You Just Can't Give it Away

Cram-Down and the Fair and Equitable Requirement

A Chapter 11 plan can be confirmed by the bankruptcy court under either of two scenarios. The first is consensually. This means that all classes of creditors and shareholders have either accepted the plan, or are not “impaired” by it because the plan pays them in full or leaves their rights unchanged. By contrast, if a class of creditors or shareholders votes to reject a plan, it can be confirmed over the class's objection only if the plan satisfies the requirements of section 1129(b) of the Bankruptcy Code. Among these is the mandate that a plan “does not discriminate unfairly” and is “fair and equitable” with respect to dissenting classes of creditors and shareholders.

The Bankruptcy Code specifically details one of the prerequisites for a plan's treatment of a class of claims or equity interests to be “fair and equitable.” The requirement varies depending on whether the dissenting impaired class contains secured claims, unsecured claims, or interests. As relevant here, section 1129(b)(2) of the Bankruptcy Code provides that a plan is “fair and equitable” with respect to a dissenting impaired class of unsecured claims if, among other things, the creditors in the class are paid in full, or failing full payment, so long as no creditor of lesser priority, or shareholder, receives any distribution under the plan. This requirement is sometimes referred to as the “absolute priority rule.”

Section 1129(b)(2) has been the focus of considerable debate in the courts even though it expressly delineates the circumstances under which a plan satisfies the standard. The dispute has generally concerned one of two areas. The first pertains to the ability of a company's existing shareholders, even though creditor claims are not paid in full, to retain an ownership interest in a reorganized debtor by infusing new value into the debtor. Referred to as the “new value” exception or corollary to the absolute priority rule, this issue is outside the scope of our discussion. See, e.g., Bank of America Nat. Trust and Sav. Ass'n v. 203 North LaSalle, 526 U.S. 434 (1999) (ruling that, even if there is a new value corollary, “plans providing junior interest holders with exclusive opportunities free from competition and without benefit of market valuation fall within the prohibition of ' 1129(b)(2)(B)(ii)”).

Instead, we focus on whether section 1129(b)(2) allows a class of senior creditors voluntarily to cede a portion of its recovery under a plan to a junior class of creditors or shareholders. Although some courts have interpreted the statute to permit this practice, the Delaware district court recently ruled in Armstrong World Industries that it violates the absolute priority rule, as codified in section 1129(b)(2).

History of the Absolute Priority Rule

As noted, section 1129(b)'s “fair and equitable” requirement is rooted in the judicially created absolute priority rule. The U.S. Supreme Court first formally articulated this rule, originally referred to as the “fixed principle,” in 1913 in Northern Pacific Railway Co. v. Boyd, 228 U.S. 482 (1913), which involved an equity receivership of a railroad. In Boyd, the old stockholders and bondholders agreed to a plan of reorganization in 1896 pursuant to which the company was to be sold to a new company in which the old stockholders had rights. Boyd asserted an unsecured claim against the predecessor company that resulted in a judgment in 1896, and was revived in 1906. However, the old railroad's assets having been sold to the new company 10 years earlier, there were no longer any assets on which to levy an execution. Boyd accordingly sued to hold the new company responsible for the old company's debt to him. The Supreme Court ruled that the stockholders' receipt of property was invalid:

“[I]f purposely or unintentionally a single creditor was not paid, or provided for in the reorganization, he could assert his superior rights against the subordinate interests of the old stockholders in the property transferred to the new company. They were in the position of insolvent debtors who could not reserve an interest as against creditors … Any device, whether by private contract or judicial sale under consent decree, whereby stockholders were preferred before the creditor, was invalid.

“[I]n cases like this, the question must be decided according to a fixed principle, not leaving the rights of the creditors to depend upon the balancing of evidence as to whether, on the day of sale, the property was insufficient to pay prior encumbrances.” Id. at 502, 504.

Thus was established the “fixed principle” — a concept that later came to be known as the absolute priority rule. According to this precept, stockholders could not receive any distribution in a reorganization case unless creditor claims were first paid in full. The Supreme Court continued to apply this principle in equity receivership cases throughout the early 1900s, emphasizing that it should be strictly applied. See Kan. City Terminal Ry. Co. v. Cent. Union Trust Co. of N.Y., 271 U.S. 445 (1926); Kan. City S. Ry. Co. v. Guardian Trust Co., 240 U.S. 166 (1916).

In 1934, Congress amended the former Bankruptcy Act to introduce the words “fair and equitable” to bankruptcy nomenclature. Section 77B(f) of the Act provided that a plan of reorganization could be confirmed only if the bankruptcy judge was satisfied that the plan was “fair and equitable and does not discriminate unfairly in favor of any class of creditors or stockholders and is feasible.” The provenance of this restriction was none other than the “fixed principle.” As later expressed by the Supreme Court, “[t]he reason for such a limitation was the danger inherent in any reorganization plan proposed by a debtor, then and now, that the plan will simply turn out to be too good a deal for the debtor's owners.” See 203 N. LaSalle, 526 U.S. at 444. The “fair and equitable” requirement endured as part of Chapter X of the former Bankruptcy Act when Congress passed the Chandler Act in 1938. As applied, the absolute priority rule prohibited any distribution to the holders of junior interests if senior creditors were not paid in full. This was so even if senior creditors agreed to the arrangement. See Case v. Los Angeles Lumber Products Co., 308 U.S. 106 (1939).

Congress partially codified the absolute priority rule into the Bankruptcy Code in 1978. Section 1129(b)(2)(B)(ii), which applies only in a cram-down context, provides that a plan is not “fair and equitable” with respect to a dissenting class of unsecured creditors unless “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 any property.” Prior to the enactment of the Bankruptcy Code, the absolute priority rule prevented junior classes from receiving consideration at the expense of a senior creditor even if the majority of senior creditors agreed. Now, the rule only applies if the senior class does not vote to accept the plan. Thus, the rule would be an obstacle to confirmation only if a class of senior creditors is “impaired” by, for example, receiving less than full payment, the senior class votes to reject a Chapter 11 plan, and the Chapter 11 plan provides for some distribution to junior creditors or stockholders.

Gifting: A Controversial Interpretation of Fair and Equitable

Notwithstanding section 1129(b)(2) (B)(ii)'s preclusion of distributions to junior interests in cases where it applies, some courts have ruled that a plan does not violate the “fair and equitable” requirement if a class of senior creditors agrees that some of the property that would otherwise be distributed to it under the plan can be given to a junior class of creditors or shareholders. In doing so, many courts rely on a 1993 decision by the First Circuit Court of Appeals in Official Unsecured Creditors' Committee v. Stern (In re SPM Manufacturing Corp.), 984 F.2d 1305 (1st Cir. 1993).

In SPM, a secured lender holding a first priority security interest in substantially all of a Chapter 11 debtor's assets entered into a “sharing agreement” with general unsecured creditors to divide the proceeds that would result from the reorganization, apparently as a way to obtain their cooperation in the case. After it became apparent that the company could not be reorganized, the court appointed a receiver to market SPM's assets, which were ultimately sold for $5 million. Soon afterward, the secured creditor obtained relief from the automatic stay and the case was converted to a Chapter 7 liquidation.

Thereafter, the secured lender and the unsecured creditors tried to force the Chapter 7 trustee to distribute the proceeds from the sale of debtor's assets in accordance with the sharing agreement. The agreement, however, contravened the Bankruptcy Code's distribution scheme because it provided for distributions to unsecured creditors before payment of priority tax claims. Relying upon its equitable powers under section 105(a), the bankruptcy court ordered the trustee to ignore the sharing agreement, and to distribute the proceeds of the sale otherwise payable to the unsecured creditors in accordance with the statutory distribution scheme. The district court upheld that determination on appeal.

The First Circuit reversed. The specific question before the court was “whether an order compelling [the secured lender] to pay [to the trustee] from monies realized under its secured interest the amount required by the [Sharing] Agreement to be paid to [the unsecured creditors] is within the equitable powers of the bankruptcy court.” The Court of Appeals concluded that the answer is no.

The Court of Appeals reasoned that, as a fully secured lienor, the lender was entitled to the entire amount of any proceeds of the sale of debtor's assets, whether or not there was a sharing agreement. Therefore, the First Circuit emphasized, any money siphoned to unsecured creditors came from funds to which the secured creditor was otherwise entitled. Next, the First Circuit explained, because the secured lender would share its proceeds only after all unencumbered estate property had been distributed, the sharing agreement had no effect on distributions to other creditors. Without the sharing agreement, the secured lender would have received the entire allotted distribution under the reorganization plan, while tax creditors would have received nothing. Thus, the First Circuit concluded, “[w]hile the debtor and the trustee are not allowed to pay nonpriority creditors ahead of priority creditors … creditors are generally free to do whatever they wish with the bankruptcy dividends they receive, including to share them with other creditors.”

Other courts have cited SPM as authority for confirming a non-consensual Chapter 11 plan (or settlement) in which a senior secured creditor assigns a portion of its recovery to creditors (or shareholders) who would otherwise receive nothing by operation of section 1129(b)(2). See, e.g., Motorola, Inc. v. Official Committee of Unsecured Creditors (In re Iridium Operating LLC), 2005 WL 756900 (S.D.N.Y. Apr. 4, 2005) (settlement agreement); In re Union Financial Services Group, Inc., 303 B.R. 390 (Bankr. E.D. Mo. 2003); In re Genesis Health Ventures, Inc., 266 B.R. 591 (Bankr. D. Del. 2001), appeal dismissed, 280 B.R. 339 (D. Del. 2002); see also In re Nuclear Imaging, 270 B.R. 365 (Bankr. E.D. Pa. 2001). Some have even extended this rationale to encompass voluntary concessions by unsecured creditors to other unsecured creditors with lesser priority. See, e.g., In re WorldCom, Inc., 2003 WL 23861928 (Bankr. S.D.N.Y. Oct. 31, 2003); In re MCorp Fin., Inc., 160 B.R. 941 (S.D. Tex. 1993). Still, as noted, the concept of allowing a senior creditor or class of creditors to assign part of its recovery under a Chapter 11 plan to junior creditors or stockholders who would otherwise receive nothing by operation of section 1129(b)(2)(B)(ii) is controversial. This was the subject of the Delaware district court's ruling in Armstrong World Industries.

In next month's issue, we discuss that ruling in depth.

Scott J. Friedman is a Senior Associate in the Business Restructuring and Reorganization Practice of Jones Day in New York. Mark G. Douglas is the firm's Restructuring Practice Development Facilitator and Managing Editor of the Business Restructuring Review. The views expressed in this article are solely those of the authors and should in no manner be attributed to Jones Day or its clients.

Part One of a Two-Part Article

Companies in Chapter 11 may have capital structures consisting of multiple tiers of debt and equity that have competing priorities of payment vis-'-vis the company and its assets. The claims and interests of these competing stakeholders may be resolved in a Chapter 11 plan. To emerge from Chapter 11, the company must obtain approval of a plan that deals with all creditor claims and equity interests in accordance with the (sometimes complicated) rules contained in the Bankruptcy Code. In an effort to achieve an agreed-upon Chapter 11 plan, some creditors may give up (or gift) a portion of the recovery to which they would otherwise be entitled to another class of creditors or equity holders.

The proposition that a creditor can do whatever it wants with its recovery from a Chapter 11 debtor may seem to be a fundamental right. In the context of confirmation of a Chapter 11 plan, that right may not be unqualified and may, in fact, violate well-established bankruptcy principles. One such principle that applies only in the context of non-consensual confirmation of a Chapter 11 plan — or “cram-down” — is commonly referred to as the “absolute priority rule,” a pre-Bankruptcy Code maxim that established a strict hierarchy of payment among claims of differing priorities. The rule's continued vitality and application under the current statutory scheme was the subject of a notable ruling recently handed down by a Delaware district court in In re Armstrong World Industries, Inc., 320 B.R. 523 (D. Del. 2005).

Cram-Down and the Fair and Equitable Requirement

A Chapter 11 plan can be confirmed by the bankruptcy court under either of two scenarios. The first is consensually. This means that all classes of creditors and shareholders have either accepted the plan, or are not “impaired” by it because the plan pays them in full or leaves their rights unchanged. By contrast, if a class of creditors or shareholders votes to reject a plan, it can be confirmed over the class's objection only if the plan satisfies the requirements of section 1129(b) of the Bankruptcy Code. Among these is the mandate that a plan “does not discriminate unfairly” and is “fair and equitable” with respect to dissenting classes of creditors and shareholders.

The Bankruptcy Code specifically details one of the prerequisites for a plan's treatment of a class of claims or equity interests to be “fair and equitable.” The requirement varies depending on whether the dissenting impaired class contains secured claims, unsecured claims, or interests. As relevant here, section 1129(b)(2) of the Bankruptcy Code provides that a plan is “fair and equitable” with respect to a dissenting impaired class of unsecured claims if, among other things, the creditors in the class are paid in full, or failing full payment, so long as no creditor of lesser priority, or shareholder, receives any distribution under the plan. This requirement is sometimes referred to as the “absolute priority rule.”

Section 1129(b)(2) has been the focus of considerable debate in the courts even though it expressly delineates the circumstances under which a plan satisfies the standard. The dispute has generally concerned one of two areas. The first pertains to the ability of a company's existing shareholders, even though creditor claims are not paid in full, to retain an ownership interest in a reorganized debtor by infusing new value into the debtor. Referred to as the “new value” exception or corollary to the absolute priority rule, this issue is outside the scope of our discussion. See, e.g., Bank of America Nat. Trust and Sav. Ass'n v. 203 North LaSalle, 526 U.S. 434 (1999) (ruling that, even if there is a new value corollary, “plans providing junior interest holders with exclusive opportunities free from competition and without benefit of market valuation fall within the prohibition of ' 1129(b)(2)(B)(ii)”).

Instead, we focus on whether section 1129(b)(2) allows a class of senior creditors voluntarily to cede a portion of its recovery under a plan to a junior class of creditors or shareholders. Although some courts have interpreted the statute to permit this practice, the Delaware district court recently ruled in Armstrong World Industries that it violates the absolute priority rule, as codified in section 1129(b)(2).

History of the Absolute Priority Rule

As noted, section 1129(b)'s “fair and equitable” requirement is rooted in the judicially created absolute priority rule. The U.S. Supreme Court first formally articulated this rule, originally referred to as the “fixed principle,” in 1913 in Northern Pacific Railway Co. v. Boyd , 228 U.S. 482 (1913), which involved an equity receivership of a railroad. In Boyd, the old stockholders and bondholders agreed to a plan of reorganization in 1896 pursuant to which the company was to be sold to a new company in which the old stockholders had rights. Boyd asserted an unsecured claim against the predecessor company that resulted in a judgment in 1896, and was revived in 1906. However, the old railroad's assets having been sold to the new company 10 years earlier, there were no longer any assets on which to levy an execution. Boyd accordingly sued to hold the new company responsible for the old company's debt to him. The Supreme Court ruled that the stockholders' receipt of property was invalid:

“[I]f purposely or unintentionally a single creditor was not paid, or provided for in the reorganization, he could assert his superior rights against the subordinate interests of the old stockholders in the property transferred to the new company. They were in the position of insolvent debtors who could not reserve an interest as against creditors … Any device, whether by private contract or judicial sale under consent decree, whereby stockholders were preferred before the creditor, was invalid.

“[I]n cases like this, the question must be decided according to a fixed principle, not leaving the rights of the creditors to depend upon the balancing of evidence as to whether, on the day of sale, the property was insufficient to pay prior encumbrances.” Id. at 502, 504.

Thus was established the “fixed principle” — a concept that later came to be known as the absolute priority rule. According to this precept, stockholders could not receive any distribution in a reorganization case unless creditor claims were first paid in full. The Supreme Court continued to apply this principle in equity receivership cases throughout the early 1900s, emphasizing that it should be strictly applied. See Kan. City Terminal Ry. Co. v. Cent. Union Trust Co. of N.Y. , 271 U.S. 445 (1926); Kan. City S. Ry. Co. v. Guardian Trust Co. , 240 U.S. 166 (1916).

In 1934, Congress amended the former Bankruptcy Act to introduce the words “fair and equitable” to bankruptcy nomenclature. Section 77B(f) of the Act provided that a plan of reorganization could be confirmed only if the bankruptcy judge was satisfied that the plan was “fair and equitable and does not discriminate unfairly in favor of any class of creditors or stockholders and is feasible.” The provenance of this restriction was none other than the “fixed principle.” As later expressed by the Supreme Court, “[t]he reason for such a limitation was the danger inherent in any reorganization plan proposed by a debtor, then and now, that the plan will simply turn out to be too good a deal for the debtor's owners.” See 203 N. LaSalle, 526 U.S. at 444. The “fair and equitable” requirement endured as part of Chapter X of the former Bankruptcy Act when Congress passed the Chandler Act in 1938. As applied, the absolute priority rule prohibited any distribution to the holders of junior interests if senior creditors were not paid in full. This was so even if senior creditors agreed to the arrangement. See Case v. Los Angeles Lumber Products Co. , 308 U.S. 106 (1939).

Congress partially codified the absolute priority rule into the Bankruptcy Code in 1978. Section 1129(b)(2)(B)(ii), which applies only in a cram-down context, provides that a plan is not “fair and equitable” with respect to a dissenting class of unsecured creditors unless “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 any property.” Prior to the enactment of the Bankruptcy Code, the absolute priority rule prevented junior classes from receiving consideration at the expense of a senior creditor even if the majority of senior creditors agreed. Now, the rule only applies if the senior class does not vote to accept the plan. Thus, the rule would be an obstacle to confirmation only if a class of senior creditors is “impaired” by, for example, receiving less than full payment, the senior class votes to reject a Chapter 11 plan, and the Chapter 11 plan provides for some distribution to junior creditors or stockholders.

Gifting: A Controversial Interpretation of Fair and Equitable

Notwithstanding section 1129(b)(2) (B)(ii)'s preclusion of distributions to junior interests in cases where it applies, some courts have ruled that a plan does not violate the “fair and equitable” requirement if a class of senior creditors agrees that some of the property that would otherwise be distributed to it under the plan can be given to a junior class of creditors or shareholders. In doing so, many courts rely on a 1993 decision by the First Circuit Court of Appeals in Official Unsecured Creditors' Committee v. Stern (In re SPM Manufacturing Corp.), 984 F.2d 1305 (1st Cir. 1993).

In SPM, a secured lender holding a first priority security interest in substantially all of a Chapter 11 debtor's assets entered into a “sharing agreement” with general unsecured creditors to divide the proceeds that would result from the reorganization, apparently as a way to obtain their cooperation in the case. After it became apparent that the company could not be reorganized, the court appointed a receiver to market SPM's assets, which were ultimately sold for $5 million. Soon afterward, the secured creditor obtained relief from the automatic stay and the case was converted to a Chapter 7 liquidation.

Thereafter, the secured lender and the unsecured creditors tried to force the Chapter 7 trustee to distribute the proceeds from the sale of debtor's assets in accordance with the sharing agreement. The agreement, however, contravened the Bankruptcy Code's distribution scheme because it provided for distributions to unsecured creditors before payment of priority tax claims. Relying upon its equitable powers under section 105(a), the bankruptcy court ordered the trustee to ignore the sharing agreement, and to distribute the proceeds of the sale otherwise payable to the unsecured creditors in accordance with the statutory distribution scheme. The district court upheld that determination on appeal.

The First Circuit reversed. The specific question before the court was “whether an order compelling [the secured lender] to pay [to the trustee] from monies realized under its secured interest the amount required by the [Sharing] Agreement to be paid to [the unsecured creditors] is within the equitable powers of the bankruptcy court.” The Court of Appeals concluded that the answer is no.

The Court of Appeals reasoned that, as a fully secured lienor, the lender was entitled to the entire amount of any proceeds of the sale of debtor's assets, whether or not there was a sharing agreement. Therefore, the First Circuit emphasized, any money siphoned to unsecured creditors came from funds to which the secured creditor was otherwise entitled. Next, the First Circuit explained, because the secured lender would share its proceeds only after all unencumbered estate property had been distributed, the sharing agreement had no effect on distributions to other creditors. Without the sharing agreement, the secured lender would have received the entire allotted distribution under the reorganization plan, while tax creditors would have received nothing. Thus, the First Circuit concluded, “[w]hile the debtor and the trustee are not allowed to pay nonpriority creditors ahead of priority creditors … creditors are generally free to do whatever they wish with the bankruptcy dividends they receive, including to share them with other creditors.”

Other courts have cited SPM as authority for confirming a non-consensual Chapter 11 plan (or settlement) in which a senior secured creditor assigns a portion of its recovery to creditors (or shareholders) who would otherwise receive nothing by operation of section 1129(b)(2). See, e.g., Motorola, Inc. v. Official Committee of Unsecured Creditors (In re Iridium Operating LLC), 2005 WL 756900 (S.D.N.Y. Apr. 4, 2005) (settlement agreement); In re Union Financial Services Group, Inc., 303 B.R. 390 (Bankr. E.D. Mo. 2003); In re Genesis Health Ventures, Inc., 266 B.R. 591 (Bankr. D. Del. 2001), appeal dismissed, 280 B.R. 339 (D. Del. 2002); see also In re Nuclear Imaging, 270 B.R. 365 (Bankr. E.D. Pa. 2001). Some have even extended this rationale to encompass voluntary concessions by unsecured creditors to other unsecured creditors with lesser priority. See, e.g., In re WorldCom, Inc., 2003 WL 23861928 (Bankr. S.D.N.Y. Oct. 31, 2003); In re MCorp Fin., Inc., 160 B.R. 941 (S.D. Tex. 1993). Still, as noted, the concept of allowing a senior creditor or class of creditors to assign part of its recovery under a Chapter 11 plan to junior creditors or stockholders who would otherwise receive nothing by operation of section 1129(b)(2)(B)(ii) is controversial. This was the subject of the Delaware district court's ruling in Armstrong World Industries.

In next month's issue, we discuss that ruling in depth.

Scott J. Friedman is a Senior Associate in the Business Restructuring and Reorganization Practice of Jones Day in New York. Mark G. Douglas is the firm's Restructuring Practice Development Facilitator and Managing Editor of the Business Restructuring Review. The views expressed in this article are solely those of the authors and should in no manner be attributed to Jones Day or its clients.