On the Edge
Mikels, Richard E
In re Iridium Operating LLC and its Impact on SPM Carve-out Arrangements
Settlements within a bankruptcy case are routine and often lead to resolutions of critical issues in the case that can pave the way for a consensual and effective reorganization plan. A settlement in a bankruptcy case, however, is not solely within the purview of the disputing parties to agree upon; a settlement must obtain the approval of the bankruptcy court after proper notice to parties in interest and review. Fed. R. Bankr. P. Rule 9019. For a settlement that is entered into prior to plan confirmation, the second Circuit Court of Appeals in Motorola Inc. v. Official Comm. of Unsecured Creditors, et al. (In re Iridium Operating LLC), 478 F.3d 452 (2007), recently announced that, in evaluating a Rule 9019 motion to approve a pre-plan settlement, the court must give primary, but not sole, consideration to whether the settlement is “fair and equitable” and in accord with the priority scheme of the Bankruptcy Code. This decision may provide greater judicial discretion in approving pre-plan settlements than the rule previously articulated by the Fifth Circuit Court of Appeals in United States v. AWECO Inc. (In re AWECO Inc.), 725 F.2d 293 (5th Ck. 1984). However, both the Iridium and the AWECO decisions may make the viability of an SPM-type carveout in a chapter 11 proceeding more tenuous.
“Fair and Equitable” and SPM Carve-Out Arrangements
Before we can adequately discuss the Iridium decision and the standards articulated by the second Circuit on Rule 9019 pre-plan settlements, we must first explore the parameters of the phrase “fair and equitable” as well as the establishment of SPM-type carve-out arrangements. By statute, the requirement of “fair and equitable” relates to chapter 11 reorganization plans. In order for a reorganization plan to be confirmed, the plan proponent must establish that the plan meets all of the applicable requirements of § 1129 of the Code. If not all of the impaired classes vote to accept a proposed plan pursuant to §1129(a), then §1129(b) provides the procedures by which a plan may be confirmed notwithstanding the objection of an impaired class of creditors or interests through a mechanism known as “cramdown.” A plan may be confirmed under §1129(b) so long as all of the requirements of § 1129(a), except subsection (8), are satisfied and “if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.” 11 U.S.C. §1129(b)(1).
The Bankruptcy Code expressly defines “fair and equitable” as it relates to secured claims, unsecured claims and interests. With respect to unsecured claims, § 1129 (b)(2)(B),aplanmay be crammed down if either: (1) the holders of claims receive or retain on account of such claims, property of a value, as of the effective date of the plan, equal to the allowed amount of such claim; or (2) the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest in any property. 11 U.S.C. §1129(b)(2)(B). This provision codifies the judicially created “absolute priority rule,” which provides that any plan that equity holders are preferred before the debtor’s creditors, is invalid.1
The absolute priority rule and other rules of priority, however, are not always absolute. The decision of the First Circuit Court of Appeals in the Official Unsecured Creditors’ Comm. v. Stern (In re SPMMfg. Corp.), 984 F.2d 1305 (1st Cir. 1993), is the leading case involving voluntary redistribution of recoveries from a senior class of creditors to a junior class of creditors. In SPM, the undersecured bank that held a lien on substantially all of the debtor’s assets had filed a motion for relief from the automatic stay in order to pursue its foreclosure of its secured collateral. The bank’s motion for relief was met with objections from the debtor and the creditors’ committee. The bank, apparently concerned that delay in realization upon its collateral would cause a loss of value, sought out an arrangement with the creditors’ committee in order to “gain an ally” in the battles over relief from stay.2 The arrangement contemplated a sharing of the proceeds of the bank’s collateral between the bank and the unsecured creditors, whether it occurred in the context of a chapter 11 plan or a chapter 7 liquidation. One major impediment existed, however: If the funds were shared between the bank and the estate, the funds going to the estate would be paid first to the priority tax claims and nothing would be available for the unsecured creditors, the very constituency of the creditors’ committee. As a result, the creditors’ committee and the bank structured an arrangement the funds that were to be carved out would be paid directly to the creditors’ committee for distribution to the unsecured creditors and not be run through the estate. By the time the arrangement was formerly brought before the bankruptcy court, SPM had been converted from chapter 11 to chapter 7.
Because the arrangement in SPM did not provide for the Internal Revenue Service (IRS), a priority claimant, both the bankruptcy court and district court denied approval of the arrangement and reasoned that such an arrangement would have resulted in “an end-run around” the Code’s priority scheme. The appeals court reversed, holding that because the SPM estate had no right to share in the proceeds of the lender’s collateral since the lender was undersecured and the validity of the lender’s liens were not disputed, the court had no basis under the Code to order the secured lender to pay a portion of its own claim proceeds to the estate. SPM, 984 F.2d at 1315. In its ruling, the First Circuit emphasized that because the lender was undersecured, the 1RS would not have received any distribution under the Code’s priority scheme. Id. at 1312.
Some courts have extended the SPM holding to chapter 11 cases involving reorganization plans.3 Other courts, however, have distinguished SPM in the context of a chapter 11 plan and further distinguished those cases holding that an SPM carve-out is in fact permissible in the context of a chapter 11 plan.4 These cases hold that an SPM carve-out constitutes an impermissible violation of the absolute priority rule or other restrictions on distribution required by § 1129.
Settlements and the Absolute Priority Rule
A settlement agreement proposed in conjunction with a reorganization plan must also adhere to the absolute priority rule. see TMT Trailer Ferry, 390 U.S. 414, 423 (1968). The Supreme Court reasoned that it is the duty of the bankruptcy court “to determine that a proposed compromise forming part of a reorganization plan is fair and equitable.” TMT Trailer Ferry, 390 U.S. at 423.
Settlements of disputes, however, do not only occur at the time a plan proponent is seeking plan confirmation. Often a settlement occurs prior to plan confirmation or is necessary to formulate a confirmable plan. In addition, many cases these days are commenced as §363 sale cases that often result in a conversion to chapter 7 or dismissal, rather than a reorganization plan. Because a settlement may be presented to the court for review at any time and not necessarily in conjunction with a proposed plan, such settlement may not be subject to the absolute priority rule while at the same time seriously altering the priority scheme that would be required for confirmation of a plan. Rule 9019 of the Federal Rules of Bankruptcy Procedure governs the approvals of settlements and its “clear purpose [is]…to prevent the making of concealed agreements which are unknown to the creditors and unevaluated by the Court.” In re Masters Inc., 141 B.R. 13,16 (Bankr. E.D.N.Y. 1992).
Rule 9019 does not have a related statutory provision in the Code to provide the standard of review for settlements. In the absence of statutory guidance for evaluating settlements, many courts have looked to TMT Trailer Ferry for guidance in evaluating whether a settlement is fair and equitable in the context of a Rule 9019 settlement. The Supreme Court in TMT Trailer Ferry articulated the framework for determining whether a settlement is fair and equitable. The Court provided that prior to approval of a settlement, the bankruptcy judge must know all relevant facts to assess the probabilities of outcome of the dispute. In addition, the Court held that the bankruptcy court judge “should form an educated estimate of the complexities, expense and likely duration of such litigation, the possible difficulties of collecting on any judgment which might be obtained, and all other factors relevant to a full and fair assessment of the wisdom of the proposed compromise with the likely rewards of litigation.”5
Pre-Plan Settlements and the Requirement of “Fair and Equitable”
The question whether pre-plan settlements must also be “fair and equitable” in the context of the priority scheme of the Code has been addressed by two appeals courts. The Fifth Circuit Court of Appeals first addressed this question in United States v. AWECO Inc., (In re AWECO Inc.), 725 F2d 293 (5th Cir. 1984), in which the debtor filed a reorganization plan but never presented it to creditors for approval. During its chapter 11 proceedings, AWECO settled with its creditor, United American Car Co. arising out of AWECO’s multimillion dollar contract with United to purchase railroad cars from United. The settlement agreement required AWECO to transfer to United $5.3 million worth of cash and property, including property that was secured by Sutton Investments, a judgment lienholder, and the 1RS as a statutory lienholder. When the settlement agreement was filed with the bankruptcy court, various parties in interest objected to the agreement, arguing that the settlement was not fair to creditors other than United and that there was no record to establish that United would receive as much as $5.3 million in distribution as an unsecured creditor in the bankruptcy proceedings. The bankruptcy court approved the settlement and found that the settlement was “fair and equitable” and “in the best interests of the Debtor, its estate, and its creditors.” The district court affirmed the bankruptcy court’s ruling and “concluded that, because testimony at the earlier hearings indicated that a settlement with United would give the debtor its only chance at reorganization, the settlement benefited all creditors.” AWECO, 725F.2dat297.
On appeal, the appeals court vacated and remanded the decision and held that the bankruptcy court had not considered sufficient factual information to determine if the settlement was fair and equitable to all creditors. In applying the requirement that the settlement must be “fair and equitable” to any objecting senior creditors, the court reasoned that “as soon as a debtor files a petition for relief, fair and equitable settlement of creditors’ claims becomes a goal of the proceedings. The goal does not suddenly appear during the process of approving a plan of confirmation.” Id. at 298. The AWECO court left no discretion to the bankruptcy judge and held that with pre-plan settlements, just as with a reorganization plan, the bankruptcy judge would abuse his or her discretion in approving a settlement with a junior creditor unless the court concludes that the priority of payments under the Code will be respected as to objecting senior creditors. Id.
Earlier this year, the second Circuit Court of Appeals suggested that the Fifth Circuit’s decision in AWECO employed a too-rigid test in its holding that a bankruptcy court would abuse its discretion in approving pre-plan settlements that did not strictly adhere to the absolute priority rule. see Motorola Inc. v. Official Comm. of Unsecured Creditors (In re Iridium Operating LLC), 478 F.3d 452 (2d Cir. 2007). The second Circuit rejected AWECO’s per se rule and held that in evaluating a Rule 9019 pre-plan settlement, the primary (but not sole) factor the bankruptcy court must consider is whether the settlement is “fair and reasonable” in that it respects Code’s priority scheme for distribution of estate assets. In Iridium, the unsecured creditors’ committee explored pursuing litigation to challenge the liens of the debtor’s secured lenders and to pursue claims against the debtor’s former parent company and creditor, Motorola. In recognition of the limited resources to pursue extensive and complex litigation against both the lenders and Motorola, the committee reached an agreement with the lenders, and they jointly sought court approval of a proposed pre-plan settlement. The agreement acknowledged that, upon court approval of the settlement agreement, the lenders’ liens are senior, perfected and unavoidable and not subject to offsets, defenses, claims or counterclaims. In addition, the settlement was to divide the estate’s remaining assets into three separate traunches, with certain funds being distributed into a newly-created limited liability company (LLC).
The LLC was created specifically to fund the anticipated litigation against Motorola and a majority of any recovery on the litigation against Motorola would be used to fund a reorganization plan, with administrative creditors taking priority. A minority of the recoveries would be paid directly to the lenders. After the litigation concluded, any remaining monies in the LLC were to be paid directly to the unsecured creditors, which would have included Motorola.
Motorola claimed Iridium owed it approximately $1.3 billion under various agreements, including approximately $700 million in administrative expenses. Motorola objected to the settlement with the lenders because it proposed the transfer of estate assets to the LLC and from the LLC to unsecured creditors after the conclusion of the litigation against Motorola. Motorola argued that the settlement could never be fair and equitable if the claims of junior creditors were satisfied before those ofsenior creditors (including Motorola’s administrative expense claim).
The bankruptcy court approved the settlement over the objection of Motorola. On appeal to the second Circuit, the court held that the settlement carve-out for unsecured creditors did not fall into the footprint of 5PM because, unlike 5PM, the determination that the lenders held a firstpriority security interest in the debtor’s assets was contingent upon the entry of the order approving the settlement. Even though Motorola did not question the validity and perfection of the lenders’ liens, Motorola argued that until the order approving the settlement was entered, there remained considerable doubt as to whether the liens were avoidable based on the committee’s pre-settlement allegations challenging the lenders’ liens. The court distinguished Iridium from 5PM because in Iridium, the lenders’ liens were not absolute until the court approved the settlement; the lenders, therefore, did not have an indefeasible right to transfer their interest in the collateral to a lower class of creditors contrary to the absolute priority rule. In providing that SPM was not applicable, the court reasoned that the appropriate review of the settlement would be pursuant to Rule 9019.
The Iridium decision also recognized the challenges in applying a per se rule that all pre-plan settlements must adhere to the absolute-priority rule. Iridium acknowledged that settlements often occur at a time when the full nature and extent of the debtor’s assets and liabilities are not known and that “a rigid per se rule cannot accommodate the dynamic status of some pre-plan bankruptcy settlements.” Iridium, 478 F.3d at 464.
In consideration of the often complex nature of pre-plan settlements, the court in Iridium held that when considering pre-plan settlements, whether a settlement adheres to the absolute priority rule “must be the most important factor for the bankruptcy court to consider when determining whether a settlement is ‘fair and equitable.'” Id. Accordingly, the Iridium decision returned some amount of judicial discretion when evaluating pre-plan settlements that may not completely adhere to Code’s priority scheme. The court cautioned that in rejecting a per se rule, a bankruptcy court evaluating settlements must carefully consider whether any settlement is the product of improper collusion.
The interesting element of Iridium is in its recognition of the complexities of preplan settlements that often are critical to the ability to formulate a reorganization plan. The court held that a bankruptcy court may use its discretion to approve a settlement that did not comply with the absolutepriority rule if the settling parties are able to justify the noncompliance and the bankruptcy court identifies the reasons for deviating from the Code’s priority scheme. In Iridium, because the settling parties had failed to justify the settlement’s proposed distribution of any balance left in the LLC to junior creditors, in apparent violation of the Code’s priority scheme, the second Circuit vacated and remanded, instructing the bankruptcy court to evaluate the facts and bases for any justification for such distribution.
Indium’s Implications for SPM Carve-out Arrangements
The holding in Indium may place the viability of an 5PM carve-out within a chapter 11 case in further doubt. The viability of an SPM carve-out in the context of a chapter 11 reorganization plan was previously put in doubt as a result of the Third Circuit decision in In re Armstrong. Armstrong denied an SPM carve-out in a plan context; however, rather than disapproving of SPM and its progeny, the court reasoned that those cases that have allowed carve-outs in a settlement or plan context are distinguishable from Armstrong. In rejecting a carve-out in Armstrong, the court reasoned that the plain meaning of the phrase “fair and equitable” under 11 U.S.C. §1129(b)(2)(B)(ii) was unambiguous and did not leave discretion to the bankruptcy judge to confirm a plan under which a junior creditor would receive a distribution over the objection of a senior creditor that did not receive satisfaction of its claim. In re Armstrong, 423 F.3d at 514.6
Although Armstrong can be distinguished from SPM, its rejection of a chapter 11 plan that contravenes the absolute priority rule limits the likelihood of an SPM carve-out’s successfully approved as part of a chapter 11 reorganization plan. Likewise, the Iridium decision makes less likely the approval of an SPM carve-out as part of a pre-plan settlement since it requires that the primary consideration for courts to consider is whether the arrangement is in accord with the absolute priority rule. Iridium, 478 BJl. at 464. It seems that the developing trends indicate that the best opportunity for an SPM-type carve-out is in the context of a chapter 11 case that has no prospect of reorganization so that 11 U.S .C § 1129(b)(2)(B)(ii) is not directly implicated. This was the scenario in the post-Armstrong case of In re World Health Alternatives from the district of Delaware. see In re World Health Alternatives, 344 B.R. 291 (Bankr. D. Del. 2006).
In World Health, the debtor commenced a chapter 11 case in order to sell substantially all of its assets. Within the case, the debtor, creditors’ committee and lender entered into a global settlement to resolve disputes relating to the DIP financing and a motion to sell substantially all of the debtor’s assets. The settlement provided an SPM-style carve-out for the benefit of general unsecured creditors, even though there were priority tax creditors that would likely not be satisfied. The U.S. Trustee filed an objection to the settlement, arguing that the settlement violated the absolute priority rule in contradiction of the Third Circuit’s decision in Armstrong. By the time the settlement was before the court for final hearing, the U.S. Trustee had filed a motion to convert the case to one under chapter 7. No one objected to the conversion; however, the debtor and committee requested that the court only rule on the conversion after the court ruled on the settlement. In allowing the settlement, the court recognized that the funds subject to the carve-out do not belong to the estate, but rather they belong to the lender. The court reasoned that this case was distinguishable from Armstrong because “Armstrong dealt with a plan of reorganization, thus implicating the absolute priority rule.” see World Health, 344 B.R. at 299.
Perhaps the lesson of Iridium is that with respect to a pre-plan settlement, there is limited flexibility and discretion on the part of the bankruptcy judge to allow a settlement “that does not comply in some minor respects with the priority rule.” Iridium, 478 F.3d at 465. In such a case, the proponents of the settlement must be prepared to establish a record that clearly articulates the reasons for deviating from the absolute priority rule. see id. A similar rule seems to be developing with respect to SPM carve-outs in the context of chapter 11 plans. SPM carve-outs have been approved as part of plans, but only in circumstances where courts upholding the requirements of the priority rules have been able to distinguish such cases on the facts. Therefore, it appears that SPM-type carve-outs in chapter 11 cases contemplating plans, and in the context of plans themselves, are discouraged, but some discretion remains to approve such settlements or plans based on the facts and circumstances of the particular case.
The current trend regarding SPM-type carve-outs as part of a chapter 11 plan is that such proposed plans are often (but not always) not confirmed. Further, an SPM carve-out as part of a Rule 9019 settlement is more likely to succeed if made in a chapter 11 case that contemplates conversion to chapter 7, rather than in a chapter 11 case that contemplates the confirmation of a chapter 11 plan. In addition, it should be noted that there cannot be an SPM carve-out arrangement within a filed chapter 7 case (rather than a case converted from chapter 11). This is because there is no creditors’ committee to negotiate for a carve-out, and a chapter 7 trustee owes a fiduciary duty to all creditors and must respect the priority of claims required by §726 of the Code. Therefore, an SPM carve-out is most likely to succeed if the arrangement is made in a chapter 11 case that is on the verge of conversion or is made prior to conversion, but enforcement is sought after conversion. Although there do not seem to be and hard-and-fast rules with respect to SPM carve-outs, the development of the case law suggests those situations in which likelihoods for success in obtaining an SPM-type carveout are becoming more apparent.
1 In re Armstrong World Indus. Inc., 432 F.3d 507 (3d CIr. 2005). In addition to the absolute priority rule, there are other rules governing priority of distribution in a bankruptcy or chapter 11 case. For example, priority claims are treated in Bankruptcy Code §1129(a)(9) for purposes of a plan, and generally must be paid in the statutorily required manner before nonpriority claims can be satisfied. section 726 governs distributions in a chapter 7 and sets forth concrete priority rules among priority and general unsecured claims (but only deals with estate assets after satisfaction of secured debt).
2 In preparing this article, the authors conferred with the creditors’ committee counsel, Attorney Eugene Berman, who graciously provided the authors with additional background information relating to the SPM case.
3 See, e.g.. In re MCorp FIn. Inc., 160 B.R. 941 (S.D. Tex. 1993), In re Genesis Health Ventures Inc., 266 B.R. 591 (Bankr. D. Del. 2001); In re Parke Imperial Canton, Ltd., 1994 WL 842777 (Banrtc. N.O. Ohio 1994).
4 See, o.g., In re Armstrong World Indus. Inc., 432 F.3d SOB (3rd Cir. 2005); In re OCA Inc., 2006 WL 3833929 (Bankr. E.D. La. 2006); In re Sentry Operating Co. of Texas Inc., 264 B.R. 850 (Bankr. S.O. Tex. 2001).
5 TMT Trailer Ferry, 390 U.S. at 424-425. Later decisions have applied the TMT Ferry Trailer framework into the following factors: (1) the balance between the litigation’s possibility of success and the settlement’s future benefits; (2) the likelihood of complex and protracted litigation with its potential for expense, inconvenience and delay and the difficulty in collection on the judgment; (3) the interests of the creditors and whether they object to or support the proposed settlement; (4) whether other parties in interest support the settlement; (5) the competence and experience of counsel who support the settlement and experience e and knowledge of the bankruptcy judge reviewing the settlement; (6) the nature and breadth of the officers’ and directors’ releases; and (7) the extent to which the settlement is the result of arms’ length bargaining. In re World Com Inc., 347 B.R. 123, 137 (Bankr. S.D.N.Y. 2006).
6 In addition, Armstrong recognized the rule that “if a plan is not consensual, a court may still confirm as long as the plan meets the other requirements of §1129(a), and ‘does not discriminate unfairly, and is fair and equitable’ as to any dissenting classes.” Armstrong, 423 F 3d at 511-512.
Richard E. Mikels
Mintz, Levin, Conn, Feiris, Glovsky
and Popeo, P.C.; Boston
Also Written by:
Adrienne K. Walker
Mintz, Levin, Cohn, Ferris, Glovsky
and Popeo, P.C.; Boston
About the Authors
Richard Mikels is a shareholder in Mintz Levin’s Boston office and chairman of its Bankruptcy, Restructuring and Commercial Law Section. Adrienne Walker is an associate in Mintz Levin’s Boston office in the Bankruptcy, Restructuring and Commercial Law Section.
Copyright American Bankruptcy Institute Dec 2007/Jan 2008
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