The Absolute Priority Rule

The rule's origins date to cases under the former Bankruptcy Act, which preceded the current Bankruptcy Code. A judicial, non-statutory requirement developed that reorganization plans must be 'fair and equitable.' See N. Pac. Ry. Co. v. Boyd, 228 U.S. 482, 504-05 (1913); Louisville Trust Co. v. Louisville, N.A. & C.R. Co., 174 U.S. 674, 684 (1899). 'The 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.' Bank of Am. Nat'l Trust & Sav. Ass'n v. 203 N. LaSalle St. P'ship, 526 U.S. 434, 444 (1999).

The judicial rule required that 'creditors ' be paid before stockholders could retain [equity interests] for any purpose whatever.' N. Pac. Ry. Co., 228 U.S. at 508. As stated by the Supreme Court, '[A]ny arrangement of the parties by which the subordinate rights and interests of stockholders are attempted to be secured at the expense of the prior rights of either [secured or unsecured] creditors comes within judicial denunciation.' Louisville Trust Co., 174 U.S. at 684.

The absolute priority rule was codified in 1978 in Bankruptcy Code ' 1129(b)(2)(B)(ii). The 'fair and equitable' portion of ' 1129(b) requires that a plan may not be confirmed over the objections of a dissenting class unless the allowed value of the claim is paid in full (' 1129(b)(2)B)(i)) or if 'the holder of any claim or interest that is junior to the claims of such [impaired unsecured] class will not receive or retain under the plan on account of such junior claim or interest any property.' Bankruptcy Code ' 1129(b)(2)(B)(ii).

In addition to the absolute priority rule, pre-Code judicial decisions developed a second and related rule: the so-called exception or corollary to the rule. Justice Douglas set forth what the Supreme Court characterized in LaSalle as the 'classic formulation' of this exception: 'It is, of course, clear that there are circumstances under which stockholders may participate in a plan of reorganization of an insolvent debtor ' Where th[e] necessity [for new capital] exists and the old stockholders make a fresh contribution and receive in return a participation reasonably equivalent to their contribution, no objection can be made ' [W]e believe that to accord 'the creditor his full right of priority against the corporate assets' where the debtor is insolvent, the stockholder's participation must be based on a contribution in money or money's worth reasonably equivalent in the view of all the circumstances to the participation of the stockholder.' Case v. Los Angeles Lumber Products Co., 308 U.S. 106, 121-22 (1939).

Years later, the Supreme Court observed that it was not taking any position 'on the continuing vitality of the Los Angeles Lumber exception,' in light of the enactment of the Bankruptcy Code, but also concluded that to the extent such an exception might exist, the phrase 'money or money's worth' in Los Angeles Lumber would not include a contribution by old equity of 'labor, experience, and expertise' because '[u]nlike 'money or money's worth,' a promise of future services cannot be exchanged in any market for something of value to the creditors today.' Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 204 (1988) (emphasis in original). But the Supreme Court also stated that with respect to the possibility that equitable exceptions to the absolute priority rule exist, ' 1129(b) 'bar[s] any expansion of any exception to the absolute priority rule beyond that recognized' in the decisions issued before the enactment of the Bankruptcy Code. Id. at 206. Then, in the subsequent LaSalle decision, the Supreme Court, after providing detailed discussion of the new value exception or corollary, stated that '[i]t is enough to say, assuming a new value corollary, that plans providing junior interest holders with exclusive opportunities free from competition and without the benefit of market valuation' would violate ' 1129(b)(2)(B)(ii). LaSalle, 326 U.S. at 458 (emphasis supplied).

The Armstrong Case

AWI filed for Chapter 11 in the U.S. Bankruptcy Court for the District of Delaware in December 2003. The U.S. Trustee there appointed two committees: 1) the Official Committee of Asbestos Personal Injury Claimants; and 2) the Official Committee of Unsecured Creditors. In May 2003, AWI filed a Fourth Amended Plan of Reorganization (the Plan) and Dis-closure Statement.

The Plan put creditors into 11 classes and equity interest holders into a 12^th class. Unsecured creditors were placed in Class 6. Present and future asbestos-related personal injury claimants were placed in Class 7. The Plan funded a $1.8 billion trust for Class 7 pursuant to Bankruptcy Code ' 524(g). Class 7 members would get an initial payment from the trust of 20% of their allowed claims. Class 6 members would get payment on about 59.5% of their claims. The Plan would also entitle Class 12 ' the equity interest holders ' to receive warrants to purchase AWI's new common stock, which was estimated to be worth up to $40 million. If Class 6 voted to reject the Plan, then Class 7 would receive the warrants, but Class 7 would also waive actual receipt in favor of Class 12.

Class 6 voted to reject the plan, and thus Class 12 was to receive the warrants based on Class 7's automatic waiver of them. Class 6 argued that the Plan violated the absolute priority rule on the ground that Class 12 received a distribution ' the warrants ' while the objecting unsecured creditors were impaired. The Bankruptcy Court held, however, that the absolute priority rule was satisfied because Class 12 got the warrants only as a result of their transfer by another class ' Class 7. On appeal, the District Court reversed, holding that the receipt of the warrants by Class 12 violated the absolute priority rule and that no equitable exception to the rule applied in these circumstances. In re Armstrong World Indus., Inc., 320 B.R. 523 (D. Del. 2005).

The Third Circuit agreed with the District Court, ruling that the Plan violated the plain meaning of ' 1129(b)(2)(b)(ii). Class 12 was to receive property while a more senior objecting class, Class 6, was not to be paid in full. AWI argued that the Plan should be confirmed because Class 12 received the warrants from another group of creditors, Class 7. In support of this argument, AWI cited the 'MCorp-Genesis' rule, which is derived from a set of cases where creditors have been allowed to transfer their property to more junior creditors without violating the absolute priority rule. See In re Genesis Health Ventures, Inc., 266 B.R. 591 (Bankr. D. Del. 2001); In re SPM Mfg. Corp., 984 F.2d 1305 (1^st Cir. 1993); and In re MCorp. Fin., Inc., 160 B.R. 941 (S.D. Tex. 1993).

The Third Circuit noted key distinctions between the MCorp-Genesis cases and AWI's proposed Plan. In SPM, for instance: 1) the case had been converted to Chapter 7 and thus ' 1129(b) was not applicable; 2) the senior creditor that transferred property to the more junior class had a perfected security interest and thus the property transferred was not from the debtor's estate; and 3) the property was distributed from a 'carve out' of the secured creditor's lien and thus did not implicate the ' 1129(b) priority scheme as well. In contrast, the Third Circuit observed, the AWI Plan was structured to ensure that property of the estate would automatically be distributed to Class 12 if Class 6 rejected the Plan.

AWI also argued that the absolute priority rule was not violated because Class 12 was not receiving the warrants 'on account of' their equity interests. See ' 1129(b)(2)(B)(ii). AWI asserted that Class 12 was getting the warrants in exchange for the settlement of inter-company claims. The Third Circuit disagreed with this argument as well, noting that the warrants had an estimated value of up to $40 million, while the inter-company claims were valued at about $12 million. Given the disparity in value, the Court concluded that Class 12 was receiving the warrants 'on account of' its equity interests in AWI.

Finally, AWI argued for Plan confirmation based on equitable exceptions to the absolute priority rule, citing In re Penn Central Transp. Co., 596 F.2d 1127 (3^rd Cir. 1979). At the time, Penn Central was 'the most complex set of interrelated and conflicting claims ever addressed under the ' Bankruptcy Act.' 596 F.2d at 1129. The railroad's bankruptcy filing in 1970 resulted in passage by Congress of the Regional Rail Reorganization Act of 1973, which was intended to 'prevent a rail transportation crisis and to address the particular difficulties of that reorganization.' Armstrong, 432 F.3d at 516. The exceptional circumstances present in Penn Central ' Congressional intervention to stave off a national crises in rail transportation ' led the Third Circuit 'to apply a more flexible absolute priority rule.' Id. at 517.

AWI tried, but failed, to persuade the Third Circuit that its case had similar unique aspects that would justify allowing Class 12 to take the warrants even if the absolute priority rule was not satisfied. The Third Circuit held that 'AWI's bankruptcy due to asbestos liabilities simply does not involve the kind of exigent circumstances present in Penn Central ' ' Armstrong, 432 F.3d at 517.

Conclusion

Armstrong is one of the latest in a long line of cases to test the limits of the absolute priority rule as codified in ' 1129(b)(2)(B)(ii). The Third Circuit rejected AWI's attempt to get millions of dollars of warrants to old equity with a transfer of estate property, albeit through the waiver by Class 7, when the unsecured creditors were not being paid in full. No doubt, debtors will continue to craft creative approaches to providing value to old equity by pushing the parameters of the absolute priority rule and its new value corollary.

Daniel A. Lowenthal, Co-Chair of Thelen Reid & Priest LLP's bankruptcy practice group, is located in the firm's New York office. He may be reached at 212-603-2468 or [email protected].

Debtors in bankruptcy cases have long sought to make distributions to old equity without running afoul of the absolute priority rule. Time and again, debtors' efforts to leave old equity with value in a reorganized entity have been challenged in the appellate courts, and often in the Supreme Court.

A proposed distribution to old equity in the complex Armstrong World Industries (AWI) case was struck down recently by the U.S. Court of Appeals for the Third Circuit Court. In re Armstrong World Indus., Inc., 432 F.3d 507 (3^rd Cir. 2005). The Third Circuit ruled that the receipt by old equity of a distribution of warrants that, pursuant to the terms of the reorganization plan, were to be transferred to, but waived by, asbestos claimants violated the absolute priority rule since the unsecured creditors, whose claims were impaired, had objected to the plan. The Third Circuit's decision sets forth a cogent analysis of the absolute priority rule in the context of the facts in AWI.

The Absolute Priority Rule

The rule's origins date to cases under the former Bankruptcy Act, which preceded the current Bankruptcy Code. A judicial, non-statutory requirement developed that reorganization plans must be 'fair and equitable.' See N. Pac. Ry. Co. v. Boyd , 228 U.S. 482, 504-05 (1913); Louisville Trust Co. v. Louisville, N.A. & C.R. Co ., 174 U.S. 674, 684 (1899). 'The 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.' Bank of Am. Nat'l Trust & Sav. Ass'n v. 203 N. LaSalle St. P'ship, 526 U.S. 434, 444 (1999).

The judicial rule required that 'creditors ' be paid before stockholders could retain [equity interests] for any purpose whatever.' N. Pac. Ry. Co., 228 U.S. at 508. As stated by the Supreme Court, '[A]ny arrangement of the parties by which the subordinate rights and interests of stockholders are attempted to be secured at the expense of the prior rights of either [secured or unsecured] creditors comes within judicial denunciation.' Louisville Trust Co., 174 U.S. at 684.

The absolute priority rule was codified in 1978 in Bankruptcy Code ' 1129(b)(2)(B)(ii). The 'fair and equitable' portion of ' 1129(b) requires that a plan may not be confirmed over the objections of a dissenting class unless the allowed value of the claim is paid in full (' 1129(b)(2)B)(i)) or if 'the holder of any claim or interest that is junior to the claims of such [impaired unsecured] class will not receive or retain under the plan on account of such junior claim or interest any property.' Bankruptcy Code ' 1129(b)(2)(B)(ii).

In addition to the absolute priority rule, pre-Code judicial decisions developed a second and related rule: the so-called exception or corollary to the rule. Justice Douglas set forth what the Supreme Court characterized in LaSalle as the 'classic formulation' of this exception: 'It is, of course, clear that there are circumstances under which stockholders may participate in a plan of reorganization of an insolvent debtor ' Where th[e] necessity [for new capital] exists and the old stockholders make a fresh contribution and receive in return a participation reasonably equivalent to their contribution, no objection can be made ' [W]e believe that to accord 'the creditor his full right of priority against the corporate assets' where the debtor is insolvent, the stockholder's participation must be based on a contribution in money or money's worth reasonably equivalent in the view of all the circumstances to the participation of the stockholder.' Case v. Los Angeles Lumber Products Co ., 308 U.S. 106, 121-22 (1939).

Years later, the Supreme Court observed that it was not taking any position 'on the continuing vitality of the Los Angeles Lumber exception,' in light of the enactment of the Bankruptcy Code, but also concluded that to the extent such an exception might exist, the phrase 'money or money's worth' in Los Angeles Lumber would not include a contribution by old equity of 'labor, experience, and expertise' because '[u]nlike 'money or money's worth,' a promise of future services cannot be exchanged in any market for something of value to the creditors today.' Norwest Bank Worthington v. Ahlers , 485 U.S. 197, 204 (1988) (emphasis in original). But the Supreme Court also stated that with respect to the possibility that equitable exceptions to the absolute priority rule exist, ' 1129(b) 'bar[s] any expansion of any exception to the absolute priority rule beyond that recognized' in the decisions issued before the enactment of the Bankruptcy Code. Id. at 206. Then, in the subsequent LaSalle decision, the Supreme Court, after providing detailed discussion of the new value exception or corollary, stated that '[i]t is enough to say, assuming a new value corollary, that plans providing junior interest holders with exclusive opportunities free from competition and without the benefit of market valuation' would violate ' 1129(b)(2)(B)(ii). LaSalle, 326 U.S. at 458 (emphasis supplied).

The Armstrong Case

AWI filed for Chapter 11 in the U.S. Bankruptcy Court for the District of Delaware in December 2003. The U.S. Trustee there appointed two committees: 1) the Official Committee of Asbestos Personal Injury Claimants; and 2) the Official Committee of Unsecured Creditors. In May 2003, AWI filed a Fourth Amended Plan of Reorganization (the Plan) and Dis-closure Statement.

The Plan put creditors into 11 classes and equity interest holders into a 12^th class. Unsecured creditors were placed in Class 6. Present and future asbestos-related personal injury claimants were placed in Class 7. The Plan funded a $1.8 billion trust for Class 7 pursuant to Bankruptcy Code ' 524(g). Class 7 members would get an initial payment from the trust of 20% of their allowed claims. Class 6 members would get payment on about 59.5% of their claims. The Plan would also entitle Class 12 ' the equity interest holders ' to receive warrants to purchase AWI's new common stock, which was estimated to be worth up to $40 million. If Class 6 voted to reject the Plan, then Class 7 would receive the warrants, but Class 7 would also waive actual receipt in favor of Class 12.

Class 6 voted to reject the plan, and thus Class 12 was to receive the warrants based on Class 7's automatic waiver of them. Class 6 argued that the Plan violated the absolute priority rule on the ground that Class 12 received a distribution ' the warrants ' while the objecting unsecured creditors were impaired. The Bankruptcy Court held, however, that the absolute priority rule was satisfied because Class 12 got the warrants only as a result of their transfer by another class ' Class 7. On appeal, the District Court reversed, holding that the receipt of the warrants by Class 12 violated the absolute priority rule and that no equitable exception to the rule applied in these circumstances. In re Armstrong World Indus., Inc., 320 B.R. 523 (D. Del. 2005).

The Third Circuit agreed with the District Court, ruling that the Plan violated the plain meaning of ' 1129(b)(2)(b)(ii). Class 12 was to receive property while a more senior objecting class, Class 6, was not to be paid in full. AWI argued that the Plan should be confirmed because Class 12 received the warrants from another group of creditors, Class 7. In support of this argument, AWI cited the 'MCorp-Genesis' rule, which is derived from a set of cases where creditors have been allowed to transfer their property to more junior creditors without violating the absolute priority rule. See In re Genesis Health Ventures, Inc., 266 B.R. 591 (Bankr. D. Del. 2001); In re SPM Mfg. Corp., 984 F.2d 1305 (1^st Cir. 1993); and In re MCorp. Fin., Inc., 160 B.R. 941 (S.D. Tex. 1993).

The Third Circuit noted key distinctions between the MCorp-Genesis cases and AWI's proposed Plan. In SPM, for instance: 1) the case had been converted to Chapter 7 and thus ' 1129(b) was not applicable; 2) the senior creditor that transferred property to the more junior class had a perfected security interest and thus the property transferred was not from the debtor's estate; and 3) the property was distributed from a 'carve out' of the secured creditor's lien and thus did not implicate the ' 1129(b) priority scheme as well. In contrast, the Third Circuit observed, the AWI Plan was structured to ensure that property of the estate would automatically be distributed to Class 12 if Class 6 rejected the Plan.

AWI also argued that the absolute priority rule was not violated because Class 12 was not receiving the warrants 'on account of' their equity interests. See ' 1129(b)(2)(B)(ii). AWI asserted that Class 12 was getting the warrants in exchange for the settlement of inter-company claims. The Third Circuit disagreed with this argument as well, noting that the warrants had an estimated value of up to $40 million, while the inter-company claims were valued at about $12 million. Given the disparity in value, the Court concluded that Class 12 was receiving the warrants 'on account of' its equity interests in AWI.

Finally, AWI argued for Plan confirmation based on equitable exceptions to the absolute priority rule, citing In re Penn Central Transp. Co., 596 F.2d 1127 (3^rd Cir. 1979). At the time, Penn Central was 'the most complex set of interrelated and conflicting claims ever addressed under the ' Bankruptcy Act.' 596 F.2d at 1129. The railroad's bankruptcy filing in 1970 resulted in passage by Congress of the Regional Rail Reorganization Act of 1973, which was intended to 'prevent a rail transportation crisis and to address the particular difficulties of that reorganization.' Armstrong, 432 F.3d at 516. The exceptional circumstances present in Penn Central ' Congressional intervention to stave off a national crises in rail transportation ' led the Third Circuit 'to apply a more flexible absolute priority rule.' Id. at 517.

AWI tried, but failed, to persuade the Third Circuit that its case had similar unique aspects that would justify allowing Class 12 to take the warrants even if the absolute priority rule was not satisfied. The Third Circuit held that 'AWI's bankruptcy due to asbestos liabilities simply does not involve the kind of exigent circumstances present in Penn Central ' ' Armstrong, 432 F.3d at 517.

Conclusion

Armstrong is one of the latest in a long line of cases to test the limits of the absolute priority rule as codified in ' 1129(b)(2)(B)(ii). The Third Circuit rejected AWI's attempt to get millions of dollars of warrants to old equity with a transfer of estate property, albeit through the waiver by Class 7, when the unsecured creditors were not being paid in full. No doubt, debtors will continue to craft creative approaches to providing value to old equity by pushing the parameters of the absolute priority rule and its new value corollary.

Daniel A. Lowenthal, Co-Chair of Thelen Reid & Priest LLP's bankruptcy practice group, is located in the firm's New York office. He may be reached at 212-603-2468 or [email protected].