In Motorola, Inc. v. Official Committee of Unsecured Creditors (In re Iridium Operating LLC), 478 F.3d 452 (2d Cir. 2007), the Official Committee of Unsecured Creditors (the “Committee”) and the debtors’ lenders sought approval of a settlement prior to confirmation of a plan of reorganization. While the Court concluded that many aspects of the settlement might otherwise be approved, it found that a provision that distributed funds in violation of the absolute priority rule lacked sufficient justification. The Second Circuit thus remanded the matter to the bankruptcy court for further finding regarding the distribution of funds to junior creditors.

Factual Background

In Iridium, the debtors’ lenders contended that they had liens on virtually all of the debtors’ assets, a large portion of which were in the form of cash deposits. The debtors sought permission to use the cash collateral, and a stipulation was entered into permitting its use, subject to lien challenges that could be lodged by other parties in the form of an adversary proceeding.

The Committee lodged such a challenge, alleging that, among other things, the liens on cash collateral were avoidable transfers. The Committee also sought permission to pursue claims against Motorola, Inc. (“Motorola”) for breach of fiduciary duty, breach of contract and avoidance of fraudulent conveyances, even though the estate had insufficient funds to pursue these claims. The Committee alleged that Motorola dominated Iridium “through a parasitic relationship that insulated Motorola from any risk associated with Iridium.” 478 F.3d at 458. As a compromise between the parties, the Committee and the lenders entered into a global settlement. The settlement directed that $92.5 million plus proceeds of certain accounts receivable would be paid to the lenders, and $37.5 million plus proceeds of certain accounts receivable would be paid to a newly created entity called Iridium Litigation LLC (the “LLC”). In addition, $5 million would be used to pay certain professional fees. The lenders would also have a validly perfected security interest in their portion of the cash and other assets.

The LLC, which was 99.9% owned by unsecured creditors of the debtors through a trust mechanism, would act as a funding vehicle for the Motorola-related litigation. Proceeds of any litigation recovery thereafter would be split among (i) the lenders (37.5%); (ii) administrative creditors (paid in full before an estate recovery); and (iii) the estate (62.5%). Any of the initial $37.5 million remaining in the trust when the litigation was completed would be paid by the LLC to unsecured creditors. The Committee articulated numerous benefits that the settlement provided to unsecured creditors. Among them was that the lenders’ lien was essentially released from the debtors’ cash on hand to fund the Motorola litigation, the lenders’ lien did not encumber all proceeds of the litigation, the settlement allowed creditors to be paid some distribution before the lenders were paid in full, and the settlement allowed for the litigation against Motorola to be coordinated and centralized. After hearing argument, the bankruptcy court approved the settlement and overruled the objection of Motorola. Motorola appealed and the district court affirmed the decision of the bankruptcy court. Motorola then asked the Second Circuit to consider the issue.

Court’s Analysis

On appeal, citing Official Unsecured Creditors’ Comm v. Stern (In re SPM Mfg. Corp.), 984 F.2d 1305 (1st Cir. 1993), the lenders first argued that, because the monies being utilized as part of the settlement were the lenders’ collateral, the lenders should be permitted to “gift” such monies to another party of their choice. (In SPM, the court found that a secured creditor may share proceeds of its collateral with an unsecured creditor, even though a creditor with superior priority will not be paid.) The lenders alleged that it was irrelevant whether any bankruptcy standard was met because such a gifting mechanism was not subject to restrictions found in the Bankruptcy Code or Rules. The Court explained that “[i]n their view, the cash belongs to the Lenders, not the Estate, and the Lenders can dispose of that cash as they wish.” SPM, 478 F.3d at 461. The Second Circuit disagreed. Instead, the Court found that, because the lenders’ liens were never found to be valid until the settlement was approved, it was not clear that the lenders were entitled to “gift” the cash to another party.

After rejecting the “gifting” argument, the Second Circuit then considered whether the settlement could be approved pursuant to Bankruptcy Rule 9019. In engaging in such an analysis, the Court utilized the traditional TMT factors, including the possibility of success of the litigation versus the settlement’s benefits, the cost and delay involved in litigating the issues, and whether parties supported the settlement, among other factors. See Protective Comm. for Indep. Stockholders of TMT Trailer Ferry, Inc. v. Anderson, 390 U.S. 414 (1968). Motorola argued that it was not disputing that the settlement met the test of TMT; instead, Motorola contended that, despite the settlement’s compliance with the TMT test, it violated the absolute priority rule. As a result, the settlement was not fair and equitable and did not merit approval.

While the term “fair and equitable” is derived from section 1129(b)(2) of the Bankruptcy Code in the context of plan confirmation requirements, the Second Circuit found it had applicability in settlement situations because settlements constitute part of a plan of reorganization. The Court of Appeals rejected a rigid rule that would require that the absolute priority rule be strictly adhered to in every settlement, explaining, “[i]t is difficult to employ the rule of priorities in the approval of a settlement in a case such as this when the nature and extent of the estate and the claims against it are not yet fully resolved. In our view, a rigid per se rule cannot accommodate the dynamic status of some pre-plan bankruptcy settlements.” 478 F.3d at 465 The Court cautioned, however, that while not a prerequisite to approval, whether the settlement complies with the absolute priority rule and thus is fair and equitable is the most important factor to consider.

The Court of Appeals concluded that, the aspect of the settlement that required that funds be split between the lenders and the LLC was acceptable even though the absolute priority rule was violated. This was because the alternative—the challenge of the lenders’ liens—presented too much risk for the estate, including administrative creditors. In this context, justification could be found for modifying the Bankruptcy Code’s priority scheme.

The Court felt differently about the settlement’s distribution to unsecured creditors of residual funds from the Committee-controlled LLC. The Court pointed out that, if Motorola prevailed in the litigation or its administrative claims exceeded its liability in the litigation, the payment would violate the absolute priority rule. The Court noted, “[i]ndeed, no reason has been offered to explain why any balance left in the litigation trust could not or should not be distributed pursuant to the rule of priorities.” 478 F.3d at 466. The Court thus remanded the matter to the bankruptcy court in order for it to evaluate the “justification for providing for a distribution of [LLC] funds to junior creditors at the completion of the Motorola litigation.” Id.

The Court also affirmed the decision of the lower court rejecting the challenge that the settlement short circuited the bankruptcy process by adopting a sub rosa plan. The Court found that the settlement had a proper business justification— resolving the lenders’ lien issues and other property disputes. As such, it was deemed to be a constructive step toward a confirmable plan and not an evasion of the plan confirmation process.

Conclusion

The Court appears to desire to emphasize that the rules of priority will not be treated lightly. Although in Iridium, the benefit of the overall settlement seemed to justify a modification of such rules, were the Court to have allowed such a settlement without requiring more, egregious violations of such rules may well have followed.

The Second Circuit’s remand relating to the payment of residual funds under the settlement outside of a plan of reorganization is a strong reminder that the rules of priority cannot be easily altered. A settlement that seeks to modify the priority scheme of the Code should thus be well presented and supported, as this aspect of the settlement will be one of the most important factors considered by the Court.