Third Circuit Approves Payment by Creditor/High Bidder to Unsecured Creditors and Bankruptcy Professionals - Leaving Government in the Cold

In In re ICL Holding Co., Inc.[i], the Third Circuit Court of Appeals (the “Court”) addressed whether a bankruptcy sale and related settlement that resulted in (1) paying some administrative claimants (i.e. the case professionals) and not others (i.e. the government) and (2) paying unsecured creditors, while not paying creditors higher on the priority scheme, violated the Bankruptcy Code’s distribution requirements.  The Court found that following the sale and related settlement (neither of which the government was successful in staying), the government’s arguments against distribution were neither constitutionally, statutorily nor equitably moot.  Nevertheless, the Court affirmed the decisions of the lower courts approving distributions to both administrative creditors at the same priority as the government and junior creditors–while not paying the government - because such transfers were not made from property of the bankruptcy estate and were thus not subject to the Code’s distribution scheme.

Facts:

Debtor LifeCare Holdings, Inc. (“LifeCare” or “Debtor”) was in the business of operating long term acute care hospitals.  Following devastation of some its facilities after Hurricane Katrina, a post-Katrina environment of increased regulation and a debt load that thwarted obtaining new capital, LifeCare explored a sale of its assets.  After LifeCare entered into an asset purchase agreement with its secured lenders (the “Lender Group”), LifeCare and its 34 subsidiaries filed for chapter 11 protection.  The asset purchase agreement involved a credit bid by the Lender Group of about 90% of the debt owed to it   for the transfer of all of the Debtor’s assets and cash.  The agreement further provided that the Lender Group would pay for the legal and accounting costs of the Debtor and the (to-be-formed) unsecured creditors’ committee  (the “Committee”) as well as Debtor’s wind down costs.  These funds were to be held in escrow and any remaining funds after the aforementioned payments were made would go back to the Lender Group.

Following initial sale approval and an auction, the Lender Group bid was determined best.  But, the Committee and the government objected.   The Committee argued that the transaction was really a “veiled foreclosure” that would leave the estate administratively insolvent.  The government argued that the sale improperly provided for payment to certain administrative creditors, namely the case professionals, but did not provide for payment of the government’s administrative claim – described as an approximately $24 million capital gains tax claim resulting from the sale.

The Lender Group and the Committee worked out a deal that would provide $3.5 million to unsecured creditors and the Committee would thus withdraw its objection.  But removal of the Committee’s objection added to the government’s objection since the settlement resulted in unsecured creditors junior in priority to the government’s tax claim being paid ahead of (and instead of) the tax claim.  Despite the government’s objections, the settlement and the sale were approved in separate hearings. The government appealed both decisions and sought a stay pending appeal which was denied.  The district court affirmed denial of the stay and dismissed the government appeal.  The Third Circuit affirmed.

The Lender Group credit bid $320 million which was 90% of its $355 million secured claim. Following the credit bid, the Lender Group had an approximately $35 million remaining secured claim against any property of the estate.  The Debtor and Committee argued that the government’s claim for a $24 million tax liability was moot.  However, the Court disagreed and found that (a) the government’s claim, though remote, was not impossible and therefore not constitutionally moot; (b) Section 363(m) did not bar review so the claim was not statutorily moot; and (c) since the matter was not being addressed in the plan context it was not equitably moot.  Having determined the government’s claims were not moot, the Court turned to whether the funds escrowed for case professionals and placed in trust for the unsecured creditors were paid from property of the Debtor’s estate.

Settlement Payment to Unsecured Creditors

The Court found that “the settlement sums paid by the purchaser [Lender Group] were not proceeds from its liens, did not at any time belong to LifeCare’s estate, and will not become part of its estate even as a pass-through.”[ii] Further, the Court was not persuaded that language in the motion seeking approval of the Committee settlement, which described the settlement as an allocation of the “proceeds of the sale”, was evidence that the settlement proceeds served as consideration for the purchased assets.[iii]

Payment to Case Professionals

The Court found more difficult the analysis of whether the funds set aside for payment to professionals were property of the estate.  The asset purchase agreement described the funds as part of the purchase price for the Debtor’s assets.  Despite that description, the Court found it could not “ignore the economic reality of what actually occurred.”[iv] The Court explained that in the sale the Lender Group took all of the Debtor’s assets, including their cash, “[t]hus, once the sale closed, there technically was no more estate property.”[v] Further, any residual funds in the escrow account set aside for professionals would be returned to the Lender Group. The Court acknowledged the following:

All that said, we recognize that, in the abstract, it may seem strange for a creditor to claim ownership of cash that it parted with in exchange for something. …. But in this context it makes sense. Though the sale agreement gives the impression that the secured lender group agreed to pay the enumerated liabilities as partial consideration for LifeCare’s assets, it was really “to facilitate ... a smooth ... transfer of the assets from the debtors’ estates to [the secured lenders]” by resolving objections to that transfer. .... To assure that no funds reached LifeCare’s estate, the secured lenders agreed to pay cash for services and expenses through escrow arrangements.[vi]

The Court distinguished this arrangement from a standard carve-out from a secured creditor’s cash collateral because in that circumstance, the cash collateral used for the carve-out is property of the estate where, as here, the funds escrowed were property of the Lender Group.

Key Take Aways:

• This sale involved the Lender Group credit bidding part of its claim for all of the Debtor’s assets, including cash. Thus, the sale effectively removed all property from the estate. An important distinction made by the Court was that the funds to be distributed to the case professionals and unsecured creditors were not “cash collateral” and arguably part of the Debtor’s estate, but were rather funds of the Lender Group.       If the sale did not go through, the funds would not go to the Debtor but back to the Lender group.       Thus – this opinion does not address the distribution scheme in a typical carve-out scenario. However, this case does give a very useful roadmap on how to provide value for professionals and unsecured creditors outside of the plan context – although such value may come at the expense of other creditors similarly situated or even superior to those receiving the value.
• This Court read substance over form in terms of the language in the sale documents even though the funds in question were specifically described as part of the purchase price. But, attention should be paid to drafting motions and asset purchase agreements in case another court is less inclined to divine the substance from the form.
• An issue raised but not determined by the Court is whether the priority requirements apply in the 363 sale context “even if textually most (save for § 507) are limited to the plan context.”[vii] The Court found that “ even assuming the rules forbidding equal-ranked creditors from receiving unequal payouts and lower-ranked creditors from being paid before higher ranking creditors apply in the § 363 context, neither was violated here.”[viii] Thus the issue as to whether the priority scheme applies in the 363 context is left open.

[i] In re ICL Holding Co., Inc., No. 14–2709,  2015 WL 5315604 (Sept. 14, 2015 3d Cir.)

[ii] Id. at *7.

[iii] Id.

[iv] Id. at *8.

[v] Id.

[vi] Id. (internal citation omitted).

[vii] Id. at *6.

[viii] Id. at *9.