Committee against Apax and therefore the Court found no compelling reason to exclude the Apax release from the Plan, particularly where the Plan had garnered such resounding creditor support.

Why the Case is Interesting

This case serves as an important lesson regarding the significance of stare decisis and understanding the current state of the law in a particular circuit. Even where the possibility exists that the law will may change in the near future, judges are still bound by the existing rulings of appellate courts in their circuit and will determine the case based on the law as it exists at that moment of the controversy being decided. In addition to having an impact on where a case is filed, in some unique instances a pending appeal before a circuit court or the Supreme Court can potentially impact the timing of a bankruptcy filing. This decision in rue21 also serves to highlight the significance of the Merit case pending before the Supreme Court and how significant issues relating to the scope of the 546(e) safe harbor provision can be in bankruptcy filings following an LBO. Lastly, it is notable that the court expanded the relevant analysis of the Master Mortgage case to include an analysis of whether the claims at issue are colorable.