In In reAm. Capital Equip., LLC1 the Third Circuit addressed the issue of whether a bankruptcy court has the authority to determine at the disclosure statement stage that a Chapter 11 plan is unconfirmable without holding a confirmation hearing. The court held that when a plan is patently unconfirmable, so that no dispute of material fact remains and defects cannot be cured by creditor voting, a bankruptcy court is authorized to convert the case to Chapter 7 without holding a confirmation hearing. Am. Capital Equip. appears to be the first circuit court decision to expressly hold that a bankruptcy court can determine the confirmability of a Chapter 11 plan at the disclosure statement stage without holding a confirmation hearing.
For more than 100 years, Skinner Engine Companies manufactured merchant ship engines. In 2001, Skinner and American Capital Equipment, LLC, the owner of all of Skinner’s common stock, filed for Chapter 11 relief. At the time of the filings, more than 29,000 personal injury claims were pending against Skinner arising from its manufacture of ship engines and parts allegedly containing asbestos. Skinner claimed entitlement to coverage for its asbestos liabilities under various insurance policies. During the Chapter 11 case, the debtors proposed five reorganization plans, each one of which failed for different reasons.
In 2009, the bankruptcy court held a hearing on the disclosure statement filed in connection with the fifth plan of reorganization proposed by the debtors. The fifth plan created a process for the resolution of the asbestos claims called the “Court Approved Distribution Procedures” (CADP). If a claimant elected to submit his or her claim to the CADP, the claimant would be required to allocate 20 percent of the amount recovered from insurance through the CADP to a “surcharge.” This surcharge would fund the CADP and a “plan payment fund” from which distributions would be paid to Skinner’s non-asbestos creditors. The surcharge was the only source of funding for the plan. Without funding from the surcharge, the plan was unworkable.
Under the CADP, the claimants would be required to present evidence of a medically diagnosed asbestos-related injury and past exposure to Skinner’s asbestos-containing products. A “plan trustee” would evaluate the claims. If an insurer disagreed with the trustee’s claim evaluation, the insurer could seek a court determination by the bankruptcy judge, who would then determine the claim using “baseball arbitration procedures.” The insurer would not be able to appeal the court’s decision.
The bankruptcy court held a hearing on the disclosure statement and determined that the plan was “facially unconfirmable” because it was not proposed in good faith and was not feasible. The court further determined that the debtors would be unable to propose a confirmable plan. The court therefore converted the debtors’ case to Chapter 7. The debtors appealed to the district court, which affirmed the bankruptcy court.
On appeal, the Third Circuit addressed three issues raised by the debtors: (1) whether, as a procedural matter, the bankruptcy court erred in finding the fifth plan to be unconfirmable without first holding a confirmation hearing; (2) whether the bankruptcy court substantively erred in finding that the fifth plan was “patently unconfirmable;” and (3) whether the bankruptcy court abused its discretion in converting the Chapter 11 case to Chapter 7.
Determining Confirmability at the Disclosure Statement Stage
On the first issue, the Third Circuit held that, based upon the court’s inherent power to control its docket, the bankruptcy court had authority to determine whether the plan was confirmable at the disclosure statement stage when it was obvious that a confirmation hearing would be futile because the plan, as described in the disclosure statement, was “patently unconfirmable.” However, the court cautioned that the bankruptcy court must “ensure that due process concerns are protected” by, inter alia, “providing sufficient notice to plan proponents, and taking care to not prematurely convert a disclosure statement hearing into a confirmation hearing.”2 This case raised no such due process concerns because the bankruptcy court’s disclosure statement hearing had been lengthy and thorough and the order that scheduled the disclosure statement hearing had notified the plan proponents that the issue of confirmability would be considered at that hearing.
‘Patently Unconfirmable’ Plan
The second issue addressed by the Third Circuit was whether the bankruptcy court erred in finding that the fifth plan was “patently unconfirmable.” The court held that a plan is patently unconfirmable “where (1) confirmation ‘defects[cannot] be overcome by creditor voting results’ and (2) those defects concern matters upon which all material facts are not in dispute or have been fully developed at the disclosure statement hearing.’”3 In order to be confirmable, a plan must satisfy various requirements, including that the plan is “feasible” and “proposed in good faith.” The court found that the fifth plan was patently unconfirmable because, on its face, the plan was not feasible and not proposed in good faith.
The Plan Was Not Feasible
A plan is feasible when it is not likely to be followed by liquidation or the need for further financial reorganization, unless such liquidation or reorganization is proposed in the plan.4 The plan needs to be reasonably likely to succeed. If a plan’s success hinges on speculative or uncertain litigation, the plan will not be deemed feasible.
The fifth plan’s sole source of funding was the surcharge. The ability to fund the plan payment fund (and pay other creditors), was highly speculative because it depended upon on (i) whether the asbestos claimants would opt into the CADP, (ii) whether their claims were successful and (iii) whether the percentage allocated from those recoveries would be adequate to generate enough funds to pay creditors. Furthermore, most of the asbestos claims against Skinner had been administratively dismissed. Therefore, the plan was not feasible. Moreover, because Skinner admitted that the plan could not be funded without the surcharge, it was clear that the feasibility defect could not be cured.
The Plan Was Not Proposed in Good Faith
The court next addressed whether the plan was proposed in good faith. Preliminarily, the court distinguished the issue addressed on appeal from the issue that the court had considered at an earlier stage, when the insurers had sought dismissal of the case on the grounds of bad faith:
“A prior determination that a bankruptcy petition was filed or proceeded in good faith does not necessarily preclude a later inquiry into whether a plan under that petition is proposed in good faith for purposes of confirmation. The question of whether a Chapter 11 bankruptcy petition is filed in good faith is a judicial doctrine, distinct from the statutory good faith requirement for confirmation pursuant to §1129(a)(3) … It might be that a bankruptcy case which is filed and proceeds in good faith nevertheless results in a plan that does not fairly achieve a result consistent with the objectives and purposes of the Bankruptcy Code. Furthermore, information affecting the good faith determination might be added to the record throughout the process leading up to confirmation.”5
The court stated that a plan is said to have been proposed in good faith when the plan will fairly achieve a result consistent with the objectives and purposes of the Bankruptcy Code, mainly to preserve the going concern and maximize property to satisfy creditor claims. The court found that the plan was not proposed in good faith for three reasons.
First, as Skinner was no longer operating as a going concern and had no assets other than the insurance policies, implementing the surcharge provision was the only way in which the plan could be financed and other creditors could be paid. Skinner’s involvement in the asbestos claim proceedings would create an inherent conflict of interest for Skinner because Skinner would be financially incentivized to sabotage its own defense in order to maximize the surcharge, thereby breaching its contractual duty to cooperate with the insurers.
Second, the plan greatly limited the insurers’ ability to defend the asbestos claims, as it disallowed the insurers’ ability to take discovery, submit evidence, contest causation or appeal decisions.
Finally, the only benefit of the CADP was the ability for claimants to pursue claims directly through the CADP rather than through the courts. Skinner’s attempt to analogize the CADP to a trust established under §524(g) of the Code was flawed because such a trust is usually funded, in part, by securities and payments contributed by the debtors; this plan did not provide for the debtors to make any contributions to the trust. Instead, the plan authorized the debtors to withdraw funds to pay attorneys and creditors. Skinner failed to show that further discovery or creditor voting would enable it to repair the plan’s lack of good faith.
Conversion to Chapter 7
Lastly, the court addressed whether the bankruptcy court abused its discretion in converting Skinner’s case to Chapter 7. The court held that cause to convert exists when there is no reasonable possibility of successful reorganization within a reasonable period of time. The bankruptcy court properly found that, after proposing five unconfirmable plans, it was unlikely that Skinner would be able to propose a confirmable plan. The debtors’ repeated unsuccessful plan confirmation attempts had generated huge administrative expenses and there was little chance that the debtors would be able to come forward with a workable plan. Therefore, the bankruptcy court did not abuse its discretion in converting the case to Chapter 7.
While Am. Capital Equip. may be the first circuit court decision to expressly hold that a bankruptcy court can determine the confirmability of a Chapter 11 plan at the disclosure statement stage, the decision is not surprising. It was well settled among lower courts that a bankruptcy court is authorized to determine at the disclosure statement stage that a plan as proposed cannot be confirmed.6 When a plan is facially unconfirmable, the court should not waste judicial resources and administrative expenses by sending the disclosure statement to creditors or initiating ballot procedures to vote on the plan. In a large Chapter 11 case with hundreds or thousands of creditors, disseminating the disclosure statement and soliciting votes can cost a lot of money. The Third Circuit’s holding in Am. Capital Equip. ratified what many bankruptcy judges were already doing – disapproving facially flawed reorganization plans at the disclosure statement stage.
However, the Third Circuit cautioned that a bankruptcy court should not make a decision on plan confirmability at the disclosure statement stage without affording adequate notice to the plan proponents that confirmability issues will be considered and affording the proponents an opportunity to have an adequate hearing on those issues.
The Am. Capital Equip. decision is also noteworthy because of the court’s holding that, even where a bankruptcy court has determined that a Chapter 11 case was filed in good faith and has proceeded in good faith, the court is not precluded from subsequently determining that a plan filed in that case was not proposed in good faith.