The U.S. District Court for the District of Delaware has affirmed a bankruptcy court order which approved both a sale of the debtors’ assets and the establishment of an escrow account, which essentially provides a “gift” to fund a distribution to the debtors’ unsecured creditors.  What is significant about this order is that it approved the use of gifting in a chapter 11 bankruptcy case.

The concept of gifting in a bankruptcy case allows a secured creditor or purchaser to overcome objections to a sale of assets interposed by an unsecured creditors committee or other creditors in the case.  The gift usually consists of a pool of funds for distribution to the debtors’ unsecured creditors.  See In re SPM Mfg. Corp., 984 F.2d 1305 (1st Cir. 1993).

Given that the creditors committee represents only unsecured creditors, the carveouts that are negotiated by creditors committees often bypass the claims of priority creditors, such as taxing authorities.  This raises the issue of whether gifting is permissible in a chapter 11 case, when in order for a plan to be confirmed by the Bankruptcy Court, it must comply with the Bankruptcy Code, including the priority scheme for distributions to creditors and the absolute priority rule set forth in Bankruptcy Code § 1129(b)(2)(B)

To the extent that a secured creditor’s or purchaser’s gift to fund a distribution solely to unsecured creditors bypasses the priority claims of a taxing authority, there may be a legitimate basis to object to the sale if it is being consummated as part of a chapter 11 plan.  See, e.g., In re DBSD North America, Inc., 634 F.3d 79 (2d Cir. 2011)In re Armstrong World Industries, Inc., 432 F.3d 507 (3d Cir. 2005).

IRS Claimed Sale Violated Bankruptcy Code; Court Overrules Objection

In the Delaware chapter 11 case of LCI Holding Company, Inc., case no. 12-13319 (KG), the bankruptcy court was faced with a 363 sale motion filed on the petition date for a significant portion of the debtors’ assets.  At the hearing to consider the sale, the United States, on behalf of the Internal Revenue Service, argued in opposition to the sale, claiming that no provision was made for the $24 million tax liability that would accrue from the sale as an administrative claim, and that the sale violated Bankruptcy Code § 1129.  The IRS requested that if the court were inclined to approve the sale, that it order the pro rata distribution of proceeds to the holders of administrative claims. 

At the close of the hearing, the bankruptcy court overruled the IRS’ objection and approved the sale, noting that this sale was not in connection with confirmation of a plan, nor was it a sale of substantially all of the debtors’ assets.  There was a sound business purpose for the sale, including the continuation of the debtors’ businesses as going concerns, and the importance of this continuity to the debtors’ patients and the communities in which the debtors’ hospitals operated.  Moreover, the purchasers were acquiring operating liabilities of the debtors. 

Based on these findings, the bankruptcy court concluded that the sale was proposed in good faith and entered an order approving the sale.  The IRS subsequently appealed the sale order to the District Court, and moved to stay the sale order to the extent necessary to stay disbursement of escrowed funds described in the asset purchase agreement.

Creditors Committee Negotiates Carveout From Non-Estate Property Effectively Bypassing IRS Arguments

In the interim, the Creditors Committee was apparently negotiating behind the scenes with the purchaser for a carveout in exchange for supporting the sale.  After the IRS filed its appeal, the Creditors Committee filed a motion seeking approval of a settlement term sheet which provided, among other things, for the purchaser to establish a $1.5 million fund (the “Gift Fund“) for the exclusive benefit of the non-priority general unsecured creditors, which would be distributed to unsecured creditors through a liquidating trust.  The purchaser also agreed that it would not pursue any of the avoidance claims it acquired under the asset purchase agreement.  The Creditors Committee argued in its motion that creation of the Gift Fund did not constitute improper gifting of estate property because the distributions to unsecured creditors were not being funded from estate property, and therefore the Third Circuit’s concerns identified in Armstrong were not implicated.  The Creditors Committee also argued that the absolute priority rule was inapplicable because the Gift Fund was being paid entirely from non-estate property.

In the IRS’ motion seeking a stay, the IRS also requested that the bankruptcy court add the Gift Fund to the escrow for distribution to all creditors in compliance with the priority provisions of the Bankruptcy Code.

The bankruptcy court rejected the IRS’ arguments, finding that the Gift Fund was not property of the bankruptcy estate.  The bankruptcy court held another hearing on the IRS’ motion to stay, but concluded that the IRS failed to satisfy the requirements for a stay.  The court stated that its inquiry began and ended with its determination that the Gift Fund was not property of the estate.

On appeal to the Delaware District Court, the IRS sought a stay of the distribution of the Gift Fund.  The District Court outlined the requirements for a stay, and focused on the first factor, which is likelihood of success on the merits.  The controlling issue identified by the District Court with respect to the appeal was whether the bankruptcy court correctly found that the Gift Fund was not part of the debtors’ estates. 

The District Court concluded that the bankruptcy court had not erred in its determination that the sale was warranted and the Gift Fund belonged to the purchaser, and not to the bankruptcy estates.  The court also concluded the possibility of irreparable harm was too speculative to weigh in favor of the IRS, the creditors would be injured by the indeterminable period of time to resolve an appeal, and the public interest would be better served by allowing the debtors’ bankruptcy estates to be administered swiftly and efficiently, and the sale to remain in effect to allow for the continuation of jobs, patient care and hospital services.  As a result, the District Court entered an order denying the IRS’ motion for a stay pending appeal, and dismissed the appeal.

Justice Department Appeals to Third Circuit to Halt Sale of Estate Assets and Distribution of Gift Fund

The Justice Department on behalf of the IRS then filed an appeal to the Third Circuit Court of Appeals of the sale order and the settlement order, asking that the court halt the Delaware bankruptcy court’s practice of approving settlements that provide “gifts” to some creditors while bypassing higher-ranking claimants.  If the Gift Fund has already been distributed to creditors, the Third Circuit will have to address the issue of whether the appeal has been rendered moot, or whether there is a basis for the Third Circuit to take up the appeal on the grounds that this is a repetitive set of facts which habitually becomes moot before it can be heard.

Interestingly, no plan of reorganization or liquidation was ever filed in the debtors’ cases.  Instead, the chapter 11 debtors filed motions seeking approval of a liquidating trust agreement, authorizing the transfer of the Gift Fund to the liquidating trust, and dismissing the debtors’ bankruptcy cases.  The bankruptcy court approved both motions, enabling the purchaser to establish the liquidating trust, and closing the book on the debtors’ chapter 11 cases, but for the IRS’ pending appeal to the Third Circuit.