On March 5, 2007, in Motorola Inc. v. Official Committee of Unsecured Creditors (In re Iridium Operating LLC, et al.), ¹ the U.S. Court of Appeals for the Second Circuit proclaimed that “in the chapter 11 context, whether a pre-plan settlement’s distribution plan complies with the Bankruptcy Code’s priority scheme will be the most important factor for a bankruptcy court to consider in approving a settlement under Bankruptcy Rule 9019.” ²

The pertinent facts giving rise to the Iridium decision are as follows: the debtors, the pre-petition lenders and the unsecured creditors' committee reached a settlement agreement that conceded the perfection, seniority and unavoidability of the lenders’ pre-petition liens and divided up the funds conceded to be secured by those liens. ³  The settlement followed the bankruptcy court’s decision to authorize the committee to commence an action against the lenders, which would have challenged the validity of the lenders’ pre-petition liens. ⁴ The settlement was “lengthy and complex,” but only a few of its provisions formed the basis for the dispute before the Second Circuit. ⁵ Specifically, the settlement provided that the bulk of the funds would be distributed to the lenders, with the remainder earmarked for a litigation trust, as well as professional expenses in connection with the settlement and the litigation trust. ⁶ As part of the settlement, money recovered by the litigation trust was to be distributed in accordance with the Bankruptcy Code’s priority scheme, but any litigation trust seed money remaining after litigating was to go to the debtors’ general unsecured creditors. ⁷

The debtors’ former parent, Motorola Inc., was an administrative creditor and the target of the litigation trust. Motorola objected to the settlement based on the Bankruptcy Code’s priority scheme. ⁸ Motorola argued that if it prevailed in the litigation brought by the litigation trust or if Motorola’s administrative claims against the debtors exceeded Motorola’s liability from the litigation, then the settlement’s allocation of unused litigation trust seed money to unsecured creditors would violate the Bankruptcy Code’s priority scheme. ⁹

The bankruptcy court approved the settlement, and the district court affirmed the bankruptcy court’s approval over Motorola’s objection. ¹⁰ The Second Circuit vacated the district court’s order and remanded the case because “the record does not explain” why the distribution of residual litigation trust seed money was to be paid to general unsecured creditors in violation of the rule of priorities. ¹¹

The Second Circuit began its analysis by reviewing the lenders’ and committee’s argument that the subject funds were “actually the lenders’ property to do with as they see fit…” ¹² The lenders and committee pointed to the reasoning of a First Circuit case, Official Unsecured Creditors’ Comm. v. Stern (In re SPM Mfg. Corp.), ¹³ for support. The Iridium court explained that SPM “stands for the proposition that in a chapter 7 liquidation proceeding, an undersecured lender with a conclusively determined and uncontested ‘perfected, first security interest’ in all of a debtor’s assets may, through a settlement, ‘share’ or ‘gift’ some of those proceeds to a junior unsecured creditor, even though a priority creditor will go unpaid.” ¹⁴  The Second Circuit held that the facts before it were distinguishable from SPM because the validity of the lenders’ liens was in dispute and therefore the property subject to those liens was estate property until court approval of the settlement. ¹⁵ The Second Circuit specifically did not decide if SPM could ever apply to chapter 11 settlements. ¹⁶

The Iridium court then turned to Bankruptcy Rule 9019 factors and the “fair and equitable” standard. Guided by the Supreme Court’s decision in Protective Committee for Independent Stockholders of TMT Trailer Ferry Inc. v. Anderson (TMT), ¹⁷ the Iridiumcourt explained that bankruptcy judges must make informed and independent judgments as to whether proposed settlements are fair and equitable. Factors considered by bankruptcy judges when evaluating proposed settlements include, inter alia: “(1) the balance between the litigation's possibility of success and the settlement's future benefits; (2) the likelihood of complex and protracted litigation, with its attendant expense, inconvenience and delay, including the difficulty in collecting on the judgment; (3) the paramount interests of the creditors, including each affected class's relative benefits and the degree to which creditors either do not object to or affirmatively support the proposed settlement; (4) whether other parties in interest support the settlement; (5) the competency and experience of counsel supporting, and the experience and knowledge of the bankruptcy court judge reviewing, the settlement; (6) the nature and breadth of releases to be obtained by officers and directors; and (7) the extent to which the settlement is the product of arm's length bargaining.” ¹⁸ Turning to the fair and equitable standard, the Iridium court noted that the fair and equitable doctrine is derived from §1129(b)(2)(B)(ii) of the Bankruptcy Code and that courts have held that a settlement that is presented as part of a chapter 11 plan “may only be approved if it, too, is ‘fair and equitable’ in the sense of conforming to the absolute priority rule.” ¹⁹When a settlement is presented apart from a chapter 11 plan, e.g., a pre-plan settlement, the Second Circuit declared that such a compromise also needs to be fair and equitable, meaning it must comply with the Bankruptcy Code’s priority scheme even though the priority rule of §1129 is not necessarily implicated. ²⁰

The Iridium court contrasted its view on pre-plan settlements with the Fifth Circuit. In United States v. AWECO Inc. (In re AWECO), ²¹ the Fifth Circuit was faced with a senior creditor’s objection to a proposed settlement reached between the debtor and a junior creditor without the benefit of an adequate valuation of estate assets. ²² The AWECOcourt held that “a bankruptcy court abuses its discretion in approving a settlement with a junior creditor unless the court concludes that priority of payment will be respected as to objecting senior creditors.” ²³ Thus, the AWECO court refused to approve the settlement before it without a reliable valuation of estate assets demonstrating that adequate assets beyond those included in the settlement existed to insure compliance with the rule of priorities. ²⁴ While the Second Circuit recognized that the priority scheme is the “most important factor” in assessing whether a pre-plan settlement is fair and equitable under Rule 9019, the Iridium court found the Fifth Circuit’s rule “too rigid.” ²⁵ The Iridium court reasoned that, “a rigid per se rule cannot accommodate the dynamic status of some pre-plan bankruptcy settlements.” ²⁶ For example, the Iridium court noted that it is difficult to employ the priority rules in approval of a settlement in a case when the nature and extent of the estate and the claims against it are not yet fully resolved. ²⁷ Accordingly, the Iridium court adopted a more lenient standard for certain chapter 11 situations. The Iridium court stated that “where the remaining factors weigh heavily in favor of approving a settlement, the bankruptcy court, in its discretion, could endorse a settlement that does not comply in some minor respects with the priority rule if the parties to the settlement justify, and the reviewing court clearly articulates the reasons for approving, a settlement that deviates from the priority rule.” ²⁸

The Iridium court then analyzed the traditional Rule 9019 factors and found that each supports the approval of the settlement. However, the Second Circuit noted that the “record does not explain” why the distribution of residual litigation trust seed money was to be paid to general unsecured creditors in violation of the rule of priorities and that the court “will not speculate as to what reasons the committee or the lenders may offer for this deviation.” ²⁹ Accordingly, the Iridium court remanded the matter to the bankruptcy court to assess the justification for providing a distribution to junior creditors at the completion of the Motorola litigation. ³⁰

The final argument addressed by the Iridum court was Motorola’s contention that the settlement was an impermissible sub rosa plan of reorganization. The Iridium court noted that the Second Circuit permits the sale of an asset under §363(b) if a good business reason is found. ³¹ The Iridium court rejected Motorola’s sub rosa argument because a proper business justification for the settlement was identified by the bankruptcy court and the settlement was properly recognized as “a step towards possible confirmation of a plan of reorganization and not an evasion of the plan confirmation process.” ³²

In sum, the Iridium decision has several important ramifications for pre-plan settlements in the Second Circuit. First, parties cannot rely on SPM reasoning as a basis for approving a settlement if a dispute about a lender’s liens is being resolved as part of the settlement, which is the typical chapter 11 scenario. Second, if parties are presenting a settlement, which deviates from the priority scheme, the proponents must provide the bankruptcy court with specific and credible grounds to justify the deviation so that the court can articulate its reasons for approving the settlement, including any priority scheme deviation. Third, the Iridium court’s conclusion that the settlement was not an impermissible sub rosa plan of reorganization underscores the Second Circuit’s recognition that settlements are often important steps towards plan confirmation and that such settlements should continue to be approved so long as the record establishes a proper business justification for the settlement.