In September 2015, the U.S. Court of Appeals for the Third Circuit issued an opinion in In re ICL Holding Co. Inc. that further reinforces the ability to use § 363 sales and settlements to resolve chapter 11 cases.
Factual Background
In 2012, Texas-based LifeCare Holdings, Inc. and its affiliated debtors (collectively, “the debtor”) were struggling financially, carrying a $484 million debt load, of which approximately $355 million was secured.[1] A group of secured lenders offered to purchase all of the assets of the debtor (including cash) for a $320 million credit bid (out of the $355 million of debt that they were then owed), plus $1.8 million in cash to pay the legal and accounting fees of the debtor and the unsecured creditors’ committee, as well as the debtor’s wind-down costs.[2] The cash was to be put into an escrow account, and any unused amounts were required to be returned to the secured lenders. In December 2012, the debtor entered into an asset-purchase agreement (APA) with its secured lenders; the next day, the debtor filed for bankruptcy.[3]
As one of its first-day motions, the debtor requested approval of the APA and to sell substantially all of its assets through a court-supervised auction under § 363(b)(1) of the Bankruptcy Code.[4] After the auction, the secured lenders’ $320 million credit bid remained the most attractive offer.[5] However, two key players in the case, the committee and the Internal Revenue Service (IRS), objected.[6]
The committee ended up settling with the secured lenders. In exchange for the committee’s promise to drop its objections and support the sale, the secured lenders agreed to deposit $3.5 million in trust for the benefit of the general unsecured creditors.
On the other hand, the IRS, who was entitled to an administrative claim based on capital-gains tax liability resulting from the sale, claimed that the proposed sale arrangement was unfair because the escrowed and settlement sums were “proceeds” paid to obtain the debtor’s assets, and thus qualified as estate property that should have been paid out according to the Code’s creditor-payment scheme.[7] The bankruptcy court approved the § 363 sale and held that the escrowed funds were not property of the estate, and therefore were not subject to distribution to the debtor's creditors, including the IRS.[8]
Following the sale hearing, the bankruptcy court held a hearing on the committee settlement agreement. Again, the IRS objected, claiming that the settlement trust was property of the estate and contending that the settlement’s attempts to distribute estate property to general unsecured creditors over the objection of senior creditors (the IRS’s administrative claim) was in violation of the absolute priority rule. The bankruptcy court approved the settlement, finding that because the purchaser made the distribution directly to the general unsecured creditors, that distribution was not property of the debtor’s estate and the absolute priority rule was not implicated. The IRS then appealed the approval of the sale order and the approval of the settlement to the Third Circuit.
Holding
The Third Circuit affirmed, holding that (1) the escrowed funds did not qualify as “property of the estate” because they belonged to the secured lenders, and (2) the settlement sums were not “property of the estate” because they were paid directly to the unsecured creditors from a trust funded by the purchaser and were not given in exchange for any property of the estate.[9]
The court rejected the IRS’s argument that the settlement sums were “property of the estate,” reasoning that, “though it is true that the secured lenders paid cash to resolve objections to the sale of Debtor’s assets, that money never made it into the estate, nor was it paid at their direction.”[10] In this context, the court concluded that “the settlement sums paid by the secured lenders were not proceeds from its liens, did not at any time belong to the debtor's estate, and will not become part of the debtor’s estate even as a pass-through.”[11]
The IRS’s argument that the escrowed funds qualified as property of the estate was also rejected. The court held that the funds did not qualify as property of the estate because they belonged to the secured lenders who purchased all of the debtor’s assets, including its cash, by crediting $320 million owed by the debtor to the secured lenders.[12] Once the sale closed, there technically was no more estate property.[13]
The court considered that the IRS’s argument that any residual cash from the sale (monies earmarked for fees and wind-down costs) would become property of the debtor was “impossible” because the debtor agreed to surrender all of its cash, and per the sale order, whatever remained of the $1.8 million in escrow goes back to the secured lenders.[14]
Case Implications
The Third Circuit ruling could have a profound effect on the structure of § 363 sales, especially in cases where there are significant claims entitled to priority treatment. It allows flexibility in the § 363 sale process (coupled with direct settlements) that does not exist in traditional chapter 11 reorganization plans. Indeed, it permits purchasers in § 363 sales to use escrow accounts to pay certain stakeholders with new funds while in essence freezing out equally ranked, or even senior, stakeholders.[15]
In contrast to this flexibility are the limitations imposed on plans of reorganization, under which all allowed administrative expense claims must be paid in full in cash on the plan effective date.[16] This makes reorganization plans even less attractive for purchasers and debtors than they already are.[17]
In addition to In re TSIC, the ICL Holding decision is consistent with the Third Circuit’s previous ruling in Official Committee of Unsecured Creditors v. CIT Group/Business Credit Inc. (In re Jevic Holding Corp.), in which the Third Circuit held that a settlement that (unlike ICL Holding) provided for a distribution of estate property that deviated from the Bankruptcy Code’s priority scheme was permissible.[18] The Third Circuit’s belief that parties in a bankruptcy proceeding should be provided substantial flexibility to resolve disputes consensually among themselves where the resolution will provide a greater overall recovery to creditors, even when those settlements prejudice creditors otherwise entitled to superior or priority treatment under the Bankruptcy Code, is apparent.[19]
[1] See In re ICL Holding Co. Inc., No. 14-2709, 2015 WL 5315604, at *1 (3d Cir. Sept. 14, 2015).
[2] Id. at 2.
[3] Id.
[4] Id.
[5] Id.
[6] Id.
[7] Id.; see also 11 U.S.C. § 541(a)(6), which defines property of the estate as “proceeds … of or from property of the estate.”
[8] Id. at 2-3.
[9] See In re ICL Holding Co. Inc., No. 14-2709, 2015 WL 5315604, at *7 (3d Cir. Sept. 14, 2015).
[10] Id.
[11] Id. The In re ICL Holding Co. Inc. decision relied on an earlier Delaware decision, In re TSIC, 393 B.R. 71 (Bankr. D. Del. 2008). The Third Circuit noted that similarly, in that case the unsecured creditors objected to the winning bid at a § 363 auction. See id. at 74. Also, similarly before the sale closed, the purchaser and creditors’ committee agreed that the latter would drop its objection if the former funded a trust account for the benefit of unsecured creditors. See id.
[12] See In re ICL Holding Co. Inc., No. 14-2709, 2015 WL 5315604, at *8 (3d Cir. Sept. 14, 2015); In re ICL Holding Co. Inc: “Third Circuit Allows Purchaser to Gift Non-Estate Property to Junior Creditors to Resolve Section 363 Sale Objections,” Practical Law (Oct. 22, 2015), available at us.practicallaw.com/w-000-6092.
[13] Id.
[14] Id.
[15] Lawrence Gelber and James Bentley, “Third Circuit Approves Use of Escrow Agreements Funded by Acquirers to Pay Junior Creditors Before Senior Creditors” (Oct. 22, 2015), available at www.srz.com/files/News/5573676c-cc1d-4a41-ac50-6f8c89a28e32/Presentatio….
[16] Id.
[17] Id.
[18] In re Jevic Holding Corp., 787 F.3d 173, 185 (3d Cir. 2015), as amended (Aug. 18, 2015).
[19] Lawrence Gelber and James Bentley, “Third Circuit Approves Use of Escrow Agreements Funded by Acquirers to Pay Junior Creditors Before Senior Creditors” (Oct. 22, 2015), available at www.srz.com/files/News/5573676c-cc1d-4a41-ac50-6f8c89a28e32/Presentatio….