On July 25, 2012, the Third Circuit issued its decision in In re American Capital Equipment LLC and Skinner Engine Co., 688 F.3d 145 (3rd Cir. 2012), becoming the first circuit court to align itself with numerous district courts that have allowed bankruptcy courts to reject a Chapter 11 plan prior to a confirmation hearing. The Third Circuit also affirmed the lower courts’ (1) rejection of the debtor’s fifth plan, pursuant to which the debtor sought to implement an asbestos claims mechanism premised on a “baseball” style arbitration, and (2) conversion of the case to a Chapter 7 proceeding. In ruling against debtors, the Third Circuit continued its scrutiny of Chapter 11 plans focused on the purported resolution of mass tort and asbestos claim exposure.

Background

In American Capital, the appellants sought the Third Circuit’s review of a Chapter 11 plan that purported to resolve debtors’ historic asbestos liability through a claims resolution process funded by a twenty percent surcharge on those asbestos claimants that opted into the plan’s claim process. The surcharge was the sole source of funding under the plan because debtors had no other assets (other than minimal cash on hand) to pay significant administrative claims. Debtors’ prepetition insurers objected to the plan, asserting what would typically be described as confirmation objections at the disclosure statement stage of the bankruptcy case. In lieu of deferring consideration of the insurers’ objections until a confirmation hearing, the bankruptcy court instead asked both the insurers and debtors to brief four discrete confirmation issues, informing the parties that the bankruptcy court would rule on these issues before considering whether to approve the disclosure statement and allow debtors’ plan to proceed to confirmation. The bankruptcy court also entered a sua sponte order requesting briefing on whether it should convert debtors’ case if it denied confirmation of their plan.

After briefing and argument, the bankruptcy court entered an order and opinion: (1) finding debtors’ plan unconfirmable as a matter of law; (2) finding that debtors had not and could not effectuate a confirmable plan; and (3) converting debtors’ cases to Chapter 7. On appeal, the district court affirmed.

The Decision

On appeal to the Third Circuit, appellants first contested the bankruptcy court’s failure to hold a confirmation hearing before rejecting debtors’ plan. In addressing this procedural issue, the Third Circuit acknowledged that Federal Rule of Bankruptcy Procedure 3020(b)(2) states that a court “shall rule on confirmation of the plan after notice and hearing” and noted that other circuit courts had concluded that an evidentiary hearing was required to reject a Chapter 11 plan. See In re Acequia, Inc., 787 F.2d 1352 (9th Cir. 1986) ; In re Williams, 850 F.2d 250 (5th Cir. 1988). Nevertheless, the Third Circuit reasoned that a bankruptcy court could exercise its equitable powers under Bankruptcy Code section 105 to reject a plan prior to a confirmation hearing, stating that “a bankruptcy court may address the issue of plan confirmation where it is obvious at the disclosure statement stage that a later confirmation hearing would be futile because the plan described by the disclosure statement is patently unconfirmable.” To reject a plan prior to a confirmation hearing, the Third Circuit found that the objectors must show that: (a) there is no dispute of material fact; and (b) the plan defects cannot be cured by creditor voting or otherwise.

The Third Circuit also affirmed the lower courts’ finding that debtors’ plan did not comply with the feasibility or good faith requirements for confirmation. As to feasibility, the Third Circuit found that the “sole source of funding” for debtors’ plan was the above-described surcharge, “which would be obtained from wholly speculative litigation proceeds.” The speculative nature of these recoveries made debtors’ plan infeasible as a matter of law. Similarly, the Third Circuit found that debtors’ plan was proposed in bad faith “because it establishe[d] an inherent conflict of interest under circumstances that are especially concerning.” In particular, the plan: (i) provided incentive for debtors to sabotage their own defense against asbestos claimants, as the only source of funding would be if asbestos litigants achieved settlements against the estate, and paid the claimant surcharge; (ii) contained a settlement procedure and baseball arbitration provision that severely limited the insurers’ procedural and substantive rights; and (iii) included no contribution from debtors to the claimant trust, but instead pulled money from the trust to repay debtors’ professionals and non-asbestos claimants.. Finally, the Third Circuit concluded that neither the infeasibility or the bad faith of debtors plan involved a dispute of material fact, and creditor voting could not address the these concerns or cure the inherent conflicts of interest.

After addressing the lower courts’ rejection of debtors’ plan, the Third Circuit upheld the lower courts’ conversion of the cases to Chapter 7 proceedings. The Third Circuit found that the five previous, unconfirmable Chapter 11 plans, the length of time debtors had spent in bankruptcy (over five years), and the primary means by which the proponents proposed a “successful” reorganization (the surcharge with its inherent conflict of interests) supported conversion of debtors’ cases to Chapter 7 proceedings.

Implications

From a procedural perspective, the Third Circuit has adopted the “patently unconfirmable” standard used by a number of lower federal courts when addressing confirmation objections at the disclosure statement stage of a bankruptcy case. This position is clearly significant for future objections to Chapter 11 plans, as it provides support for cutting-off the confirmation process at the disclosure statement stage--- which is often before parties have expended significant resources in discovery. Consequently, future debtors may be less likely to introduce speculative Chapter 11 plans with hopes of eventually curing defects during the confirmation process.

Moreover, the American Capital decision continues a line of Third Circuit decisions that have been critical of certain mass tort bankruptcy schemes. In 2004, the Third Circuit vacated the confirmation of Combustion Engineering’s chapter 11 plan because it (a) sought to enjoin claims against certain non-bankrupt affiliates of debtor for their own asbestos-related liabilities and (b) included a scheme by which settling asbestos plaintiffs with current claims would receive significantly higher recoveries on their claims, compared to those asbestos plaintiffs with unsettled claims or future claims. See In re Combustion Eng’g, Inc., 391 F.3d 190 (3d Cir. 2004)). In 2005, the Third Circuit in Congoleum held that insurers had standing to standing to object to the disinterestedness of debtor’s professionals under Bankruptcy Code section 327(a). See Century Indemnity Co. v. Congoleum Corp. (In re Congoleum Corp.)., 426 F.3d 675 (3d Cir. 2005). In Owens Corning decided in the same year, the Third Circuit set forth the standard for substantive consolidation of multiple chapter 11 estates and held that the plan proponents had not met this standard in seeking substantive consolidation of Owens Corning and its affiliated entities. See In re Owens Corning, 419 F.3d 195 (3d Cir. 2005). Finally, in 2011, the Third Circuit (sitting en banc) in Global Industrial Technologies, Inc. held that insurers that had standing to object to confirmation of the company’s Chapter 11 plan, even though the plan had been designed to be “insurance neutral,” relying on evidence before the lower courts of collusion with respect to the negotiation of the plan and substantial increase in silica claims.

It should be noted that the objectors in in Congoleum and GIT, like the objectors in American Capital, presented evidence of collusion to support their plan objections. By its recent American Capital decision, the Third Circuit has again signaled that it will not condone collusive action in conjunction with purported efforts to maximize insurance for asbestos or other mass tort claimants, even if such collusion might be in the best interests of, or condoned by, such creditors.