Tipping Point: Plan Clarification or Plan Modification? Third Circuit Denies Bankruptcy Court’s Use of Its Plan Clarification Powers to Circumvent Plan Modification Requirements of Section 1127

In post-confirmation proceedings, bankruptcy courts maintain the ability to clarify a plan where silent or ambiguous, and interpret a plan to advance equitable considerations.  However, bankruptcy courts are not allowed to modify a plan outside the confines of section 1127 of the Bankruptcy Code.  This fine line between clarification and modification was recently addressed by the Third Circuit.  In re SCH Corp., et al., Case No. 14-2888 (3rd Cir. Feb. 24, 2015).  Specifically, a Third Circuit panel addressed whether a post-confirmation agreement among the debtors’ representative and the funder of the debtors’ plan constituted a proposed settlement that could be considered under Federal Rule of Bankruptcy Procedure 9019 based on the court’s ability to clarify and interpret the Plan, or as a proposed plan modification subject to section 1127.  Because the agreement changed certain specified terms of the plan (the timeline for the plan funder to make payments), the Third Circuit held that it was a modification and not a simple clarification or interpretation. 
The Debtors and the Confirmed Plan
Prior to filing for chapter 11 in January 2009, the debtors were in the consumer debt collection business and were defendants in numerous class action lawsuits over alleged violations of consumer protection laws including the Fair Debt Collection Practices Act.  In April 2009, the debtors sold the assets of the business to National Corrective Group, Inc. (“National”), a subsidiary of the debtors’ largest secured creditor.  Following the sale, the debtors proposed a plan of liquidation.  The largest group of unsecured creditors in the case – the class action claimants – objected to the breadth of the releases granted to National and its parent under the proposed plan.  A compromise was reached and, under the plan confirmed by the Bankruptcy Court and supported by the class action claimants, National agreed to pay up to $1 million in five installments from April 2010 through April 2014, subject to offsets for unpaid professional fees and up to $500,000 for certain losses incurred by National in defending future consumer lawsuits.
Post-Confirmation Proceedings
Following confirmation of the Plan, additional consumer lawsuits were indeed filed against National and National asserted its right to offset litigation expenses and losses against its required payments under the Plan.  Notably, National asserted offset rights with respect to litigation expenses that had been reimbursed by insurance.  The debtors’ plan, however, was silent on the narrow issue of whether insurance reimbursement of litigation expenses negated National’s right of offset those litigation expenses against its required plan payments.  Based on National’s asserted offsets, very little, if any, distributions had been made under the plan to the unsecured creditors.  As a result, the class action claimants moved to dismiss the bankruptcy cases for lack of good faith and, in the alternative, moved for enforcement of the confirmed plan.
To avoid litigation over the propriety of the offsets under the Plan, the debtors’ representative reached a settlement with National that called for a fixed payment of $233,631 for April 2014.  The settlement also extended the period for National to make payments under the Plan by calling for three new payments of up to $100,000 in 2015, 2016 and 2017.  These additional payments were subject to offset of up to $25,000 in each year for litigation expenses and related losses.
In addition to the pending motions to dismiss and enforce the plan as written, the class action claimants lodged a number of objections to the proposed settlement including that the settlement was not a settlement at all, but a post-confirmation modification of the confirmed plan.  Over the objections of the class action claimants, the Bankruptcy Court, in an oral ruling, approved the settlement under Bankruptcy Rule 9019.  The District Court affirmed the Bankruptcy Court’s approval of the settlement and disposed of the class action claimants’ plan modification argument in a footnote by noting that the debtors’ representative’s argument that the settlement resolved a funding dispute and did not modify the Plan was consistent with the Bankruptcy Court’s statement in its oral ruling that litigating the plan language would involve testimony regarding the parties’ intentions and expectations during negotiations three years earlier.
Plan Clarification or Plan Modification?
The Third Circuit, however, found that the Bankruptcy Court abused its discretion by failing to evaluate the proposed settlement as a modification of the Plan in accordance with section 1127 of the Bankruptcy Code.  Under section 1127(b) of the Bankruptcy Code, a plan may be modified before substantial consummation if “circumstances warrant such modification and the court, after notice and a hearing, confirms such plan as modified, under section 1129” of the Bankruptcy Code.  Modification is not defined in the Bankruptcy Code and courts have developed the concept of modification by distinguishing a modification of a plan, on the one hand, from a clarification or interpretation of a plan, which courts are permitted to do, on the other hand.
In finding an abuse of discretion, the Third Circuit found that while the Bankruptcy Court had the ability to resolve the conflict over the plan’s silence on the narrow issue of the treatment of insurance proceeds under the offset provisions – which would be permissible as a clarification or interpretation of the plan – the Bankruptcy Court went too far by approving the extension of the plan payment period by three years.  Such an extension of the “life of the economic relationships” among those affected by the plan is a plan modification subject to section 1127.  Indeed, even if the modification benefitted unsecured creditors, a modification still requires approval under section 1127.  Ultimately, turning a 5 year plan into an 8 year plan is a “drastic step [that] should not be taken under the guise of either a plan interpretation, the exercise of equitable powers, or a Rule 9019 settlement.”
In sum, the Third Circuit’s strong message to the lower courts on crossing the line between plan clarification and plan modification should serve as a cautionary tale for those involved in post-confirmation plan disputes.