Third Circuit Rules that If It’s Not Estate Property, There’s No Need to Respect Priority

Contributed by Christopher Hopkins
Section 363 of the Bankruptcy Code provides debtors an efficient and flexible mechanism to dispose of substantially all estate assets outside of the confines of the Bankruptcy Code’s provisions concerning plan confirmation.  The Third Circuit’s recent decision in In re ICL Holding Co., Inc. may provide debtors additional flexibility, especially in cases where the purchasers desire to prefer certain constituencies over others of similar or senior priority. 
The court also addressed – and ultimately rejected – arguments made by the debtors that certain objections to their 363 sale (discussed below) were constitutionally, statutorily, and equitably moot. We will discuss these issues in a future Bankruptcy Blog post.
In re ICL Holdings
In ICL Holdings, the debtors’ secured creditors (who were undersecured) credit bid the value of their secured debt to acquire substantially all of the debtors’ assets, including their cash, in a sale under section 363(b) of the Bankruptcy Code.  The secured creditors also agreed to pay the legal and accounting fees of the debtors and the committee of unsecured creditors and the debtors’ wind-down costs.  Under the parties’ asset purchase agreement, the secured creditors were required to deposit cash funds into separate escrow accounts to cover such fees.
The committee initially objected to the proposed sale on the grounds that the deal was a “veiled foreclosure” that would leave the debtors’ estates administratively insolvent.  The committee agreed to withdraw its objections, however, in exchange for a $3.5 million payment from the secured lenders, which would be placed in trust for the benefit of the general unsecured creditors.  The parties’ settlement agreement was subsequently submitted as a standalone motion for court approval.
The U.S. government also objected to the proposed sale and the settlement agreement.   The government’s argument was that the sale would result in a $24 million capital-gains tax liability, which would be an administrative claim that the debtors would be unable to pay following the consummation of the sale.  The government argued that the sale agreement unfairly favored similarly situated administrative claimants – namely, the debtors’ and the committee’s professionals – by providing for payment of their claims when the government’s administrative claim would likely go unpaid.  The government objected to the settlement agreement on a similar ground, reasoning that the $3.5 million settlement was property of the debtors’ estate, and, therefore, distributing such funds to the general unsecured creditors over a senior creditor’s objection also violated the Bankruptcy Code’s priority scheme.
The United States Bankruptcy Court for the District of Delaware approved the sale motion and the settlement agreement (at separate hearings) over the government’s objections.  The government subsequently appealed both decisions.
The government argued that the bankruptcy court erred in (i) approving the provision of the sale agreements where the secured lenders agreed to pay some administrative claims but not others of equal priority and (ii) approving the settlement payment to the unsecured creditors even though senior creditors – i.e., the government – would receive nothing.  Specifically, the government reasoned that the escrow and settlement were proceeds paid to obtain the debtors’ assets and, therefore, should have been paid out according to the Bankruptcy Code’s priority scheme.
On appeal the Third Circuit (in an opinion by Judge Ambro, a former bankruptcy attorney) focused its inquiry on what it viewed to be the lynchpin of the government’s argument: whether the escrowed funds or the settlement payment constituted estate property under the Bankruptcy Code.  The court reasoned that if the escrows and settlement payments were not “proceeds of or from property of the estate” under section 541(a)(6) of the Bankruptcy Code, then the Bankruptcy Code’s priority provisions simply did not apply.
The Settlement Payments
The Third Circuit first rejected the government’s argument that the $3.5 million settlement payment, which was paid by the secured creditors directly to a trust that was to make payments to the debtors’ unsecured creditors, was effectively an increased bid by the secured lenders to secure their success and, therefore, was estate property.  Instead, the court held that those funds did not constitute estate property because they were not proceeds from the secured creditors’ liens and did not at any time belong to or go through the debtors’ estates.  Rather, they were the purchaser’s own funds, and the purchaser was free to do with those funds as it saw fit.  The court contrasted the purchaser’s funds from a senior creditor’s plan distributions.  The latter would be estate property, and under the Third Circuit’s well-known Armstrong ruling, cannot be “gifted” to junior creditors in violation of the Bankruptcy Code’s priority scheme.
The Escrowed Funds
The Third Circuit had a tougher time deciding whether the escrows constituted estate property.  The government argued that, under the terms of the sale agreement, the escrows constituted part of the purchase price and, therefore, were proceeds of the debtors’ asset sale that constituted property of the estate.
The court ultimately rejected this argument based on the “economic reality of what really happened.”  The agreement provided that the secured lenders purchased all of the debtors’ assets, including their cash, by credit bidding the amount of their claims.  The court reasoned that, as a result, there technically was no more estate property following the closing of the sale.  Accordingly, the government mistakenly presumed that any residual cash from the sale – i.e., the money ear marked for fees and wind-down costs – would become property of the debtors’ estates.  Put simply, the debtors had agreed to surrender all of their cash to the secured lenders under the terms of the sale agreement, and the agreement expressly provided that any residual amounts in the escrows would be returned to the secured lenders.  Accordingly, the court held that the escrows did not constitute estate property and overruled the government’s objection.
ICL Holdings suggests that, at least in the Third Circuit, debtors and creditors may have flexibility in structuring 363 sales to prefer certain constituencies and overcome obstacles in cases involving significant priority claims.  The key to successfully structuring such transactions appears to be designing deal structures that ensure payments that may not conform to the Bankruptcy Code’s priority scheme are not paid out of and never become property of the debtor’s estate.
Might ICL Holdings have broader implications?  For example, can a secured creditor get around the proscription on gifting by structuring the payments to junior stakeholders as payments from the secured creditor’s own funds, rather than payments out of the proceeds of its plan distributions (which are clearly property of the estate)?   One thing we know for sure is that restructuring professionals will put on their “thinking caps” and continue to come up with creative structures for achieving their clients’ objectives.  And the courts will continue to police those structures and determine which ones are kosher and which are verboden.