“Give ups” by senior classes of creditors to achieve confirmation of a plan have become an increasingly common feature of the chapter 11 process, as stakeholders strive to avoid disputes that can prolong the bankruptcy case and drain estate assets by driving up administrative costs. Under certain circumstances, however, senior class “gifting” or “carve outs” from senior class recoveries may violate a well-established bankruptcy principle commonly referred to as the “absolute priority rule,” a maxim predating the enactment of the Bankruptcy Code that established a strict hierarchy of payment among claims of differing priorities. The rule’s continued application under the current statutory scheme has been a magnet for controversy.
Most of the court rulings handed down recently concerning this issue have examined the rule’s application to the terms of a proposed chapter 11 plan that provides for the distribution of value to junior creditors without paying senior creditors in full. A decision recently issued by the Second Circuit Court of Appeals, however, indicates that the dictates of the absolute priority rule must be considered in contexts other than confirmation of a plan. In Motorola, Inc. v. Official Comm. Of Unsecured Creditors (In re Iridium Operating LLC), the Second Circuit ruled that the most important consideration in determining whether a pre-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.
Cram-Down and the Fair and Equitable Requirement
If a class of creditors or shareholders votes to reject a chapter 11 plan, it can be confirmed only if the plan satisfies the requirements of section 1129(b) of the Bankruptcy Code. Among these is the mandate that a plan be “fair and equitable” with respect to dissenting classes of creditors and shareholders.
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, no creditor of lesser priority, or shareholder, receives any distribution under the plan. This requirement is sometimes referred to as the “absolute priority rule.”
Section 1129(b)(2) has been the focus of considerable debate in the courts. One of the most significant disputes concerns the propriety of an increasingly common, albeit controversial, practice in large chapter 11 cases — whether section 1129(b)(2) allows a class of senior creditors voluntarily to cede a portion of its recovery under a plan to a junior class of creditors or shareholders, while an intermediate class is not receiving payment in full.
Legitimacy of Senior Class “Give Ups” under the Absolute Priority Rule
Notwithstanding section 1129(b)(2)’s preclusion of distributions to junior classes of claims or interests in cases where it applies, some courts have ruled that a plan does not violate the “fair and equitable” requirement if a class of senior creditors agrees that some of the property that would otherwise be distributed to it under the plan can be given to a junior class of creditors or shareholders. In doing so, many courts rely on a 1993 decision involving a chapter 7 case issued by the First Circuit Court of Appeals in In re SPM Manufacturing Corp.
In SPM, a secured lender holding a first priority security interest in substantially all of a chapter 11 debtor’s 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, the secured lender and the unsecured creditors tried to force the chapter 7 trustee to distribute the proceeds from the sale of the debtor’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 otherwise payable to the unsecured creditors 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 lienor, 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, “[w]hile 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.”
Other courts have cited SPM as authority for confirming a non-consensual chapter 11 plan (or a settlement) 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). Still, the concept of allowing a senior creditor or class of creditors to assign part of its recovery under a chapter 11 plan to junior creditors or stockholders who would otherwise receive nothing by operation of section 1129(b)(2) is controversial. So much so, in fact, that the Third Circuit in 2005 declared the practice invalid under certain circumstances in In re Armstrong World Indus., Inc.
Armstrong World Industries
Floor and ceiling products manufacturer Armstrong World Industries, Inc., whose chapter 11 case was filed in the United States Bankruptcy Court for the District of Delaware, proposed a chapter 11 plan under which unsecured creditors (other than asbestos claimants) would recover approximately 59.5% of their claims and asbestos personal injury creditors would recover approximately 20% of an estimated $3.1 billion in claims. In addition, the plan provided that Armstrong’s shareholders would receive warrants to purchase new common stock in the reorganized company valued at $35 million to $40 million. A key provision of the plan was the consent of the class of asbestos claimants to share a portion of its proposed distribution with equity. The plan provided that, if Armstrong’s class of unsecured creditors (other than asbestos claimants) voted to reject the plan, asbestos claimants would receive new warrants, but would automatically waive their distribution, causing equity holders to obtain the warrants that otherwise would have been distributed to the asbestos claimants.
Armstrong’s general unsecured creditors voted against the plan. The court denied confirmation, ruling that distribution of new warrants to the class of equity holders over the objection of the general unsecured creditors class violated the “fair and equitable” requirement of section 1129(b)(2)(B)(ii). In doing so, it distinguished, or characterized as “wrongly decided,” cases in which the courts have not strictly applied section 1129(b)(2). It found SPM to be inapposite because the distribution in SPM occurred in a chapter 7 case, “where the sweep of 11 U.S.C. § 1129(b)(2)(B)(ii) does not reach,” and SPM’s unsecured creditors, rather than being deprived of a distribution, were receiving a distribution ahead of priority, such that “the teachings of the absolute priority rule — which prevents a junior class from receiving a distribution ahead of the unsecured creditor class — are not applicable.” The court also found that the sharing agreement in SPM might be more properly construed as an ordinary “carve out,” whereby a secured party allows a portion of its lien proceeds to be paid to others as part of a cash collateral agreement.
The Third Circuit affirmed on appeal, adopting substantially all of the lower court’s reasoning regarding the strictures of the absolute priority rule. According to the Court of Appeals, allowing the distribution scheme proposed in Armstrong’s plan “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.”
Armstrong and most other court rulings construing the “fair and equitable” requirement in section 1129(b) involve proposed distribution schemes under a chapter 11 plan. In many cases, however, the framework of a plan may be dictated in large part by agreements or settlements negotiated among the debtor and various significant creditor groups prior to confirmation. It is well understood that a bankruptcy court will approve a proposed settlement only if it is “fair and equitable” (or, as articulated by some courts, “fair and reasonable”) as well as in the best interests of the estate. Less clear, however, is whether that determination encompasses examination of a pre-plan settlement to ensure that its terms comply with the Bankruptcy Code’s distribution scheme, and more specifically, the absolute priority rule. Any lingering doubt concerning that issue was eradicated, at least in the Second Circuit, by the ruling in Iridium.
Iridium Operating LLC is a former Motorola, Inc. subsidiary incorporated in 1991 to provide global satellite-based telecommunications services. The company filed for chapter 11 protection in 1999 shortly after creditors filed involuntary chapter 11 petitions against certain affiliates. At the time of the chapter 11 filings, the companies (collectively, referred to as “Iridium”) had amassed nearly $4 billion in debt, including $800 million in financing provided by a consortium of lenders (the “Lenders”), represented by JP Morgan Chase Bank (“Chase”). According to the Lenders, the loans are secured by liens on all of Iridium’s assets, including roughly $156 million in cash deposits held in various accounts at Chase, a satellite operations center, $243 million in reserve capital calls, 66 satellites and various causes of action.
The creditors’ committee appointed in Iridium’s chapter 11 cases vigorously contested the validity of the Lenders’ asserted possessory and contractual liens on Iridium’s cash, which the committee argued were avoidable as preferences because the cash was transferred to Chase within 90 days of the bankruptcy filings. It also sought to pursue claims against Motorola for breach of contract, breach of fiduciary duty and avoidance of a fraudulent transfer in connection with its 1993 spin-off of Iridium, but lacked money to fund the litigation.
The committee and the Lenders ultimately reached a settlement of their dispute and sought court approval of the agreement. The settlement conceded the validity of the Lenders’ liens and provided for the distribution of the estate’s cash to the Lenders and to a litigation vehicle established for the purpose of suing Motorola. Any recoveries from the litigation were to be divided among the Lenders, administrative creditors and the estate (to be distributed under a future chapter 11 plan). Any of the $37.5 million in cash used to fund the litigation vehicle remaining at the end of the litigation was to be paid directly to Iridium’s unsecured creditors, whether or not the Lenders’ claims or administrative claims were paid in full.
Motorola objected to the settlement, arguing that it violated the absolute priority rule by providing for the payment of estate assets to lower priority creditors (the litigation vehicle and the unsecured creditors) before any payments would be made to Motorola on account of its administrative claims. The bankruptcy court approved the settlement over Motorola’s objection, and the district court affirmed on appeal.
The Second Circuit’s Ruling
The Court of Appeals vacated the ruling. At the outset, the Second Circuit distinguished the case before it from SPM, where there was no dispute that the lender had valid and perfected liens on substantially all of the debtor’s assets. As such, the Court explained, “we need not decide if SPM could ever apply to Chapter 11 settlements, because it is clear that the Lenders did not actually have a perfected interest in the cash on hand.”
The Second Circuit then directed its attention to the standards applied to proposed settlements. Although the Bankruptcy Code expressly makes the “fair and equitable” requirement applicable only in cases of non-consensual confirmation of a plan, the Second Circuit explained, the Supreme Court has held “that a settlement presented for approval as part of a plan of reorganization, because it constitutes part of the plan, may only be approved if it, too, is ‘fair and equitable’ in the sense of conforming to the absolute priority rule.” Less clear, the Court acknowledged, is the rule’s application to pre-plan settlements, when the nature and extent of the bankruptcy estate and claims against it are not fully resolved.
The Second Circuit rejected application of the absolute priority rule to all pre-plan settlements, observing that “a rigid per se rule cannot accommodate the dynamic status of some pre-plan bankruptcy settlements.” Mindful that rejecting strict application of the rule in all cases increases the risk that parties to a settlement may engage in improper collusion, the Court of Appeals opted instead for stricter scrutiny in the settlement approval process. It concluded that “whether a particular settlement’s distribution scheme complies with the Code’s priority scheme must be the most important factor for the bankruptcy court to consider when determining whether a settlement is ‘fair and equitable.’” Under this standard, the Second Circuit explained, whether a settlement complies with the statute’s priority scheme “will often be the dispositive factor.” Even so, the Court observed, settlements that deviate in minor respects from that scheme may be approved, if the “remaining factors weigh heavily in favor of approving a settlement” and the court clearly articulates the reasons for approving it.
Examining the bankruptcy court’s reasons for approving the settlement between the Lenders and the creditors’ committee, the Second Circuit faulted only one aspect of the court’s analysis — the absence of any explanation for authorizing an agreement whose terms violated the absolute priority rule. Because “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,” the Court vacated the order approving the settlement and remanded the case below for consideration of that issue.
Where Do We Go from Here?
Taken together, Armstrong and Iridium erect stringent standards to govern agreements, either as part of a chapter 11 plan or a pre-plan settlement, that provide for distributions of assets in a way that deviates from the absolute priority rule. Even so, the rulings should not be read as a blanket prohibition of senior class gifting, which continues to be a vital part of an overall negotiating strategy in chapter 11. First, the absolute priority rule applies only in cases involving the non-consensual confirmation of a chapter 11 plan — if an intervening class of creditors does not object to a senior class give-up as a means of achieving consensual confirmation, the rule does not come into play. In addition, cases involving carve-outs from recoveries that would otherwise go exclusively to a senior class of secured creditors (as in SPM) are far more likely to pass muster under the standards articulated in Iridium and Armstrong.
The Second Circuit did not break new ground in ruling that the terms of a pre-plan settlement should comply with the absolute priority rule. In fact, the Iridium ruling is more flexible than at least one prior circuit court precedent. In In re AWECO, Inc., the Fifth Circuit held that the absolute priority rule must apply to pre-plan settlements, concluding that “a bankruptcy court abuses its discretion in approving a [pre-plan] settlement with a junior creditor unless the court concludes that priority of payment will be respected as to objecting senior creditors.” In Iridium, the Second Circuit declared that the rule stated in AWECO is “too rigid,” emphasizing that “a rigid per se rule cannot accommodate the dynamic status of some pre-plan bankruptcy settlements.” Instead, the Second Circuit determined that a pre-plan settlement may deviate from the Bankruptcy Code’s priority rules if the “remaining factors weigh heavily in favor of approving a settlement” and the court clearly articulates the reasons for approving it. At this juncture, it remains to be seen what kinds of settlement agreements would pass muster under the Second Circuit’s unique formulation of the “fair and equitable” standard.