Funds Earmarked By Section 363 Purchaser To Pay Creditors Need Not Be Distributed In Accordance With Bankruptcy Code's Priority Scheme

A ruling recently handed down by the U.S. Court of Appeals for the Third Circuit may provide significant flexibility to debtors in that circuit who are implementing sales of substantially all of their assets. In In re LCI Holding Company, Inc., 2015 BL 295784 (3d Cir. Sept. 14, 2015), the court of appeals ruled that funds provided by a secured lender which purchased a debtor's assets by means of a credit bid, pursuant to section 363(b) of the Bankruptcy Code, for the payment of administrative fees, wind-down costs, and unsecured claims need not be distributed in accordance with the Bankruptcy Code's priority rules because the funds were not property of the debtor's estate.

The Bankruptcy Code's Priority Scheme

Secured claims have the highest priority under the Bankruptcy Code, to the extent of the value of the secured claimant's collateral. A claim is secured only to the extent that the value of the underlying collateral is equal to or greater than the face amount of the indebtedness. If this is not the case, the creditor will hold a secured claim in the amount of the collateral value and an unsecured claim for the deficiency. Applicable nonbankruptcy law and any agreements between and among the debtor and its secured creditors generally determine the relative priority of secured claims. However, if certain requirements are met, the Bankruptcy Code provides for the creation of priming liens superior even to pre-existing liens in connection with financing extended to a debtor during a bankruptcy case.

The order of priority of unsecured claims is specified in section 507(a) of the Bankruptcy Code. Priorities are afforded to a wide variety of unsecured claims, including, among others, specified categories and (in some cases) amounts of domestic support obligations, administrative expenses, employee wages, taxes, and certain wrongful death damages awards.

In a chapter 7 case, the order of distribution of unencumbered bankruptcy estate assets is determined by section 726 of the Bankruptcy Code. This order ranges from payments on claims in the order of priority specified in section 507(a), which have the highest ranking, to payment of any residual assets to the debtor, which has the lowest. Distributions are to be made pro rata to claimants of equal ranking within each of the six categories of claims specified in section 726. If claimants in a higher category of distribution do not receive full payment of their claims, no distributions can be made to lower category claimants.

In a chapter 11 case, the plan determines the treatment of secured and unsecured claims (as well as equity interests) in accordance with the provisions of the Bankruptcy Code. If a creditor does not consent to "impairment" of its claim under a plan—such as by agreeing to receive less than payment in full—and votes to reject the plan, the plan can be confirmed only under certain specified conditions. Among these are the following: (i) the creditor must receive at least as much under the plan as it would receive in a chapter 7 case (section 1129(a)(7)), a requirement that incorporates the priority and distribution schemes delineated in sections 507(a) and 726; and (ii) the plan must be "fair and equitable." Section 1129(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, if no creditor or equity holder of lesser priority receives any distribution under the plan. This requirement is sometimes referred to as the "absolute priority rule."

Senior-Class "Gifting" Under Chapter 11 Plans

A matter of considerable debate concerning section 1129(b)(2) is whether the provision allows a class of senior creditors voluntarily to cede, or "gift," a portion of its recovery under a chapter 11 plan to a junior class of creditors or equity holders, while an intermediate class does not receive payment in full.

In approving senior-class "gifting," some courts rely on the First Circuit's ruling in Official Unsecured Creditors' Comm. v. Stern (In re SPM Manufacturing Corp.), 984 F.2d 1305 (1st Cir. 1993). In SPM, a secured lender holding a first-priority security interest in substantially all of a chapter 11 debtor's assets, in an amount exceeding the value of the 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...