Restructuring

Contributed by Prashant Rai
The question of what constitutes “equal treatment” is a question as old as law itself. Though a favored topic by the Aristotles and the Rousseaus of the world, the question is not entirely esoteric.  The concept plays a central role in the law of bankruptcy – courts occasionally describe the principle of equitable distribution between similarly situated creditors as one of the “pillars” of the Bankruptcy Code.  A pillar, indeed – it is not uncommon for players in the distressed space to spin their gears finding deal structures and work-arounds that are consistent with this most central of tenets.  In In re Energy Future Holdings Corp., the Third Circuit rendered an opinion that shed additional light on the scope of the rule, this time as it applies to pre-plan settlement offers.  Particularly, the Court held that pre-plan settlements are not subject to the same equal treatment strictures as plans, and that settlement offers that offer similar creditors different economic value in exchange for their claims do not necessarily treat them unequally.  After Energy Future, dealmakers in the Third Circuit arguably have more wiggle room to develop creative and nuanced settlement structures. 
Background
In Energy Future, the debtors filed for chapter 11 relief in the Bankruptcy Court for the District of Delaware in April 2014.  The debtors’ capital structure essentially consisted of two groups of entities—the “E-side” and the “T-side.”  The E-side debtors’ capital structure included $4 billion of first lien notes, $2.2 billion of second lien notes, and $1.7 billion of unsecured notes.  The first lien notes consisted of approximately $3.5 billion of 10% notes due 2020 and $500 million of 6 7/8% notes due 2017.  Both sets of first lien notes contained “make-whole” provisions, which required the debtors to pay the noteholders a premium if the debtors redeemed the notes prior to their maturity date.  The parties agreed that the make-whole provisions in both first lien notes were contractually identical.  For both make-whole provisions, the amount that the noteholder would receive would depend upon the interest rate and the maturity date of the note.  Therefore, the contractual identity of the make-whole provisions notwithstanding, if the debtor were to prematurely redeem both the 10% notes and the 6 7/8% notes on the same day, the 10% notes would receive a larger make-whole premium per $1,000 face amount due to their higher interest rate and later redemption date.
Prior to filing for chapter 11 relief, the debtors entered into a restructuring support agreement with several large creditors, including certain first lien noteholders.  The RSA contemplated that the first lien noteholders that so desired could exchange their notes for new debt obligations under a $5.4 billion DIP facility, and would in so doing release their make-whole claims.  One week after filing, the debtors initiated a “tender offer” to all first lien noteholders, intended to effectuate the terms of the RSA.  The “tender offer” would compensate all accepting first lien noteholders with 105% of their outstanding principal, and 101% of accrued interest in exchange for release of their make-whole claims.  After fourteen days, the 105% would step down to 103%.  As this was merely a settlement offer to compensate participating first lien noteholders for releasing their make-whole claims (the applicability of which was subject to dispute), non-accepting first lien noteholders would retain their right to litigate their make-whole claims.  Ultimately, 97% of 6 7/8% noteholders and 34% of 10% noteholders accepted the offer.
The debtors filed a motion for approval of the settlement.  The indenture trustee of the first lien notes, on behalf of the non-settling first lien noteholders, objected to the debtor’s motion on the theory, among other grounds, that the settlement discriminated between similarly situated creditors.  The trustee noted that the settlement offer provided for a significantly lower dollar-for-dollar recovery on the make-whole claims for the 10% noteholders than for the 6 7/8% noteholders because the 10% noteholders were offered the same consideration for more valuable claims. The trustee argued that the settlement ran afoul of both the Bankruptcy Code and the Bankruptcy Rules.  Bankruptcy Rule 9019, as interpreted by case law, requires that, in approving settlements, the court must consider, among other factors, whether the settlement is “fair and equitable.”  The trustee argued that the principle that a settlement must be “fair and equitable” implies that pre-plan settlements must conform to the requirement in Bankruptcy Code section 1123(a)(4) that plans provide the same treatment to each member of the same class.  Because the settlement offer provided for disparate recoveries for noteholders with contractually identical make-whole provisions and identical collateral, the trustee argued that the settlement was not fair and equitable.
The Bankruptcy Court disagreed with the trustee and entered an order approving the settlement.  The trustee appealed to the District Court, and the District Court affirmed.  Acknowledging that Third Circuit law requires that “in order to approve the settlement, the Bankruptcy Court must ultimately find that it is fair and equitable,” the District Court rejected the view that this requires that pre-plan settlements must conform to Bankruptcy Code section 1123(a)(4).  Moreover, the District Court concluded that the settlement was consistent with section 1123(a)(4) because section 1123(a)(4) allows creditors to agree to less favorable treatment, and the settlement was voluntary.  The District Court also noted that the settlement offer allowed parties to elect to litigate the full value of their claim, thus allowing all claimants the same opportunity for recovery.
As described in greater detail below, the disagreement between the trustee and the lower courts rested to a degree on a split of authority over the teeth of the equal treatment rule in the context of pre-plan settlements.  At the time of the District Court ruling, the Third Circuit had yet to take a position on the split of authority.  However, after the time that the District Court issued its ruling in Energy Future, but before the Third Circuit could similarly rule, the Third Circuit resolved this ambiguity in another case, In re Jevic Holding Corp. Therefore, when the trustee in Energy Future appealed again, this time to the Third Circuit, new Third Circuit precedent existed that directly bore on the issue in the case.
Split of Authority
Prior to Jevic, the Third Circuit had not taken a position on a split of authority over whether the absolute priority rule applied equally to pre-plan settlements as it does to plans.  On the one hand, the Fifth Circuit, in In the Matter of AWECO, Inc., held that the requirement that settlements be “fair and equitable” entails that pre-plan settlements must satisfy the absolute priority rule per se.  The AWECO court reasoned:

As soon as a debtor files a petition for relief, fair and equitable settlement of creditors’ claims becomes a goal of the proceedings. The goal does not suddenly appear during the process of approving a plan of compromise. Moreover, if the standard had no application before confirmation of a reorganization plan, then bankruptcy courts would have the discretion to favor junior classes of creditors so long as the approval of the settlement came before the plan. . . .

AWECO, 725 F.2d at 298.
On the other hand, the Second Circuit, in In re Iridium Operating LLC, adopted a more flexible approach.  While the Second Circuit acknowledged that the Fifth Circuit “accurately capture[d] the potential problem a pre-plan settlement can present for the rule of priority,” the Second Circuit concluded that the Fifth Circuit’s test was too rigid.  Id. at 464.  Specifically, the Second Circuit noted that the Iridium facts presented a not-uncommon situation where, among other things, the decision to approve the settlement may itself significantly affect the nature and the extent of the estate, making the application of the rule of absolute priority difficult.  The Second Circuit therefore rejected the Fifth Circuit’s per se rule, but cautioned:

Rejection of a per se rule has an unfortunate side effect, however: a heightened risk that the parties to a settlement may engage in improper collusion. Thus, whether 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. The court must be certain that parties to a settlement have not employed a settlement as a means to avoid the priority strictures of the Bankruptcy Code.

Id.  The Second Circuit thus concluded that while violation of the absolute priority rule may often be the dispositive factor as to whether a pre-plan settlement is fair and equitable, it may in some cases be outweighed by other factors.  To overcome a violation of the absolute priority rule, the Second Circuit held that the debtor “must come before the bankruptcy court with specific and credible grounds to justify that deviation and the court must carefully articulate its reasons for approval of the agreement.”  Id. at 466.
Faced with this split of authority, the Third Circuit in Jevic adopted the position of the Second Circuit.  The Third Circuit cited to the Second Circuit’s observation that for settlements that occur early in the life of a case, the nature and extent of the estate may remain unresolved.  Nevertheless, the Third Circuit expressed similar concern as both the Fifth and the Second Circuits that “settlements that skip objecting creditors in distributing estate assets raise justifiable concerns about collusion among debtors, creditors, and their attorneys and other professionals.”  Jevic, 787 F.3d at 184.  Therefore, the Third Circuit agreed with the Second Circuit that debtors seeking approval for such settlements must have “specific and credible grounds to justify [the] deviation” from the absolute priority rule.  Id.
The Application of Equal Treatment to Settlement Offers
Coming full circle, the Third Circuit rendered its opinion in Jevic after the District Court delivered its decision in Energy Future, but before the Third Circuit could rule. Faced with this new authority, the Third Circuit in Energy Future held that the analysis in Jevic regarding the impact of the absolute priority rule on pre-plan settlements applied with equal force to the equal treatment rule. The Court wrote:

[While] a bankruptcy court has latitude in declining to apply confirmation plan rules in connection with settlements, . . . a bankruptcy court cannot disregard the central tenets of the bankruptcy system. When a debtor files its petition, it enters into a process in which a bankruptcy court is responsible for both protecting estate assets and the interests of the creditors. As to creditors, a bankruptcy court is obligated to ensure that the creditors are treated in an “evenhanded and predictable” fashion, both in and outside of the settlement context.

Energy Future, 2016 WL 2343322 at *4.  The Energy Future Court therefore held that in order for a settlement to treat similarly situated creditors differently, the debtor must present a specific and credible ground for doing so.
This, of course, leaves open the question of what constitutes disparate treatment in the context of a pre-plan settlement.  As the District Court in Energy Future noted, a pre-plan settlement is different from a plan in that creditors have the choice to decline the settlement offer, making the acceptance of any settlement offer an act of consent to any disparate treatment that the creditor may receive as a result.  To wit, in Energy Future, the Third Circuit declined to conclude that the settlement offer treated the 10% noteholders and the 6 7/8% noteholders unequally.  The Court observed that the debtors extended the settlement offer to all first lien noteholders (unlike in Jevic wherein the settlement barred an entire class of creditors from participating), and on the same terms.  Although the settlement offer represented different economic value to the 10% noteholders than it did to the 6 7/8% noteholders, both sets of noteholders were free to reject the offer and litigate the full value of their claims.  The Third Circuit thus affirmed the District Court on those grounds and approved the settlement.  The Court thus did not reach the question of what would constitute specific and credible grounds that would justify treating the noteholders unequally.
Conclusion
What we are left with is a bit of a quagmire.  In the Third Circuit, the rule now seems to be that pre-plan settlements generally must treat similarly situated creditors similarly, but may deviate from this rule by presenting to the Court specific and credible grounds for doing so, particularly with reference to the other factors that courts have said support the approval of settlements under Bankruptcy Rule 9019.  This creates a two-step line of analysis: (1) does the settlement provide for disparate treatment between similarly situated creditors, and (2) if so, is there a specific and credible grounds for doing so.
The standards for applying either of the steps remain unclear.  As to (1), the Third Circuit in Energy Future held that a settlement offer that offers different economic value to noteholders with the same collateral and same contractual entitlements does not rise to the level of disparate treatment.  One could argue that under a straight application of this holding, it may be difficult for courts to find that a pre-plan settlement treats similar creditors unequally, so long as the settlement is voluntary and is offered to all creditors (no matter the relative economic value of the offer).   This may leave open an opportunity for creative deal-making between debtors and their preferred creditors.  Of course, if a debtor took this holding too far, a court could find a basis on which to reject a settlement.  The Energy Future case had somewhat unique facts in that an offer that looked superficially the same to similarly situated creditors actually provided the creditors with different economic value.  A court might react differently to an offer to different creditors that on its surface contained different terms.
As to (2), we await an appellate decision that describes the factors that may counsel in favor of approval of a settlement, notwithstanding that it provides for disparate treatment of similar creditors.  It bears noting that both the Third Circuit in Jevic and the Second Circuit in Iridium remanded their respective cases back to the lower courts for further findings of fact on this question.  What is clear is that courts are aware of the risk of collusion between debtors and creditors in the context of pre-plan settlements, and will pay careful mind for parties’ attempts to circumvent the requirements that the Bankruptcy Code imposes on reorganization plans.
Prashant Rai is an Associate at Weil Gotshal & Manges, LLP in New York.