The "absolute priority" rule embodied in the "fair and equitable" test for cramdown of a plan just became a little more "absolute," at least according to the recent decision of the U.S. District Court of Delaware in In re Armstrong World Industries.² The court denied confirmation of the debtor's fourth amended reorganization plan because the plan provided value to equity—albeit in a roundabout way—over the objection of unsecured creditors who were impaired and dissented.³

The plan contemplated giving warrants to stock of the reorganized Armstrong to equity-holders unless the general unsecured creditors rejected the plan.⁴ If general unsecured creditors rejected, then the warrants would be paid to one class of creditors, the asbestos personal injury claimants, but these claimants would waive distribution of the warrants, and thus equity would receive the warrants anyway.⁵ The court held that this distribution scheme violated the absolute priority rule and denied confirmation.

The court began its analysis with an extended historical review of the underpinnings of the "fair and equitable" requirement of Bankruptcy Code §1129(b), which was the "judicially created absolute priority rule,"⁶ and concluded that before the enactment of the current Code the rule mandated that junior creditors receive nothing until all senior classes are paid in full.⁷ The court noted the admonition of the Supreme Court in 1913 that "[a]ny device, whether by private contract or judicial sale under consent decree, whereby stockholders were preferred before the creditor, [is] invalid."⁸ The court noted that the Code of 1978 modified the absolute priority rule so that impaired classes could consent to a distribution to a junior class. If all impaired classes vote to accept the plan, §1129(b) does not apply. However, §1129(b)(2)(B) prevents confirmation of a plan (because it is not "fair and equitable"⁹) when a class of unsecured claims is impaired, votes to reject the plan and a holder of any junior claim or interest is to receive or retain any property under the plan.¹⁰

The court then reviewed the Code to determine whether the statutory language of §1129(b)(2)(B) had a plain meaning¹¹ and concluded that it did, stating that "a plan is not 'fair and equitable' if a class of creditors 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."¹² Thus, the plan violated the requirements of §1129(b)(2)(B) and was not "fair and equitable" and could not be confirmed.¹³

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Armstrong has redrawn the battle lines, and now the aggrieved will have a powerful opinion on their side.

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The district court noted that "available legislative history demonstrates that Congress did not intend for the Code to allow a senior class to sacrifice its distribution to a junior class when a dissenting intervening class had not been fully compensated. Congress anticipated, but ultimately rejected, this possibility."¹⁴ In passing the Code, the congressional floor managers rejected a statement contained in the Senate report that said a senior creditor could "adjust his participation for the benefit of stockholders" over the dissent of an intervening class.¹⁵

The court distinguished the First Circuit's holding in Official Unsecured Creditors' Committee v. Stern (In re SPM Manufacturing Corp.)¹⁶ (SPM) and rejected all authority that did not strictly enforce the absolute priority rule. The Armstrong court first noted that the distribution in SPM occurred in a chapter 7 proceeding, which is not subject to §1129(b)(2)(B).¹⁷ Second, the secured lender in SPM—which agreed to share proceeds with the unsecured creditors, even though there would be no payment to priority tax claims—held a perfected security interest in most of the debtor's assets, and the proceeds of that property were not subject to distribution under the Code's priority scheme.¹⁸ Finally, the Armstrong court analogized the sharing agreement in SPM to a "carve-out" in which the secured creditor agreed to have a portion of its assets directed to a third party.¹⁹ According to the court, the secured lender in SPM had a substantive right to dispose of its property, including the right to share the proceeds subject to its lien with other classes.²⁰

The Armstrong court then briefly distinguished other cases cited in favor of the plan,²¹ but more importantly concluded that, to the extent that any of these cases interpret SPM to stand for the unconditional proposition that "[c]reditors are generally free to do whatever they wish with the bankruptcy dividend that they receive, including sharing them with other creditors,"²² "that contention is flatly rejected here."²³ "Bluntly put, no amount of legal creativity or counsel's incantation to general notions of equity or to any supposed policy favoring reorganizations over liquidation supports judicial rewriting of the Bankruptcy Code."²⁴

Encouraged by SPM, some debtors have pushed the envelope to reward some classes and punish others. Armstrong has redrawn the battle lines, and now the aggrieved will have a powerful opinion on their side. Furthermore, despite the distinction noted between SPM and Armstrong—that a secured creditor has a "substantive right to dispose of its property"²⁵—it is not at all clear that a plan could do what the Armstrong plan wanted to do if a secured creditor class wanted to "donate" property to a junior class over the objection of an impaired intervening class. That difference would appear to be irrelevant to the language of §1129(b)(2)(B); its focus is on whether the junior class receives or retains property under the plan—not the source of that property.²⁶

Footnotes

¹ The author gratefully acknowledges the assistance of Will Sugden, an associate in the Bankruptcy Group at Alston & Bird LLP, in the preparation of this article. Return to article

² In re Armstrong World Indus. Inc., 320 B.R. 523 (D. Del. 2005). Return to article

³ Id. at 526. The procedural posture of the Armstrong case is notable. The Third Circuit assigned the case, along with four other asbestos-related bankruptcy cases, to Judge Wolin, district judge for the district of New Jersey, who in turn referred the cases to separate Delaware bankruptcy judges. The order consolidating these cases contemplated joint district court/bankruptcy court oversight of the cases to streamline case administration. The Third Circuit later removed Judge Wolin from the cases. The bankruptcy court then issued proposed findings of fact and conclusions of law. The district court (District of Delaware) refused to adopt these findings and therefore refused to confirm the plan. Return to article

⁴ Id. at 526. Return to article

⁵ Id. Return to article

⁶ Id. at 533. Return to article

⁷ Id. at 533-34. Return to article

⁸ Id., quoting N. Pac. Ry. Co. v. Boyd, 228 U.S. 482 (1913). Return to article

⁹ 11 U.S.C. §1129(b)(2)(B). Return to article

¹⁰ In re Armstrong World Indus. Inc., 320 B.R. at 534. Return to article

¹¹ Id. at 534-37. Return to article

¹² Id. at 536. Return to article

¹³ Id. Return to article

¹⁴ Id. Return to article

¹⁵ Id. at 536 n.25. In disagreeing with this provision of the Senate report the Congressional managers of the Code noted that "[c]ontrary to the example contained in the Senate report, 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." 124 Cong. Rec. S34007 (daily ed. Oct. 5, 1978) (remarks of Sen. DeConcini); 124 Cong. Rec. H32408 (daily ed. Sept. 28, 1978) (remarks of Rep. Edwards). Return to article

¹⁶ Official, Unsecured Creditors' Comm. v. Stern (In re SPM Mfg. Corp.), 984 F.2d 1305 (1st Cir. 1993). The Armstrong court described SPM's facts as follows:

In SPM, a secured lender entered into a "sharing agreement" with general unsecured creditors to share in the proceeds that would result from a debtor's reorganization. The apparent purpose of the agreement was to obtain the cooperation of the unsecured creditors in the debtor's reorganization, which, given that the secured lender had a perfected, first-security interest in the debtor's assets, would not have inured to the benefit of the unsecured creditors. The reorganization did not work. Instead, the case was converted to a chapter 7 proceeding, and the debtor's assets were liquidated.
The secured lender and the unsecured creditors then sought to compel the chapter 7 trustee to distribute proceeds from the sale of debtor's assets in accordance with the sharing agreement. The sharing agreement provided for the distribution of proceeds from the sale of the debtor's assets to the unsecured creditors, ahead of the priority tax creditors in apparent contravention of the Code's statutory scheme for distribution. The bankruptcy court disagreed and, relying on its equitable powers under 11 U.S.C. §105(a), ordered the trustee to distribute the portion of the proceeds due to the unsecured creditors under the sharing agreement in accordance with the distribution scheme embodied by the Code, i.e., priority tax creditors should be paid ahead of the unsecured creditors. After the district court affirmed the bankruptcy court's decision, the court of appeals reversed.

In re Armstrong World Indus. Inc., 320 B.R. at 537 (citations and footnotes omitted). Return to article

¹⁷ In re Armstrong World Indus. Inc., 320 B.R. at 538. Return to article

¹⁸ Id. Return to article

¹⁹ Id. Return to article

²⁰ Id. Return to article

²¹ Id. at 539. In re WorldCom Inc., No. 02-13533, 2003 Bankr. LEXIS 1401 at *180 (Bankr. S.D.N.Y. Oct. 31, 2003), was inapplicable to the Armstrong case because the plan in WorldCom did not "involve the distribution of the debtor's property to any class of interests junior to the unsecured creditors on account of the junior creditors' equity interests in the debtor." Similarly, the Armstrong court distinguished In re Genesis Health Ventures Inc., 266 B.R. 591 (Bankr. D. Del. 2001), which involved a distribution to management from the senior lender's liens. Genesis Health Ventures, according to the court, was like SPM in that it involved a carve-out from a secured creditor. The Armstrong court then distinguished In re MCorp Fin. Inc., 160 B.R. 941 (S.D. Tex. 1993), which provided for a distribution from senior creditors to fund settlement of pre-petition litigation between the debtor and a third party. Finally, the court reasoned that MCorp was inapplicable because the plan did not involve a settlement between the asbestos claimants and the equity-holders. Return to article

²² In re Armstrong World Indus. Inc., 320 B.R. at 539. Return to article

²³ Id. at 539-40. Return to article

²⁴ Id. at 540. Return to article

²⁵ Id. at 539. Return to article

²⁶ The Armstrong decision quotes an article that also considers the historical development of the absolute priority rule, and which concludes:

[A] plan should not be permitted to be crammed down where a senior class gives up value to a junior class while skipping over an intermediate or co-equal class. Although the argument can be and has been made that senior creditors should be entitled to do what they want with their property, the lessons of history should suffice to impose a per se rule that precludes senior creditors from collaborating with junior creditors or equity owners at the expense of intervening classes.

Id. at 540. A footnote to that article notes that "Equity receiverships during the early part of the twentieth century were notorious for the collaborations of secured creditors and owners to squeeze out unsecured creditors." Klee, Kenneth N., "Adjusting Chapter 11: Fine-tuning the Plan Process," 69 Am. Bankr. L. J. 551 n.110 (1995) (emphasis added). Return to article