Lesson for the Juniors: Beware of Senior Creditors Bearing Gifts
 
April 9, 2007
 

In order to obtain confirmation of a consensual plan of reorganization in a bankruptcy case, senior creditors often agree to give up some of their distribution to junior classes in order to ensure the junior creditors’ cooperation on the plan. These plans are sometimes called “gifting” plans. Similarly, settlement agreements often provide for senior creditors giving up some of their distribution (or their collateral, if the creditors’ claims are secured) to junior creditors. In this regard, the Third Circuit has held that a “gifting” plan providing for a senior class of unsecured creditors to give part of their distribution to equity, when junior classes of unsecured creditors were not getting paid in full, violated the absolute priority rule and could not be confirmed. See In re Armstrong World Indus., Inc., 432 F.3d 507 (3d Cir. 2005).¹

This view, however, is not universally held. The Bankruptcy Court for the Southern District of New York has held that a plan that provided for classes of senior and junior bondholders to gift a portion of their recovery to members of the Ad Hoc Committee of Trade Creditors (which were in one class), while giving nothing to other unsecured creditors, did not violate the absolute priority rule and did not unfairly discriminate because the amounts gifted by the bondholders are not the result of the debtors’ distribution of estate property to such creditors, but simply one creditor giving some of its distribution to another creditor. See In re WorldCom, Inc., 2003 WL 23861928 (Bankr. S.D.N.Y. 2003). As the court noted, “[c]reditors are generally free to do whatever they wish with the bankruptcy dividends they receive, including sharing them with other creditors, so long as recoveries under the Plan by other creditors are not impacted.” Id. at *61 (citing Official Unsecured Creditors’ Comm. v. Stern (In re SPM Mfg. Corp.), 984 F.2d 1305, 1313 (1st Cir. 1993). The WorldCom court also cited to In re MCorp Fin., Inc., 160 B.R. 941, 960 (S.D. Tex. 1993), for the proposition that the contributing creditor need not be a secured creditor. In MCorp, the court confirmed a plan in which senior bondholders gifted a portion of their recovery to the FDIC, which was involved in litigation with the debtor, while junior bondholders (senior to the FDIC) were not being paid in full. MCorp, 160 B.R. at 960 (“The seniors may share their proceeds with creditors junior to the juniors, as long as the juniors continue to receive at least as much as what they would without the sharing.”). MCorp also stated that the decision in SPM did not depend on the secured status of the contributing creditor, but only on its priority. Id. (“That the creditor was secured is not relevant; it was the creditor’s status as prior to the IRS that allowed it to share with those under the IRS, just as the seniors’ priority over the juniors allows them to fund the FDIC settlement.”).

 

The Absolute Priority Rule: When Does It Apply?

The Second Circuit Court of Appeals recently addressed this issue with respect to settlement agreements that do not follow the absolute priority rule. See In re Iridium Operating LLC, 2007 WL 642590 (2d Cir. March 5, 2007). The bankruptcy and district courts had approved a settlement between the Official Committee of Unsecured Creditors, which had challenged the liens held by a consortium of lenders represented by JPMorgan Chase Bank, N.A. (Lenders). The settlement, inter alia, conceded the liens. Under the settlement, the Lenders would receive a large upfront cash payment (out of cash held by the debtor), but would also contribute $37.5 million out of the debtor’s cash to a litigation trust to fund litigation (the Motorola Litigation) against Motorola, Iridium’s former parent and a major administrative and unsecured creditor, with the balance, if any, going to unsecured creditors. In addition, a substantial portion of the recovery, if any, from the Motorola Litigation would go to the litigation trust for distribution to unsecured creditors. Motorola argued that the settlement violated the absolute priority rule because junior creditors would be receiving a distribution before Motorola. Relying on SPM, the lower courts rejected Motorola’s argument, finding that the settlement agreement dealt with funds that belonged to the Lenders and not to the bankruptcy estates. Consequently, the settlement did not implicate let alone violate the absolute priority rule.

As a preliminary matter, the Second Circuit disagreed with the lower courts, holding that SPM did not apply because in SPM the validity and priority of the liens of the lenders were not in dispute when those lenders agreed to give some of their recovery to a junior class. In Iridium, however, the Lenders claimed liens were contested and the settlement agreement was the mechanism for perfecting and validating the Lenders’ liens. Accordingly, until the settlement agreement was approved, the monies held by the Lenders was an asset of the bankruptcy estate.

The Second Circuit continued and held that the appropriate analysis starts with considering whether the settlement agreement satisfies the six-part test that has evolved for approving settlements under Federal Rule of Bankruptcy Procedure 9019:

(1) the balance between the likelihood of success in the litigation compared to the present and future benefits offered by the settlement, (2) the prospect of complex and protracted litigation with its attendant expense, inconvenience, and delay, and the difficulties associated with collection of any judgment, (3) the paramount interests of the creditors, which includes the relative benefits to be received by members of any affected class and the degree to which creditors either do not object to or affirmatively support the proposed settlement, (4) the degree to which the settlement is supported by other parties in interest and the competency and experience of counsel who support the settlement, (5) the nature and breadth of releases to be obtained by officers and directors, and (6) the extent to which the settlement is the product of arm’s length bargaining.

In re Worldcom, Inc., 347 B.R. 123, 137 (Bankr. S.D.N.Y. 2006) (citing Nellis v. Shugrue, 165 B.R. 115, 122 (S.D.N.Y.1994)).

The reviewing court must then add the factor of whether the absolute priority scheme has been violated. Although this additional factor would be the most important consideration, it would not be the only one and thus a settlement that violated the absolute priority rule could still pass muster if the other factors weighed in its favor. In Iridium, the Second Circuit found that while all of the Rule 9019 factors (except, of course, factor no. 5) weighed in favor of the settlement terms (in particular, the settlement had the approval of all parties in interest except Motorola), the creditors’ committee and the Lenders had failed to explain why the balance of the original $37.5 million, as well as the recovery from the Motorola Litigation, should go directly to unsecured creditors, rather than being distributed according to the absolute priority rule. The Second Circuit, however, did not condemn settlements that violated the absolute priority rule, but instead remanded the case for clarification of the justification for the funds going directly to unsecured creditors, skipping more senior classes.

The lesson is obvious – if you are going to craft a settlement that looks like it may violate the absolute priority rule, be prepared to show why such violation is necessary.

 

For more information, e-mail Peter A. Zisser at peter.zisser@hklaw.com  or call toll free, 1-888-688-8500.

¹ The decision in In re Armstrong World Indus., Inc. has been interpreted by the Bankruptcy Court for the District of Delaware as applying only to the gifting by senior unsecured creditors to junior unsecured creditors, not to gifting by senior secured creditors. See In re World Health Alternatives, Inc., 344 B.R. 291 (Bankr. D. Del. 2006).

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