Contributed by Brian Wells
The settlement of conflicts is often preferable to a long, drawn out litigation, particularly in the case of a bankruptcy where a debtor’s limited resources may best be used elsewhere (for example, in distributions to creditors).  Although courts have created various tests and standards governing the permissibility of a settlement, the Bankruptcy Code and Bankruptcy Rules offer little guidance on when settlements should be approved, and many questions remain unanswered.  For example, must a settlement comply with the strict requirements for a plan of reorganization, such as the absolute priority rule?  Can the implementation of a settlement prevent appeals from the order approving that settlement?  The United States District Court for the District of Delaware recently addressed both of these issues in Deangelis v. Official Committee of Unsecured Creditors (In re Kainos Partners Holding Co.), where it dismissed as equitably moot an appeal from a settlement approval order.  In an alternative holding, the court also found that the settlement did not violate the absolute priority rule, notwithstanding a gift from secured creditors to unsecured creditors where administrative claims would not be paid in full. Both rulings reinforce the flexibility of settlements as a means to efficiently resolve conflicts and allocate assets within a bankruptcy restructuring.
Kainos Partners Holding Company, the owner and operator of numerous Dunkin’ Donuts stores and a donut manufacturing plant, petitioned for chapter 11 in the midst of a liquidity crisis.  New financing was needed to continue operations.  Several of the debtor’s largest secured creditors made an offer to extend postpetition financing if, in exchange, Kainos would confirm the validity and non-avoidability of the secured lenders’ claims and liens and waive all defenses to such claims.  Kainos took the deal, and the bankruptcy judge approved the financing arrangement.  Importantly, the judge also granted the unsecured creditors’ committee derivative standing to challenge the lenders’ claims and to assert other claims against them on behalf of the estate.
The donut business wasn’t what it used to be, and after another year of operations—and losses—it became clear that the new money would run dry.  The lenders were remiss to throw good money after bad, but without more the stores would go dark, the remaining assets would be liquidated, and, as the bankruptcy court later recognized, all parties would suffer a catastrophic loss.  The debtors, secured lenders, and unsecured creditors’ committee began frantic negotiations and, on the last day of financed operations, an agreement was reached.  Dunkin’ Brands, the largest of the secured creditors, would extend an additional $500,000 in financing to fund operations during a sale process and would also stand in as the stalking horse bidder (with a bid of $3.5 million). Furthermore, in exchange for support from the unsecured creditor’s committee and the settlement of its derivative claims against the lenders, secured lenders would earmark a portion of their recoveries to be transferred to the general unsecured creditors. 
The settlement had unanimous support, with the exception of one detractor.  The U.S. Trustee objected on the principle that the unsecured creditors’ committee should not be able to waive claims belonging to the estate for the sole benefit of its constituents and that the gift from the secured creditors should instead be paid to the estate to be distributed according to the Bankruptcy Code’s priority scheme (and, in particular, the absolute priority rule).  In response, counsel for the debtors pointed out that every asset of the estate was encumbered and that the value of the estate—roughly several million dollars—would not come close to satisfying the secured creditors’ claims.  They argued that the gift was beyond the scope of the absolute priority rule because the settlement payments were made by a carve-out from the secured creditors’ collateral (literally, the transfer of one of their rights to repayment to a trust for the general unsecured creditors).
These arguments roughly tracked two leading precedents on the issue of “gifting” distributions to lower-priority classes: Armstrong World Industries and SPM Manufacturing.  In Armstrong, the Third Circuit considered a plan that provided that certain estate assets would be distributed to unsecured creditors (who were not recovering in full) and then automatically transferred to equity holders. The Third Circuit found that the plan violated the absolute priority rule and rejected it, noting that to hold otherwise would “encourage parties to impermissibly sidestep the carefully crafted strictures of the Bankruptcy Code, and would undermine Congress’ intention to give unsecured creditors bargaining power in this context.”  Conversely, in SPM, the First Circuit held that in a chapter 7 liquidation, a secured creditor could gift part of its recovery to unsecured creditors even though higher priority claimants were not being paid in full.  The First Circuit noted that no money would remain to be distributed once secured creditors had been paid, and that the gifted money came entirely from the secured creditor’s recovery.  Reasoning that the skipped-over claimants were in no worse position than they would have been in if the transfer had not been made, the circuit court concluded that the property transfer did not violate the absolute priority rule.
Although the Deangelis bankruptcy court did not explicitly follow SPM, it rejected the U.S. Trustee’s argument that the absolute priority rule was being violated, particularly focusing on the fact that the distribution was being made pursuant to a settlement.  The bankruptcy court distinguished Armstrong, noting that the class-skipping arrangement there was built into a plan and therefore subject to “all of the procedural protections and requirements built into section 1129,” including the absolute priority rule.  Instead of section 1129 of the Bankruptcy Code, the bankruptcy court considered whether the settlement had satisfied the general test for approval of settlements laid out by the Third Circuit in In re Martin.  Finding that, among other things, the settlement was in the best interest of the estate and its creditors, the bankruptcy court approved it.
Soon after, the U.S. Trustee appealed to the United States District Court for the District of Delaware, arguing that the absolute priority rule should apply even though the distributions were made pursuant to a settlement and not a plan.  Before the appeal was decided, the asset sale was consummated, the settlement was implemented, and the Kainos General Unsecured Trust (created pursuant to the settlement) received the earmarked funds and distributed them to the general unsecured creditors.
The district court dismissed the appeal as equitably moot.  It pointed out that the U.S. Trustee had not stayed execution of the settlement order and, as a result, distributions had been made and the settlement had been substantially consummated.  The court further noted that the public policy of affording finality to bankruptcy judgments also weighed in favor of dismissing the appeal, given the complexity of the settled litigation, the number of parties involved, and the bankruptcy court’s finding that the absence of a settlement would have resulted in a catastrophic loss.  In an alternative holding, the court found that the settlement did not violate the absolute priority rule, and was permissible under the requirements of Bankruptcy Rule 9019 and the Martin standards.  The district court also emphasized that the payment to the unsecured creditors arose from a carve-out from the secured creditors’ collateral. 
The district court’s decision to find an appeal from a settlement approval order equitably moot was important.  This doctrine is usually applied to dismiss appeals that would unwind substantially consummated plans.  One of its consequences is to make confirmed plans more reliable, and to put the burden on appellants to obtain a stay of implementation—and an often-pricey appeal bond.  Extending the doctrine to settlements makes them more reliable and provides an additional layer of insulation against an appeal, strengthening the ability of debtors and other parties to resolve their conflicts prior to and outside of the plan approval process.
Also important was the district court’s decision not to bar the settlement under Armstrong.  However, many legal questions remain unanswered because the court did not fully explain the basis for its decision that the settlement did “not violate Bankruptcy Code’s statutory priority scheme.”  The rationale could have been that the carve-out from the secured creditors’ collateral did not violate the absolute priority rule (consistent with SPM) or that the absolute priority rule did not govern because settlements are approved according to the Martin standards and not the stricter requirements governing the confirmation of a plan.  The decision may also have been driven by the circumstances of the case, including the facts that the case had converted to a chapter 7 liquidation, that without the settlement everyone would have suffered a catastrophic loss, and that the skipped-over classes were no worse off (indeed, better) than they would be without the settlement.  Because the court did not fully explain its reasoning, the extent to which its holding will influence other decisions is uncertain.