Application Of The Absolute Priority Rule To Pre-Chapter 11 Plan Settlements: In Search Of The Meaning Of 'Fair And Equitable'

"Give-ups" by senior classes of creditors to achieve confirmation of a plan have become an increasingly common feature of the chapter 11 process, as stakeholders strive to avoid disputes that can prolong the bankruptcy case and drain estate assets by driving up administrative costs. Under certain circumstances, however, senior-class "gifting" or "carve-outs" from senior-class recoveries may violate a well-established bankruptcy principle commonly referred to as the "absolute priority rule," a maxim predating the enactment of the Bankruptcy Code, which established a strict hierarchy of payment among claims of differing priorities. The rule's continued application under the current statutory scheme has been a magnet for controversy.

Most of the court rulings handed down recently concerning this issue have examined the rule's application to the terms of a proposed chapter 11 plan that provides for the distribution of value to junior creditors without paying senior creditors in full. A decision recently issued by the Second Circuit Court of Appeals, however, indicates that the dictates of the absolute priority rule must be considered in contexts other than confirmation of a plan. In Motorola, Inc. v. Official Comm. of Unsecured Creditors (In re Iridium Operating LLC), the Second Circuit ruled that the most important consideration in determining whether a pre-plan settlement of disputed claims should be approved as being "fair and equitable" is whether the terms of the settlement comply with the Bankruptcy Code's distribution scheme.

Cramdown and the Fair and Equitable Requirement

If a class of creditors or shareholders votes to reject a chapter 11 plan, it can be confirmed only if the plan satisfies the requirements of section 1 129(b) of the Bankruptcy Code. Among these is the mandate that a plan be "fair and equitable" with respect to dissenting classes of creditors and shareholders.

Section 1 129(b)(2) of the Bankruptcy Code provides that a plan is "fair and equitable" with respect to a dissenting impaired class of unsecured claims if the creditors in the class receive or retain property of a value equal to the allowed amount of their claims or, failing that, no creditor of lesser priority, or shareholder, receives any distribution under the plan. This requirement is sometimes referred to as the "absolute priority rule."

Section 1129(b)(2) has been the focus of considerable debate in the courts. One of the most significant disputes concerns the propriety of an increasingly common, albeit controversial, practice in large chapter 11 caseswhether section 1129(b)(2) allows a class of senior creditors voluntarily to cede a portion of its recovery under a plan to a junior class of creditors or shareholders, while an intermediate class is not receiving payment in full.

Legitimacy of Senior-Class "Give-Ups " Under the Absolute Priority Rule

Notwithstanding section 1129(b)(2)'s preclusion of distributions to junior classes of claims or interests in cases where it applies, some courts have ruled that a plan does not violate the "fair and equitable" requirement if a class of senior creditors agrees that some of the property that would otherwise be distributed to it under the plan can be given to a junior class of creditors or shareholders. In doing so, many courts rely on a 1993 decision involving a chapter 7 case issued by the First Circuit Court of Appeals in In re SPM Manufacturing Corp.

In SPM, a secured lender holding a first-priority security interest in substantially all of a chapter 11 debtor's assets entered into a "sharing agreement" with general unsecured creditors to divide the proceeds that would result from the reorganization, presumably as a way to obtain their cooperation in the case. After the case was converted to a chapter 7 liquidation, the secured lender and the...