Junior Claims Paid Ahead of Seniors in a Section 363 Sale
Reprinted with permission from the December 4, 2015 edition of The Legal Intelligencer. © 2015 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. (ALMReprints.com, 877.257.3382).
The U.S. Bankruptcy Code contains carefully created priority rules that dictate the order in which claims are entitled to be paid. For example, secured creditors have the right to be paid from the proceeds of their collateral, and claims incurred during bankruptcy generally must be paid ahead of all other creditors. Prepetition, general unsecured creditors, although not at the very bottom of the ladder, typically cannot be paid until secured, administrative and priority creditors are paid first. As a result, it is often difficult to enlist the support of unsecured creditors during the case when there are no funds to pay them. To solve this dilemma, bankruptcy professionals have devised a number of schemes to side-step the strict bankruptcy waterfall payment rules that otherwise would control. The U.S. Court of Appeals for the Third Circuit decision in In re ICL Holding, 802 F.3d 547 (3d Cir. Del. 2015), aff'g sub nom United States v. LCI Holding (In re LCI Holding), 519 B.R. 461 (D. Del., 2014), represents one of the more creative workarounds to date.
In ICL Holding, a Section 363 sale of substantially all of the debtors' assets was approved despite being predicated upon a settlement in which the secured lender/purchaser gifted funds to general unsecured creditors, while the claims of more senior creditors went unpaid, and further, paid certain administrative claims, while not providing for others. On its face, this settlement arguably afforded payment in violation of the priority of payment procedures established under the Bankruptcy Code. For example, the settlement appears to conflict with the "absolute priority rule," which is the rule of "vertical equity" prohibiting payment of junior creditors until more senior creditors are paid or allocated value in full. In addition, it appears to run counter to the "horizontal equity" required under the Bankruptcy Code, which requires that creditors of the same priority receive proportionally equal distributions of estate property.
As mentioned, the settlements and payments were all made in connection with a Bankruptcy Code Section 363 sale, which allows a debtor to sell substantially all of its assets outside of a bankruptcy plan of reorganization. Section 363 sales are increasingly employed in modern bankruptcy practice to bring an expeditious and efficient resolution to a bankruptcy case without needing to confirm a plan. Due to the upside-down nature of the capital structure in nearly every expedited Section 363 sale case, unsecured creditors frequently face limited to no recovery under the Bankruptcy Code's distribution rules. As a result, the creditors' committee will vigorously challenge the sale process as a thinly veiled foreclosure designed solely for the benefit of the secured creditor. As a means to mollify those objections, secured creditors are increasingly "gifting" funds to the unsecured creditors. Through its ruling, the Third Circuit has provided its imprimatur to such gifting where the assets gifted are not "estate assets."
By way of factual background, prior to the bankruptcy filing, the debtors operated long-term acute care hospitals and owed approximately $355 million to their secured lenders. In light of ongoing financial difficulty, the company sought to either restructure its balance sheet or engage in a sale transaction. The hospitals were unable to reach a restructuring agreement with their creditors and unable to find a purchaser willing to pay more than the secured debt. The secured lenders thus decided to purchase the company through a Section 363 sale, by which the secured lenders would acquire the debtors' assets by "credit bid." With the asset purchase agreement in place, the hospitals filed for bankruptcy. Pursuant to the proposed sale agreement, the secured lenders would acquire the assets by a credit bid representing approximately 90 percent of the secured debt. As structured, the debtors would receive no cash from the deal.
The result of the sale would leave no funds to satisfy the administrative expenses incurred during the bankruptcy cases. The secured lenders therefore agreed to provide a set amount of cash funding into separate escrow accounts for certain wind-down costs, including the fees and expenses of the professionals for the debtors and the official committee of unsecured creditors. The committee nevertheless objected to the sale, since unsecured creditors would receive nothing if the credit bid was approved. To resolve that objection, the secured lenders agreed to deposit $3.5 million in trust for the benefit of the general unsecured creditors.
The bankruptcy court approved the sale and the secured lenders' direct payment of the (1) escrow for the professional fees and expenses and certain other wind-down case costs and (2) the $3.5 million into trust for distribution to holders of allowed general unsecured claims. Bankruptcy court approval occurred despite objection by the Internal Revenue Service, which argued that it held an administrative expense tax claim in the amount of approximately $24 million that would go unpaid, notwithstanding the fact that certain administrative claims were to be paid and that general unsecured creditors were to receive a distribution.
The IRS requested a stay of the sale, which was denied. The sale closed and the senior lenders paid the settlement funding into escrow. The IRS appealed and argued that the approved distributions were impermissible because they favored creditors with an equal (the administrative costs) or lesser (the unsecured claims) priority and therefore violated the distribution scheme under the Bankruptcy Code.
As an initial matter, the Third Circuit ruled that the appeal was neither constitutionally, statutorily, nor equitably moot, principally because through the appeal the IRS did not seek to upset and avoid the sale itself, but rather sought to avoid the distribution of the escrowed amounts. On the merits, the Third Circuit upheld the bankruptcy court's approval of the sale and settlement. The Third Circuit found that neither of the two payments from the secured lenders went into or came out of the bankruptcy estate. As non-estate property, the funds therefore were not subject to the Bankruptcy Code's distribution provisions and the secured lenders were free to distribute their funds as envisaged by the settlements as approved by the bankruptcy court.
With respect to the $3.5 million payment to unsecured creditors to resolve the committee's objection, the court found that the funds were never part of the estate and were not paid at the direction of the debtors. The funds were paid directly by the lenders rather than from lien proceeds arising from the debtors' property and, therefore, were not part of the estate. The court also rejected the idea that the funds became a part of the estate as a pass-through.
The Third Circuit found that with respect to the funds used for professional fees and other wind-down costs, they were also direct payments made by the lenders and not payments from the estate. The court further noted that the direct payment was different than a carve-out from the lenders' collateral, noting that payment from a carve-out would have suggested that it was from estate property.
The court concluded that the rules forbidding equal-ranked creditors from receiving disparate treatment and lower-ranked creditors from being paid before higher priority creditors were not disturbed by the secured lenders' distribution of non-estate property. The implications of this decision remain to be seen, but it likely portends an ever-increasing reliance on the use of Section 363 sales and ought act as caution to holders of bankruptcy administrative and other priority claims that they cannot assume their claims will be paid prior to lower ranked or even similarly situated claims.
This case provides yet another path to enable debtors and secured creditors to utilize the Section 363 process to cleanse assets without strictly following the Bankruptcy Code's priority rules. Careful structuring of a deal before bankruptcy, at least in the Third Circuit, should help to neutralize many of the roadblocks to an expedited sale closing. The positive side is that more operating businesses may be saved by eliminating objections that would otherwise prolong the sale process. The negative is that the relevance of a Chapter 11 plan and its general creditor protections, at least in the current economic environment, is fading.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.
Content contributed by attorneys of Troutman Sanders LLP and Pepper Hamilton LLP prior to April 1, 2020, is included here, together with content contributed by attorneys of Troutman Pepper (the combined entity) after the merger date.