A court-approved pre-plan settlement that would have resolved a dispute between a Chapter 11 creditors’ committee and the debtor’s secured lenders over the lenders’ liens was vacated by the U.S. Court of Appeals for the Second Circuit on March 5. Motorola, Inc. v. Official Committee of Unsecured Creditors and J.P. Morgan Chase Bank, N.A. (In re Iridium Operating LLC). The settlement also would have funded massive litigation against the debtor’s former parent, Motorola Inc.
Motorola’s Successful Argument
Motorola, an administrative priority claimant (post-bankruptcy loan and contract expenses), argued successfully on appeal that the settlement (approved separately, not as part of a plan) had improperly used estate funds, at Motorola’s expense, to pay junior unsecured creditors: “a settlement can never be fair and equitable if junior creditors’ claims are satisfied before those of more senior creditors.” According to the court, payment of estate funds to the unsecured creditors under the settlement “would violate the absolute priority rule if Motorola prevails in the litigation or its administrative claims exceed its liability in the litigation.”
Reorganization Plan Unnecessary
The court acknowledged that the settlement was “presented for court approval apart from a reorganization plan” and that “the priority rule of [Bankruptcy Code §] 1129 [was] not necessarily implicated,” Nevertheless, reasoned the court, citing Fifth Circuit precedent, “pre-plan settlements” should conform to “the absolute priority rule [,] the most important factor for courts to consider” when evaluating a proposed settlement (Id.) unless “the parties to the settlement justify, and the reviewing court clearly articulates the reasons for approving, a settlement that deviates from the priority rule.” Despite a strong record favoring approval of the settlement here, “the bankruptcy court, in its discretion, could [still] endorse a settlement that does not comply in some minor respects with the priority rule ….”
The Settlement’s Flaw
The settlement approval process in this case was flawed because the bankruptcy court failed to “explain … the Settlement’s distribution of residual [estate] funds to the [unsecured creditors] in violation of the absolute priority rule …. Indeed, 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.” Accordingly, the court remanded the matter “to the bankruptcy court … to assess the justification for providing a distribution of [estate] funds to the junior creditors at the completion of the Motorola litigation …. Our remand … seeks only clarification of why the settlement need require a possible deviation from the rule in one regard.”
The Settlement Proceeds Were Not the Lenders’ Property
The court rejected the argument made by the lenders and the committee that any available cash distributed to unsecured creditors constituted the lenders’ property, entitling the lenders “to do with [it] as they see fit,” such as distributing cash to unsecured creditors “to pursue Motorola ….” The lenders and the committee relied on In re SPM Mfg. Corp. reasoning that a secured lender with a valid lien may, through a settlement, share some of its settlement proceeds with unsecured creditors even when a priority creditor will go unpaid. Here, however, because the committee had contested the lenders’ liens and the cash had been an asset of the debtor’s estate, not the lenders’ undisputed collateral, the lenders “did not actually have a perfected [i.e., valid] interest in the cash on hand.” The court thus did not decide whether SPM could ever apply to a Chapter 11 settlement. Although the settlement eliminated a dispute with the lenders by providing for a distribution of estate assets to be used for litigation against Motorola, it triggered the Bankruptcy Rule 9019 settlement procedure.
No Covert Reorganization Plan
The court also rejected Motorola’s argument that the settlement agreement constituted an impermissible sub rosa plan of reorganization. Id. at 35-36. Because the bankruptcy court had identified “a proper business justification” for the settlement, which would lead “towards possible confirmation of a plan of reorganization,” the committee and the lenders had not evaded the planconfirmation process. Moreover, Motorola had not objected when other operating assets of the estate were sold.
1. The decision confirms the need for the settling parties to establish a solid record when seeking court approval of a settlement. Despite a strong judicial predisposition in favor of settlements, an effectively represented objector, particularly one whose economic interests are affected, can torpedo the entire process.
2. This litigation is still alive. On remand, the creditors’ committee and the lenders will be free to convince the bankruptcy court why a departure from the absolute priority rule was justified. And, in a footnote, the Second Circuit also acknowledged the possibility that the controversy may be moot, stating that the parties should be able to show, if the facts warrant, that “the [litigation] funds [have been] dissipated.” Id. at 34, n.20.
3. The Second Circuit’s ruling was hardly novel. See In re ATC Properties, 784 F.2d 1377, 1383 (9th Cir.), cert. denied sub nom. Martin v. Robins, 479 U.S. 854 (1986) (“approval of a compromise, absent a sufficient factual foundation which establishes that it is fair and equitable, inherently constitutes an abuse of discretion”); In re Aweco, Inc., 725 F.2d 293, 298-30 (5th Cir. 1984) (settlement rejected on appeal because, in absence of “requisite factual background,” payment to junior creditor might deplete estate to detriment of senior creditor, violating absolute priority rule); Porter Dry Way Co. Inc. v. Haven Inc., 2005 Bankr. LEXIS 541, *24 (B.A.P. 6th Cir. 2005) (same).