Delaware Court Invalidates Use of So-called SPM Arrangement in Chapter 11 Plan

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May 2005

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Bankruptcy Code

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In an important recent decision, U.S.
District Judge Robreno, sitting by designation in
Delaware,<a href="#2" name="2a">2</a> denied
confirmation of Armstrong World Industries Inc.'s reorganization
plan.<a href="#3" name="3a">3</a>

Specifically, Judge Robreno found that the plan violated bankruptcy's
"absolute priority" rule, as codified in §1129(b)(2)(B)(ii) of the
Code, by seeking to effect a distribution of warrants to existing equity
through a waiver of the right to receive such warrants by a class of
asbestos personal injury claimants—a so-called "SPM
arrangement"<a href="#4" name="4a">4</a>—notwithstanding that another class of
general unsecured creditors voted against the plan and stood to receive
only approximately $0.60 on the dollar.<a href="#5" name="5a">5</a> The decision's significance extends beyond
Armstrong because it rejects the use under a cramdown plan of a
commonly employed technique to leak value down to junior classes where
none might otherwise exist.

<h4>Armstrong's Chapter 11 Plan</h4>

Armstrong's plan classified creditors into 11 separate creditor
classes and included a single class of equity interest-holders. Of
importance to Judge Robreno's decision were the distributions to three
of those classes—Class 6 (general unsecured creditors), Class 7
(asbestos personal injury claimants) and Class 12 (equity
interest-holders). Under Armstrong's plan, general unsecured creditors
in Class 6 and asbestos personal injury claimants in Class 7 would not
be paid in full, while equity interest-holders would receive warrants in
the reorganized debtor valued at approximately $35-$40
million.<a href="#6" name="6a">6</a>

A critical component of the plan was the asbestos personal injury
claimants' consent to share through the plan a portion of their proposed
distribution with equity interest-holders. Specifically, pursuant to the
plan, if Class 6 (general unsecured creditors) voted against the plan
(which it did), then the warrants to be distributed directly to equity
interest-holders would be distributed to holders of allowed asbestos
personal injury claims who, in turn, would automatically waive receipt
of the distribution, directing it instead to the equity
interest-holders. If allowed, this reallocation of distributions under
the plan would have resulted in holders of equity interests receiving
warrants on account of their equity interests despite a senior class of
general unsecured creditors receiving less than full payment of its
allowed claims. "It is the lawfulness of this arrangement that forms the
central issue in the case."<a href="#7" name="7a">7</a>

<h4>In re SPM Manufacturing Corp.</h4>

The practice of senior creditors forfeiting a portion of their
distributions in favor of junior creditors or equity interest-holders is
rooted in the First Circuit's decision in In re SPM Mfg. Corp.,
the case Armstrong primarily relied upon. At issue in SPM
was the validity of an agreement between the debtor's secured lender and
the creditors' committee under which the former agreed to share a
portion of its distribution with general unsecured creditors, despite
the debtor's inability to pay intervening priority tax creditors in
full. The secured lender held a lien on substantially all of the
debtor's assets, but the obligations secured by the lien exceeded the
value of the debtor's assets; as a result, absent the sharing
arrangement, unsecured creditors stood to recover little if anything on
account of their claims. By agreeing to share a portion of its recovery
with unsecured creditors, the secured lender sought to obtain the
committee's cooperation throughout the remainder of the
case.<a href="#8" name="8a">8</a>

Subsequent to the secured lender and the committee's entry into the
sharing arrangement, the debtor's assets were sold for $5 million, or $4
million less than the secured creditor's claim. Almost immediately after
the sale, the debtor's case was converted to chapter 7 and the secured
lender and the committee jointly moved for entry of an order authorizing
that the sale proceeds be distributed to them in accordance with their
sharing arrangement. The debtor and its principal objected on the ground
that the sharing arrangement violated the Code's distribution
requirements by permitting a distribution to general unsecured creditors
ahead of priority tax creditors. The secured lender and the committee
responded that the sale proceeds belonged to the secured creditor, and
the secured creditor had the right to share them with general unsecured
creditors without first having to satisfy priority claims.<a href="#9" name="9a">9</a>

The bankruptcy court agreed with the debtor and ordered that the
money that otherwise would have gone to the general unsecured creditors
under the sharing arrangement (net of certain expenses) should instead
be paid to the chapter 7 trustee for distribution to creditors,
including holders of priority tax claims, in accordance with the Code's
priority scheme. On appeal, the district court determined that the
bankruptcy court appropriately exercised its equitable powers by
reforming the sharing arrangement to comply with the Code's chapter 7
distribution priorities.<a href="#10" name="10a">10</a>

However, the First Circuit Court of Appeals reversed, holding that
the sharing arrangement did not violate the Code's priority scheme. The
court observed correctly that priority creditors were not entitled to
receive a distribution given that the entire $5 million rightfully
belonged to the secured lender. Importantly, for purposes of upholding
the arrangement, the siphoning of a portion of the $5 million to general
unsecured creditors was to occur after distribution of the funds
to the secured lenders, having no effect whatever on the distributions
of estate property to other creditors.<a href="#11" name="11a">11</a> The First Circuit went on to note that
§726 and the other Code provisions governing payment priorities
apply only to distributions of estate property and are not implicated by
agreements to transfer estate property once it has passed into the hands
of the debtor's creditors. At that point, the court observed, "creditors
are generally free to do whatever they wish with the bankruptcy
dividends they receive, including to share them with other
creditors."<a href="#12" name="12a">12</a>

<h4>The Holding in Armstrong</h4>

Unlike the sharing arrangement the First Circuit upheld in
SPM, the arrangement proposed by Armstrong required a
distribution of estate property—i.e.,
warrants—under the plan to a junior class of
interest-holders ahead of a senior creditor class that was not being
paid in full and voted to reject the plan. Such an arrangement, though
not uncommon in chapter 11 plans, implicates the Code's "absolute
priority" rule and, according to Judge Robreno, absent consent, must
comply with §1129(b)(2)(B)(ii) to pass muster.<a href="#13" name="13a">13</a>

Section 1129(b)(2)(B)(ii) provides, in pertinent part, that:

<blockquote>
(b) ...the court...shall confirm the plan...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.

<blockquote>
(2) For the purpose of this subsection, the condition that a plan be
fair and equitable with respect to a class includes the following
requirements...

<blockquote>
(B) With respect to a class of unsecured claims... 
(ii) 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.
</blockquote>
</blockquote>
</blockquote>

11 U.S.C. §1129(b)(2)(B)(ii). This provision is referred to
colloquially as the "absolute priority" rule.

Construing §1129(b)(2)(B)(ii) to give it its plain meaning,
Judge Robreno determined that "a plan is not 'fair and equitable' if a
class of creditors [sic] that is junior to the class of unsecured
creditors receives debtor's property because of its ownership interest
in the debtor while the allowed claims of the class of unsecured
creditors have not been paid in full."<a href="#14" name="14a">14</a> Applying these plain requirements to the
situation before him, Judge Robreno found that it was clear that (1) the
interests held by the debtor's equity interest-holders were junior to
the claims of the debtor's general unsecured creditors; (2) under the
plan, the interest-holders would receive property of the
debtor—i.e., warrants—on account of their interests
in the debtor; and (3) the unsecured creditors' allowed claims would not
be paid in full. Under these circumstances, Judge Robreno found that
Armstrong's plan violated §1129(b)(2) (B)(ii) of the Code because
it was not "fair and equitable" to the debtor's general unsecured
creditors.<a href="#15" name="15a">15</a>

Judge Robreno found further support for his conclusion that the plan
was not "fair and equitable" in the Code's legislative history.
Specifically, Judge Robreno noted that Sens. Edwards and
DeConcini—key legislators of the Code—rejected a proposal
contained in the Senate Report that would have permitted a senior
creditor to alter its distribution for the benefit of stockholders under
the "fair and equitable" standard. "'[A] senior class will not be able
to give up value to a junior class over the dissent of an intervening
class unless the intervening class receives the full amount, as opposed
to value, of its claims or interests.'"<a href="#16" name="16a">16</a>

Finally, Judge Robreno distinguished SPM and the cases
Armstrong relied upon to support its distribution of warrants to
interest-holders. Most notably, Judge Robreno found SPM
inapposite because, unlike in Armstrong, the arrangement in
SPM altered the parties' distributions only after the
estate property had already been distributed. Judge Robreno further
distinguished SPM in the following two respects:

<ul>
<li>SPM involved distributions under chapter 7 where
§1129(b)(2)(B)(ii) does not apply, and

</li><li>The property distributed in SPM was not subject to chapter
7's priority scheme—see 11 U.S.C. §726—which is
not implicated until all valid secured claims are first satisfied (in
SPM, the secured lender was undersecured).<a href="#17" name="17a">17</a>
</li></ul>

The other cases upon which Armstrong relied—In re
WorldCom Inc., No. 02-13533, 2003 Bankr. LEXIS 1401 (Bankr. S.D.N.Y.
Oct. 31, 2003); In re Genesis Health Ventures Inc., 266 B.R. 591
(Bankr. D. Del. 2001); and In re MCorp. Fin. Inc., 160 B.R. 941
(S.D. Tex. 1993)—were determined to be factually
inapposite.<a href="#18" name="18a">18</a>
Alternatively, Judge Robreno concluded that to the extent these other
cases read SPM unconditionally to mean that "'[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 received under the [p]lan by other creditors are not
impacted,'...without adherence to the strictures of 11 U.S.C.
§1129(b)(2)(B)(ii), that contention is flatly rejected
here."<a href="#19" name="19a">19</a>

<h4>The Future of SPM Arrangements</h4>

Judge Robreno's Armstrong decision does not spell an end to
the use of "SPM arrangements" under a plan. To the contrary, a
senior creditor class can still siphon value to a junior class under a
plan where an intervening or co-equal class(es) is not being paid in
full if such intervening or co-equal class(es) consents. Absent such
consent, however, parties should consider implementing the "SPM
arrangement" outside of a plan, to the extent practicable.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Brian S. Hermann is a
partner in the Bankruptcy Department of Paul, Weiss, Rifkind, Wharton
& Garrison LLP, which is co-counsel to the Official Committee of
Unsecured Creditors in Armstrong World Industries Inc.'s chapter 11
case. The author is not involved in the case. <a href="#1a">Return to
article</a>

<big><a name="2">2</a></big> Hon. Eduardo C. Robreno, a
judge in the U.S. District Court for the Eastern District of
Pennsylvania, was designated by the Third Circuit Court of Appeals to
sit on the District Court for the District of Delaware in the
Armstrong case. Because Armstrong's reorganization plan required
the issuance of a §524(g) channeling injunction, the bankruptcy
court's proposed findings of fact and conclusions of law and proposed
confirmation order were reviewed by Judge Robreno pursuant to Bankruptcy
Rule 9033. <a href="#2a">Return to article</a>

<a name="3">3</a> In re Armstrong World
Indus. Inc., 320 B.R. 523 (D. Del. 2005). Armstrong has appealed
Judge Robreno's order denying confirmation to the Third Circuit Court of
Appeals. <a href="#3a">Return to article</a>

<a name="4">4</a> SPM is a reference
to the First Circuit's decision in Official Unsecured Creditors'
Comm. v. Stern (In re SPM Mfg. Corp.), 984 F.2d 1305 (1st Cir.
1993), in which a senior secured lender was permitted to surrender a
portion of its distribution from the debtor's estate to general
unsecured creditors notwithstanding that priority creditors were not
paid in full. <a href="#4a">Return to article</a>

<a name="5">5</a> Armstrong, 320
B.R. at 526. <a href="#5a">Return to article</a>

<a name="6">6</a> Id. at 525-26. <a href="#6a">Return to article</a>

<a name="7">7</a> Id. at 526. <a href="#7a">Return to article</a>

<a name="8">8</a> Id. at 1308. <a href="#8a">Return to article</a>

<a name="9">9</a> Id. at 1309. <a href="#9a">Return to article</a>

<a name="10">10</a> Id. at 1309-10.
<a href="#10a">Return to article</a>

<a name="11">11</a> Id. at 1312. <a href="#11a">Return to article</a>

<a name="12">12</a> Id. at 1313
(internal citations omitted). <a href="#12a">Return to article</a>

<a name="13">13</a> Id. at 526. <a href="#13a">Return to article</a>

<a name="14">14</a> Armstrong, 320
B.R. at 536. <a href="#14a">Return to article</a>

<a name="15">15</a> Id. <a href="#15a">Return to article</a>

<a name="16">16</a> Id., citing 124
Cong. Rec. S. 34007 (Oct. 5, 1978) (remarks of Sen. DeConcini); 124
Cong. Rec. H. 32408 (Sept. 28, 1978) (remarks of Rep. Edwards). Though
Armstrong did not involve a senior class siphoning value to a
junior class over the objection of an intervening class, Judge
Robreno nonetheless invoked this prohibition found in the legislative
history to prevent the co-equal class of asbestos personal-injury
claimants from giving up value to a junior class of interest-holders
over the objection of the co-equal class of general unsecured
creditors. <a href="#16a">Return to article</a>

<a name="17">17</a> Id. at 538-39.
<a href="#17a">Return to article</a>

<a name="18">18</a> Id. at 539. <a href="#18a">Return to article</a>

<a name="19">19</a> Id. at 540
(internal citations omitted). <a href="#19a">Return to article</a>

Journal Authors

Brian S. Hermann

Journal Date

Sunday, May 1, 2005 - 12:00

Bankruptcy Rule

2005

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