Senior Lender's Carve Out for Benefit of General Unsecured Creditors Does Not Violate Absolute Priority Rule
In re World Health Alternatives, Inc., 344 B.R. 291 (Bankr. D. Del. 2006) (Judge Peter J. Walsh)
The Debtors, Committee, and Senior Lender moved for approval of a global settlement and the United States Trustee objected, arguing that the Committee was not authorized to borrow and/or compromise estate claims and causes of action at the expense of priority unsecured creditors in a Chapter 11 case. The Court approved the settlement. Funds set aside for the general unsecured creditors were part of the lender’s perfected security interest and not property of the estate, so the settlement did not violate the Code’s absolute priority rule.
The Debtors filed for bankruptcy protection under Chapter 11 and concurrently filed a series of motions to sell substantially all of the Debtors’ assets and for post-petition secured and super-priority debt from the pre-petition lender (“Lender”). The Official Committee of Unsecured Creditors (“Committee”) objected to the sale and debtor-in-possession financing (“DIP”). The Committee received an extended deadline to investigate and object to the Lender’s secured position in exchange for withdrawing its objection to the DIP. Shortly thereafter, the Debtors, Committee and the Lender entered into a global settlement of all the disputes among the parties (“Letter Agreement”) and filed a motion under Fed.R.Bankr.P. 9019 to approve the settlement (“Settlement Motion”).The Letter Agreement 1) extended the time to challenge the Lender’s secured position until after the Court had approved the Settlement Motion; 2) capped the Lender’s secured claim; 3) created a $1.625 million collateral carve-out for the benefit of the general unsecured creditors for distribution to those creditors and/or to be used to fund investigation and prosecution of cases against parties other than the Lender; 4) secured releases for the Lender from the Committee and the Debtors; and 5) granted the Committee the right to pursue avoidance actions and any claims on behalf of the estate against the former officers, directors, and pre-petition professionals of the Debtors.
The United States Trustee (“UST”) objected to the settlement, arguing that a Committee is not authorized to borrow and/or compromise estate claims and causes of action at the expense of priority unsecured creditors in a Chapter 11. No other objections were raised to the settlement. In support of its argument, the UST asserted that the Debtors’ schedules listed, among other unknown priority tax creditors, a debt owed to the I.R.S. of $4 million. The UST therefore argued that the collateral carve-out negotiated by the Committee violated the Third Circuit precedent in In re Armstrong World Indus., Inc., 432 F.3d 507 (3rd Cir. 2005) and violated the absolute priority rule of 11 U.S.C. § 1129(b). The UST also filed a motion to appoint a Chapter 11 Trustee or convert the Chapter 11 case to one under Chapter 7. The Debtors likewise filed a motion to convert the case to a Chapter 7, and the Committee supported conversion. The Committee and the Debtors, however, requested a ruling on the Settlement Motion prior to conversion.
The Court held that the funds set aside for the general unsecured creditors were not property of the estate and were property of the Lender, removing the funds from the Code’s priority scheme. Both the fact that the funds were part of a secured party’s perfected security interest and that the secured party had agreed to allow a portion of its lien proceeds to be paid to others removed it from the property of the estate. The Court further held that the settlement did not disturb the absolute priority rule because the case did not involve a plan of reorganization.
The Court also found that the Committee’s withdrawal of its objection to the sale motion was substantial consideration given by the Committee itself, not on behalf of the estate or the Debtors, in exchange for the collateral carve-out. If the settlement was denied, the Lender would be able to keep the carve-out. Additionally, $1.3 million remaining from the sale proceeds could be sought by the Lender as a secured claim without the cap on its claim under the Letter Agreement. The Court found that the estate would suffer if these funds were not available to a Chapter 7 trustee to pursue claims against the Debtors’ officers, directors, professionals and others.
The Court noted that it had received uncontradicted testimony from both the Debtors and the Committee that causes of action against the Lender would be expensive, time consuming and uncertain. The Court agreed that there was a low probability of litigation success in challenging the Lender’s secured position. The Court also noted that pursuing causes of action against the former officers, directors, and pre-petition professionals of the Debtors was a more reasonable course of action for an estate with limited resources as opposed to pursuing a challenge to the secured position of the Lender. The Court held that approval of the Settlement Agreement supported this strategy.
The Court briefly discussed that caselaw holding a creditors committee only owes a fiduciary duty to the general unsecured creditors is the recognition that there is an implicit conflict of interest between general unsecured creditors and priority creditors.
For these reasons, the Court approved the Settlement Motion as being in the best interest of the estate.
The UST ultimately appealed the order. The appeal was resolved by a settlement agreement approved in the Bankruptcy Court, which included a provision dismissing the appeal. See Order. [Docket No. 631, Bankruptcy Case No. 06-10166]. In settling the appeal, the Committee gave up its right to distribution of the $1.625 million collateral carve out and agreed that the money could be paid to the debtor and would be property of the debtor’s estate for distribution in accordance with the Code’s priority scheme. Soon after payment was received by the Debtor, the cases were to be converted to Chapter 7. See Stipulation and Order Dismissing Appeal. [Docket No. 5, United States District Court for the District of Delaware Civil Action Number 06-cv-535 (SLR)].
