Armstrong World Industries Absolute Priority Rule Is More than FAIR
In December 2000, Armstrong Worldwide Industries Inc. (AWI) and two subsidiaries filed for chapter 11 in Delaware, largely as a result of their alleged liabilities relating to the manufacture and distribution of asbestos-containing products. Throughout most of 2003, AWI believed it was on its way to confirming a reorganization plan (in advance of many of the other asbestos bankruptcy cases filed at about the same time). AWI had reached agreement on the terms of a plan with its key constituencies, including the asbestos claimants and the unsecured creditors' committee (UCC), the latter representing all unsecured creditors other than asbestos personal-injury claimants.
The reorganization plan provided, in pertinent part, that AWI would distribute $1.8 billion in value to a trust established pursuant to §524(g) of the Code to satisfy claims of all present and future asbestos creditors (Class 7). General unsecured creditors (Class 6) represented by the UCC would receive approximately 59.5 percent of the value of their claims. Class 12, consisting of Armstrong Worldwide Inc. (AWWD), AWI's parent, would receive $35-40 million in warrants to purchase equity in reorganized AWI. However, in the event that the unsecured creditors in Class 6 rejected the plan, those warrants would be distributed to the asbestos claimants in Class 7, who would automatically waive receipt, and the warrants would be issued to AWWD, the existing Class 12 holder of the equity interests.
The AWI plan began to spring a leak in September 2003, when the UCC—the same committee that negotiated the treatment in the plan for its constituency of unsecured creditors—filed a limited objection to confirmation. The UCC argued that such treatment would be inadequate if pending federal asbestos trust legislation, known as the FAIR Act,2 were passed by Congress because, under FAIR, an additional $1 billion in value would be available to satisfy claims of non-asbestos unsecured creditors.3 The UCC also contended that the plan violated the absolute priority rule, as codified in 11 U.S.C. §1129(b)(2)(B), in awarding the warrants to the existing equity-holder. After the unsecured creditors in Class 6 rejected the plan in October 2003, the issue was joined and the UCC pressed its objections to confirmation.
The Lower Courts' Decision4
After a two-day confirmation hearing, the bankruptcy court held that the UCC waived its right to object to the plan by "enter[ing] into a consensual plan encompassing" the issuance of warrants to equity. The bankruptcy court also held that the absolute priority rule was satisfied because the plan provided that in the event Class 6 rejected the plan, the class of asbestos claimants would receive the warrants and then automatically waive receipt of the warrants so that they could be issued to the existing equity-holders.
The district court, reviewing the matter de novo, denied confirmation.5 The district court engaged in a detailed analysis of the absolute priority rule, from its judicial creation to its subsequent codification in §1129(b). The court found that the statute's meaning was plain on its face and that, accordingly, the AWI plan violated the absolute priority rule because equity received consideration before the claims of impaired objecting creditors were paid in full. In re Armstrong World Industries, 320 B.R. 523, 532-536 (D. Del. 2005). The court distinguished a number of cases that seemed to bend the rule, finding that to the extent these cases "stand for the unconditional proposition that 'creditors are generally free to do whatever they wish with the bankruptcy dividends they receive, including sharing them with other creditors, so long as recoveries received under the plan by other creditors are not impacted,' without adherence to the strictures of 11 U.S.C. §1129(b)(2)(B)(ii), that contention is flatly rejected here." Id. at 539-40 (citations omitted). The district court also dismissed AWI's call for equity: "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." Id. at 540. AWI then appealed the district court's decision to the Third Circuit Court of Appeals.
The Third Circuit's Opinion
On appeal before the Third Circuit, AWI raised two issues with respect to the applicability to the plan of 11 U.S.C. §1129(b)(2)(B): (1) whether the issuance of warrants to AWWD violated the absolute priority rule, and (2) whether an equitable exception to the absolute priority rule applied in the circumstances of the AWI asbestos bankruptcy case.
The Third Circuit rejected AWI's contention that §1129(b)(2)(B) of the Code was intended by Congress to protect only "intermediate" classes of unsecured creditors. The court instead found that the plain language of that section precluded the distribution of warrants to AWWD over the objection of the unsecured creditors in Class 6 for the simple reason that "the plan would give property to Class 12, which has claims junior to those of Class 6." 432 F.32 at 513. The court found no conflict between the legislative history and the language of the statute.
The court then addressed whether any exceptions might apply to the application of the absolute priority rule to the plan. Adopting the district court's reasoning, the appeals court distinguished those cases cited by AWI for the proposition that a creditor class can transfer some of its recovery to a junior class without violating §1129(b) of the Code,6 finding that they did not "stand for the unconditional proposition that creditors are generally free to do whatever they wish with the bankruptcy proceeds they receive." Id. at 514. Noting that the structure of the plan ensured that Class 12 received the warrants regardless of whether Class 6 consented, the court held that "[a]llowing this particular type of transfer would encourage parties to impermissibly sidestep the carefully crafted structures of the Bankruptcy Code and would undermine Congress' intention to give unsecured creditors bargaining power in this context." Id. at 514-15.
The court then addressed AWI's argument that Class 12 was receiving the warrants in settlement of AWWD's intercompany claims, and not "on account of" its equity interests, the latter of which would violate §1129(b)(2)(B)(ii).7 Although acknowledging "that there are some cases in which property can transfer to junior interests not 'on account of' those interests but for other reasons," the court found that the AWI plan was not one of those cases. Id. at 515. Under the plan, AWWD would get warrants worth $35-40 million, among other considerations, in exchange (according to AWI's argument) for the release of a $12 million intercompany claim. "This settlement would amount to a substantial benefit for Class 12, especially as the warrants were only a part of the consideration for which the intercompany claims were released." Id. at 516. Because no adequate explanation was offered for the difference in value, the court concluded that the warrants would be received on account of AWWD's status as equity-holder and thus violative of the absolute priority rule. Id.
The appeals court also rejected AWI's argument that an equitable exception to the absolute priority rule should be applied. AWI primarily relied upon In re Penn Central Transportation Co., 596 F.2d 1127, 1142 (3d. Cir. 1979), in which the Third Circuit held, in the context of resolving what was then "the most complex set of interrelated and conflicting claims ever addressed under...the Bankruptcy Act," that 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." Id. at 1129, 1142. Although AWI set forth a long list of factors that it contended demonstrated the uniqueness of its case—including that the UCC objected primarily because of the possibility of FAIR becoming law—the court concluded that AWI's asbestos bankruptcy case did not involve the kind of "exigent circumstances" that would warrant an exception to the absolute priority rule. 432 F.3d at 517.
Finally, the Third Circuit found nothing untoward in the UCC's decision to abandon its support for AWI's plan in anticipation of the possible enactment of the FAIR Act. Framing the issue as one of judicial estoppel, the Third Circuit held that the UCC was free to file an objection at any time prior to the objection deadline, notwithstanding that it was premised, in part, upon the possible passage of FAIR.8 That the UCC's objection was also based on an alleged violation of the absolute priority rule, however, outweighed any concern that the objection was based "on speculation that legislation will be passed...." Id. at 518.
The Armstrong World Industries decision is instructive for the Third Circuit's strict application of the absolute priority rule and its refusal to consider this asbestos bankruptcy case as raising "exigent circumstances" worthy of an exception to §1129(b). The issues that troubled the bankruptcy court—the timing of the UCC's objection and that the objection was based partly upon the possible passage of the FAIR Act—did not trouble the Third Circuit (or the district court) because the AWI plan violated §1129(b). Yet, as the appeals court plainly—and ironically—recognized, its ruling returned the case to square one, making it "less likely that the purposes of chapter 11 (preserving the business as a going concern and maximizing the amount that can be paid to creditors) will be fulfilled." Id. at 518.
1 Alison R. Pearsall, an associate with Stroock, substantially contributed to the preparation of this article.
2 "FAIR" is an acronym for Fairness in Asbestos Injury Resolution Act. As of press time, FAIR is on life support, having failed to survive a challenge that its passage into law would violate Senate budget rules. Senate Majority Leader Frist has promised to bring the budget challenge to the floor for a re-vote if at least 60 senators publicly declare that they will reject the budget challenge and end any filibuster of the bill.
3 Under FAIR, AWI would be required to contribute some $520 to $805 million to a trust established to pay asbestos personal injury claimants, while under the plan AWI was to pay $1.8 billion to resolve its present and future asbestos personal injury claims.
4 For another discussion of the history related to the absolute priority rule issue, see Weitnauer, Kit, "Absolute Priority Rule Is, Indeed, Absolute for Purposes of the Fair and Equitable Test," ABI Journal, Vol. XXIV, No. 4, May 2005 at 40.
5 The district court appears to have reviewed the matter as an appeal from the bankruptcy court's findings of fact and conclusions of law, but final confirmation of certain aspects of the plan also required approval by the district court because the plan included a channeling injunction under 11 U.S.C. §524(g) governing the asbestos claims. Regardless, the district court appropriately engaged in a de novo review of the absolute priority issue raised by the UCC before the bankruptcy court.
6 Id. at 514; see In re Genesis Health Ventures Inc., 266 B.R. 591 (Bankr. D. Del. 2001); In re SPM Mfg Corp., 984 F.2d 1305 (1st Cir. 1993); In re MCorp Fin Inc., 160 B.R. 941, 948 (S.D. Tex. 1993).
7 That section provides that holders of junior claims "will not receive or retain [any property] under the plan on account of such junior claim or interest." 11 U.S.C. §1129(b)(2)(B)(ii).
8 As the district court held: "Even if the unsecured creditors changed their minds based on political calculus that the FAIR Act would be passed, this was their prerogative. In the absence of bad faith, which was not alleged here, and particularly in light of the changed circumstances, until a party consents and the consent is final, that party may walk away from the table for a good or bad reason or no reason at all." 320 B.R. at 534 n. 24.