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Financially troubled debtors often seek bankruptcy protection to restructure their finances by substantially reducing their debt obligations. One method involves the filing of a petition under Chapter 11 of the U.S. Bankruptcy Code. Such a filing allows debtors to restructure their finances and business operations by maintaining a debtor-in-possession status-i.e., debtors are permitted to proceed with their business operations. In the restructuring process, debtors often face the Herculean task of attempting to provide distribution to their shareholders (equity interest holders) when they lack sufficient funds to fully compensate their more senior creditors. This task was made even more difficult by the recent 3d U.S. Circuit Court of Appeals decision in In re Armstrong World Indus. Inc., 432 F.3d 507 (3d Cir. 2005). The court ruled that shareholders, who rank below all creditors entitled to payment from a debtor, cannot share in the bankruptcy estate distributions on account of prepetition interests when other, more senior creditors are not fully compensated. Debtors’ attempts to provide distribution to shareholders cannot contravene the absolute-priority rule, said the 3d Circuit, no matter how indirect those distributions are made to appear, or by what means they are proposed. The Armstrong court analyzed, and mostly rejected, the debtor’s creative arguments for the distribution of warrants to shareholders when a senior class of creditors was not being paid in full. More importantly, the Armstrong court declared that the code strongly limits, if not squarely prohibits, the formation of alliances among classes of creditors and shareholders that result in the sharing of distributions made under a plan in a manner that is inconsistent with the absolute-priority rule. Armstrong is just one of several cases in which the debtor made an orchestrated effort to make virtually certain that shareholders participated in the distributions under proposed plans of reorganization. But unlike the results in the other cases, the 3d Circuit and the absolute-priority rule stood in Armstrong’s way. In fact, just recently, Armstrong filed a modified plan of reorganization that eliminated distribution to equity holders. Armstrong and its affiliates, which made asbestos-containing floor and ceiling products, filed for Chapter 11 protection in Delaware. The debtor’s proposed plan of reorganization faced a twofold objection by the unsecured creditors’ committee: that the plan violated the absolute-priority rule by distributing warrants to shareholders when other unsecured creditors were not being fully paid; and that the equitable exception to the absolute-priority rule-if one exists-did not apply. The district court agreed that the proposed plan violated the absolute-priority rule. In re Armstrong World Indus. Inc., 320 B.R. 523 (D. Del. 2005). ‘Fair and equitable’ For a Chapter 11 debtor to restructure its finances successfully, the court must confirm, or approve, its plan of reorganization. Generally, a plan may be confirmed only with the assent of each class of impaired creditors. See �� 1126(c), 1129(a)(8). If an impaired class of creditors rejects the plan, however, the plan may be confirmed only if the other requirements of confirmation are met and the plan satisfies the requirements of � 1129(b) of the bankruptcy code. This section establishes the so-called cramdown method of confirming a plan over the objection of a dissenting class of creditors. In a cramdown, a plan may be confirmed if it does not discriminate unfairly and is fair and equitable with respect to each class of claims or interest that is impaired under and has not accepted the plan. Section 1129(b)(2)(B) codified judicial decisions dating to 1913, and it addresses the “fair and equitable” (i.e., the absolute-priority rule) requirement of the code as far as claims of unsecured creditors are concerned. The absolute-priority rule calls for creditors to be paid in full before stockholders receive any value on account of their interests. The relevant portion of the statute is � 1129(b)(2)(B)(ii), which states that “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.” This section was the focal point of the Armstrong decision, in which at least three classes of creditors were deemed impaired (subject to receive less than 100% satisfaction of their claims) and the plan proposed to distribute warrants to shareholders. Warrants are certificates entitling the owner to buy a specified amount of stock at a specified time for a specified price. Although the Armstrong case was decided under the code as it existed prior to amendments that became effective on Oct. 17, 2005, the code section dealing with the absolute-priority rule was mostly unaffected, and any changes to it made by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 are not relevant to this article. For many years, creative debtors, in an attempt to provide distribution to shareholders, cut deals with classes of creditors. It appears that this is what happened in Armstrong-a deal the facts suggest was probably made between the asbestos claimants and the shareholders-as the proposed plan made fairly certain that the shareholders would receive the warrants. The 3d Circuit expressed its disapproval, finding that such agreements between creditors and shareholders cannot contravene the plain meaning of the statute and the absolute-priority rule embodied therein. The 3d Circuit found inconsequential the channels by which distributions to shareholders were proposed when other, senior, creditors were not scheduled to be fully compensated. The plan of reorganization proposed by the Armstrong debtor involved 11 classes of creditors and one class of shareholders; three of said classes were the focus of the court’s decision. A class of unsecured creditors was to receive 59.5% of its $1.6 billion in claims; a class of present and future asbestos-related personal-injury claimants with estimated claims of $3.1 billion was to receive an initial 20% of its allowed claims from a $1.8 billion trust established in accordance with � 524(g) of the bankruptcy code; and a class of common-stock shareholders of the parent company of the debtor was to be issued warrants to purchase the debtor’s new common stock valued at $35 million to $40 million, contingent on certain events. (Although the unsecured creditors and the asbestos claimants classes each comprised holders of general unsecured claims, due to the nature of their claims they were divided into two separate classes.) The plan provided that if the unsecured creditors rejected the plan, the asbestos claimants would receive the warrants. Moreover, in such a case the asbestos claimants would automatically waive receipt of the warrants, which would then be issued to the debtor’s parent company’s shareholders. The asbestos claimants then would only receive distributions from the trust. (It turned out that, but for the denial of confirmation, the shareholders would have received the warrants, because the unsecured creditors voted to reject the plan, while the asbestos claimants and the shareholders accepted it.) The arrangement proposed in the plan would result in the shareholders receiving an interest in the debtor post-confirmation even though a senior class of unsecured creditors would be denied full satisfaction of its allowed claims. The unsecured creditors’ committee maintained that this treatment was a violation of the absolute-priority rule . The debtor made three distinct arguments as to why the proposed plan did not violate � 1129(b)(2)(B)(i)-(ii) of the code. First, the debtor argued that this practice is permitted in light of that section’s legislative history; second, that case law provides for uninhibited transfers of distributions between creditors and others; and finally, that the plan did not propose to give warrants to the shareholders “on account of” their equity interests. The 3d Circuit found the arguments unpersuasive. The legislative history that the debtor relied on included statements by Representative Don Edwards, D-Calif., and Senator Dennis DeConcini, D-Ariz., that “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.” To the debtor, that meant that the absolute-priority rule was not intended to apply to the situation in its case, since the unsecured creditors were not an intervening class, nor was the unsecured creditor class being “squeezed out” by the asbestos claimants’ automatic transfers of the warrants to the shareholders-a method also known as “leapfrog” distribution. The 3d Circuit, however, concluded that the plain reading of the statute makes it clear that if an impaired senior claimant objects, the plan cannot give property to a junior claimant or equity-interest holder. Whether a senior (or co-equal) class of claimholders is being squeezed out is inconsequential, according to the 3d Circuit, as the plain language of the statute is devoid of any mention that the objecting class must be an intervening class. The debtor’s argument that the code freely permits transfers of bankruptcy distributions between creditors and shareholders also failed to persuade the court. Recognizing that the debtor’s argument finds support in the MCorp-Genesis line of cases, including In re SPM Manufacturing Corp., 984 F.2d 1305 (1st Cir. 1993), the 3d Circuit nevertheless found them distinguishable mainly as either falling under Chapter 7, or as cases involving “carve-out” arrangement for the benefits of junior claimants. In re MCorp Fin. Inc., 160 B.R. 941 (S.D. Texas 1995); In re Genesis Health Ventures Inc., 266 B.R. 591 (Bankr. D. Del. 2001). Circuit split In SPM, the 1st Circuit found enforceable an agreement between a secured creditor and the unsecured creditors’ committee. The SPM debtor was a family-owned manufacturer of photo albums and related products that filed for bankruptcy protection under Chapter 11. SPM owed approximately $5.5 million to general unsecured creditors-of which $750,000 was due to the Internal Revenue Service (IRS) and had priority status-and approximately $9 million to a bank that held a perfected, first-security interest in virtually all of the SPM’s assets. Because the efforts to reorganize SPM were contentious and far from fruitful, and recognizing that liquidation of SPM’s assets would leave nothing for any creditor besides the bank, the unsecured creditors’ committee-exclusive of the IRS-entered into a distribution-sharing agreement with the bank. The agreement provided for mutual cooperation, but more importantly, the parties agreed to share whatever proceeds they received-on certain percentage basis-as a result of the reorganization or liquidation of SPM. Subsequently, because there was no hope for SPM’s reorganization, the case was converted to Chapter 7, a stay relief was granted in the bank’s favor and SPM’s assets were sold for $5 million-substantially less than the bank’s secured claim. Because the agreement between the bank and the unsecured creditors’ committee would result in payment to the general unsecured creditors and not the priority claim of the IRS, the bankruptcy court, affirmed by the district court, rejected such distribution as violating the statutory distribution scheme under �� 724-726 of the code. Not so, said the 1st Circuit. It held that the distribution scheme of �� 726 and 507 never comes into play until all valid liens on the property are satisfied. Thus, because the bank’s secured claim was well in excess of the $5 million realized by the sale of SPM’s assets, and because the bank was granted a stay relief, there was nothing left for the bankruptcy estate-or the parties, including the IRS, with its priority claim, that normally would share from it. The syphoning of the money to general unsecured creditors came from the bank’s $5 million, said the court, and not anybody else, i.e., the estate. More importantly, and perhaps contrary to Armstrong, the SPM court held that “creditors are generally free to do whatever they wish with the bankruptcy dividends they receive, including to share them with other creditors.” The 3d Circuit did not expressly reject the holding of SPM, but it did conclude that such transfers are limited by the absolute-priority rule. Its holding in Armstrong thus limits the debtor’s ability to be creative in securing distribution via a plan of reorganization to shareholders. The method of cutting deals between creditors and shareholders is no longer sanctioned in the 3d Circuit if the result infringes on the absolute-priority rule. The court concluded that the Armstrong plan did run contrary to the absolute-priority rule, as it permitted the transfer of warrants from one unsecured creditor class to the shareholders in the event that its co-equal class of unsecured creditors rejected the plan. In addition, Armstrong frowned upon an automatic waiver of rights by one class of creditors without the means for dissenting members of the waiving class to express their opposition. The debtor’s third argument, and one that was perhaps a close call for the Armstrong panel, was the argument that the shareholders were not getting the warrants “on account of” or “because of” their equity interest, but rather because they settled certain intercompany claims with the debtor. The 3d Circuit had noted earlier, in In re PWS Holdings Corp., 228 F.3d 224 (3d Cir. 2000), that a causal connection between holding a prior claim or interest and receiving or retaining property will trigger the absolute-priority rule. In Armstrong, the court recognized that the Supreme Court in Bank of Am. Nat’l Trust & Sav. Ass’n v. 203 N. LaSalle St. P’ship, 526 U.S. 434 (1999), did not decide the necessary degree of causation under � 1129(b)(2)(B)(ii). It did, however, reveal “that the absolute priority rule, as codified, was not in fact absolute.” Armstrong, 432 F.3d at 515. The 3d Circuit in PWS recognized the fact that the “on account of” statutory language “confirms that there are some cases in which property can transfer to junior interest not ‘on account of’ those interests but for other reasons.” PWS, 228 F.3d at 238 (holding that “without direct evidence of causation, releasing potential claims against junior equity does not violate the absolute priority rule . . . where the claims are of only marginal viability and could be costly for the reorganized entity to pursue”). In differentiating the PWS ruling’s release of claims and the Armstrong debtor’s release of intercompany claims in exchange for the warrants, the court engaged in a mathematical comparison of the values of the intercompany claims and of the warrants. The court found that the amount of the intercompany claims constituted between 30% and 34% of the amounts of the warrants-meaning that the debtor was giving a lot more than it received as a result of this exchange. Because the debtor did not adequately explain to the court the reasons for the disparity in value, the Armstrong court concluded that the shareholders were slated to receive the warrants on account of their status as shareholders. Equitable arguments also have their limits. More than two decades ago, the 3d Circuit found an exception to the absolute-priority rule in In re Penn Central Transportation Co., 896 F.2d 1127, 1142 (3d Cir. 1979), finding that “our construction and application of precedents such as the absolute priority rule must necessarily take account of the unique facts of this Plan and proceed in an environment pervaded more by relativity than by absolutes.” Practitioners should be careful, however, in analogizing Penn Central to their cases. Penn Central was a unique case, involving Congress’ intervention by passing the Regional Rail Reorganization Act of 1973. It also involved the creation of a special court to determine certain contested issues. The issues in Penn Central were on a scale of a national crisis. It can be assumed from the court’s reasoning in Armstrong that equitable arguments generally will not cause the court to deviate from the strict interpretation of the absolute-priority rule. Armstrong raises certain policy questions that will affect Chapter 11 practice. Although Armstrong‘s reading of the absolute-priority rule has the virtue of straightforwardness and simplicity, it may not make sense from a policy perspective. Why should senior lienholders, for example, be forbidden from carving out some of their distribution in order to pay some key unsecured suppliers? Stated another way, why should it be anyone’s business what happens with money slated for distribution to a particular class of creditors? Perhaps, as can be implied from Armstrong, the courts are wary of alliances being formed between certain classes of creditors and equity interest holders resulting in the disenfranchisement of other impaired classes of creditors. In sum, debtors in the 3d Circuit must keep in mind the requirements of the absolute-priority rule when shareholders are slated to receive distribution under a plan. Although Armstrong did not break new ground in this area, it made it clear that even a sophisticated attempt to circumvent the plain meaning of the statute will not be tolerated. John K. Sherwood is a director, and Wojciech F. Jung is an associate, in the bankruptcy, financial restructuring and creditors’ rights practice group at Lowenstein Sandler in Roseland, N.J. Sherwood can be reached at [email protected]; Jung can be reached at [email protected].

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