Pre-Plan Settlements May Reorder Priorities

By: Peter Doggett, Jr.

St. John's Law Student

American Bankruptcy Institute Law Review Staff

 

Rejecting a per se rule, the Second Circuit Court of Appeals in Motorola Inc. v. Official Comm. of Unsecured Creditors (In re Iridium Operating LLC)

[1]

attempted to balance the need for flexibility with the Bankruptcy Code’s priority scheme

[2]

by holding that compliance with the Code's priority rules is the “most important factor” to consider in approving a pre-plan settlement under Bankruptcy Rule 9019

[3]

where the settlement distributes assets.

[4]

In the Chapter 11 case of Iridium Operating LLC (“Iridium”) JPMorgan Chase Bank and other lenders (“Lenders”) asserted liens over much of what was left of Iridium.

[5]

  The Official Committee of Unsecured Creditors (“Committee”) contested those liens, especially the Lenders' claim to Iridium's remaining cash held in accounts at Chase.

[6]

  In addition, the Committee also asserted claims against Motorola Inc. (“Motorola”), Iridium's former parent company.

[7]

  The Committee sought approval of a settlement with the Lenders that created and funded a litigation vehicle, the Iridium Litigation LLC (“ILLLC”), so that the Committee could prosecute its claims against Motorola.

[8]

  Of importance, the settlement provided that any unspent litigation funds would be distributed to unsecured creditors, rather than going into the estate for distribution.  Motorola objected on the grounds that the settlement violated the “absolute priority rule” by distributing estate property to lower priority unsecured creditors before paying Motorola’s priority claims.

[9]

 The settlement was approved at the Bankruptcy Court and that decision was affirmed by the District Court.

[10]

 

On appeal Motorola argued that “a settlement can never be fair and equitable if junior creditors' claims are satisfied before those of more senior creditors.”

[11]

   Motorola based this claim on the “fair and equitable standard” set out in the Chapter 11 confirmation standards.

[12]

  The court noted that although that standard appears in the statutory provision dealing with the “cram down” of a plan of reorganization on non-consenting class, the test has been held to also apply to settlements.

[13]

  The court in Iridium stated that when a settlement impairs the priority scheme the proponent must show specific and credible grounds to justify that deviation and the court must “carefully articulate its reasons” for approval of the agreement.

[14]

  Therefore, the court remanded the case to the bankruptcy court for an assessment of the justification for the provision of this agreement that altered the Code’s priority scheme.

[15]

 

This decision is important because it takes a different approach to pre-plan settlements than the Fifth Circuit did in United States v. AWECO.

[16]

  AWECO established a per se rule that the Code's absolute priority rule must be honored in all pre-plan settlements under Rule 9019.

[17]

  While the Iridium court acknowledged that the Fifth Circuit was correct in its view that there could be problems if the priority scheme was not considered when approving settlements, it reasoned that the per se approach was too rigid.

[18]

 

Because the Second Circuit in Iridium adopts a less rigid rule, it gives judges discretion to allow settlements that do not follow the priority scheme of 11 U.S.C §1029(b)(2)(B)(ii).

[19]

  This creates a heightened risk of collusion between parties to a settlement.

[20]

    However, this risk may not be as great as one might think.  Giving judges discretion may be the best route because a judge's decision can always be reviewed on appeal, whereas a per se rule would leave no room for discretion.

[21]

  Furthermore, if the risk of collusion still exists even with the opportunity for appeal there may be benefits that outweigh the risk of collusion.  The Second Circuit’s discretionary test may promote settlements and therefore increase judicial efficiency.  As the Second Circuit noted, a per se rule might make it impossible to settle disputes early in a case when the priority of claims is still uncertain.

[22]

  Settlements are an important aspect of bankruptcy practice.  There is a clear a split among the circuits that is ripe for resolution by the Supreme Court.



[1]

478 F.3d 452 (2d Cir. 2007).

[2]

11 U.S.C. § 1129(b)(2)(B)(ii)(“[T]he 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 . . .”)

[3]

Fed. Rules. Bankr. Proc. 9019

[4]

In re Iridium, 478 F.3d at 464 (“[W]hether a particular settlement's distribution scheme complies with the Code's priority scheme must be the most important factor for the bankruptcy court to consider when determining whether a settlement is fair and equitable under Rule 9019.”)

[5]

In re Iridium, 478 F.3d at 456.

[6]

Id.

[7]

Id.

[8]

Id.at 459.

[9]

Id.

[10]

In re Iridium Operating LLC, No. 01-5429, 2005 WL 756900 (S.D.N.Y. Apr 04, 2005).

[11]

Id. at 462.

[12]

11 U.S.C. § 1129(b)(2)(B)(ii).

[13]

In re Iridium, 478 F.3d at 463 (quoting TMT Trailer Ferry v. Anderson, 390 U.S. 414, 424 (1968) ('''The requirements . . . that plans of reorganization be both ''fair and equitable,'' apply to compromises just as to other aspects of reorganizations.''')).

[14]

Id. at 465 (“[B]ankruptcy court . . . could endorse a settlement that does not comply . . . 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.”)

[15]

Id.at 467.

[16]

United States v. AWECO, Inc. (In re AWECO, Inc.), 725 F.2d 293 (5th Cir. 1984).

[17]

Id.at 298.

[18]

In re Iridium, 478 F.3d at 464 (“The Fifth Circuit accurately captures the potential problem a pre-plan settlement can present for the rule of priority, but, in our view, employs to rigid a test. . . . A rigid per se rule cannot accommodate the dynamic status of some pre-plan bankruptcy settlements.”).

[19]

Id. at 463.

[20]

Id. at 464 (noting that by rejecting the per se rule there is a heightened risk that parties to a settlement may engage in improper collusion).

[21]

Id. at 461 n. 13 (“bankruptcy court's articulation of Rule 9019's standard for evaluation a settlements is a legal issue subject to de novo review.”)

[22]

Id. at 464.