emerging plan issues: third party protections, … · emerging plan issues: third party prote...

EMERGING PLAN ISSUES: THIRD PARTY PROTECTIONS, ABSOLUTE PRIORITY POST-

LASALLE, CLASSIFICATION OF CLAIMS AND RES JUDICATA

RAKHEE V. PATEL Kirkpatrick & Lockhart LLP

RAY W. BATTAGLIA

DEBORAH L. INNOCENTI Oppenheimer, Blend, Harrison & Tate, Inc.

State Bar of Texas 22ND ANNUAL ADVANCED

BUSINESS BANKRUPTCY COURSE May 6-7, 2004

Houston

CHAPTER 10

RAYMOND W. BATTAGLIA Shareholder OPPENHEIMER, BLEND, HARRISON & TATE, INC. 711 Navarro, Sixth Floor San Antonio, TX 78205 210.299.2361 (direct phone) 210.224.7540 (fax) [email protected] AREAS OF EXPERIENCE Business Reorganizations High Wealth Individual Financial Workouts Business and High Wealth Individual Bankruptcies, Concentrating on Debtor, Creditor Committee, Secured Creditor and Landlord representations EDUCATION J.D., University of Houston Law Center, 1983 B.A. University of Texas at San Antonio, 1980 PROFESSIONAL AFFILIATIONS/CERTIFICATIONS Named in the 2001-2002 Edition of The Best Lawyers in America published by Woodward/White, Inc. of New York American Bankruptcy Institute San Antonio Bankruptcy Bar Association, Past President Board Certified in Business Bankruptcy Law by the Texas Board of Legal Specialization ADMITTED Texas Bar U.S. Court of Appeals for the Fifth Circuit U.S. District Court, Western District of Texas U.S. District Court, Southern District of Texas EXPIRIENCE Mr. Battaglia has over 19 years of experience representing all manner of interests involved in financial restructuring for businesses and high wealth individuals, both in and out of Bankruptcy Court. The following is a summary of some of his representations: Debtors - Confirmed 26 Plans of Reorganization in Chapter 11 cases, including the following: · Star Food Processing, Inc. - The Debtor was the largest manufacturer of processed foods for the U.S. Military · Tom Fairey Company - The Debtor was the largest distributor of John Deere heavy equipment in North America with assets and liabilities in excess of $40 million · Sutherland Media, Inc. - The Debtor and its affiliates published suburban newspapers throughout Texas and Ohio. · Twigland Fashions, Inc. - The Debtor sold young women’s fashions at 18 retail locations located across the United States

Unsecured Creditor’s Committees · McGinnis Hedge Funds - The Debtors operated a series of hedge funds heavily invested in sophisticated investments involving Russian debt instruments. The case involved unsecured creditor claims in excess of $125 million and investors interests totaling more than $180 million. · Healthcare International - The Debtor was a publicly traded health care provider with a chain of mental health care hospitals and rehabilitation centers located in the southern and western United States. · Quantum Soutwest Medical Management, Inc. and Quantum Southwest Medical Associates, Inc. - The Debtors operated a delegated heatlhcare network of more than 1500 providers serving 34,000 Pacificare enrollees. Trustees - Represented Chapter 11 and Plan trustees on numerous occasions, including the following cases: · Mustang Oil & Gas, Inc. - Chapter 11 Trustee in the liquidation of the assets of an equipment and materials supplier to the oil and gas drilling industry. · Winn’s Store’s Inc. - Retained by the Plan Trustee to pursue avoidance actions against more than 350 defendants. Secured Creditors · Counsel to the secured lender group in the Chapter 11 proceedings of Al Copeland Enterprises, Inc. (Church's Fried Chicken and Popeye's Fried Chicken). Successful in defeating a management plan and confirming competing plan proposed by the Lender Group. Mr. Battaglia is a frequent speaker and author at numerous institutes and continuing legal education courses sponsored by the State Bar of Texas, the University of Texas and Lorman Business Center numerous other institutes and continuing legal education courses.

RAKHEE V. PATEL Kirkpatrick & Lockhart LLP

2828 N. Harwood Street, Suite 1800 Dallas, Texas 75201

Telephone: (214) 939-4998 Fax: (214) 939-4949

PRACTICE AREAS:

Bankruptcy, Business Reorganization and Business Restructuring. Representation of debtors, secured and unsecured creditors, equity holders, trustees and committees in chapter 11 reorganization and out-of-court restructuring and/or liquidation. LAW RELATED HONORS, APPOINTMENTS AND PUBLICATIONS

Law clerk for the Honorable Harlin D. “Cooter” Hale, United States Bankruptcy Judge for the Northern District of Texas, November 2002 to July 2003 Law clerk for the Honorable Robert C. McGuire, Chief Judge for the United States Bankruptcy Court for the Northern District of Texas, August 2001 to October 2002 Co-Author, “From Solicitation to Confirmation: The Final Thirty Days,” presented at Advanced Business Bankruptcy Course 2003, San Antonio, Texas, May 22-23, 2003

PROFESSIONAL ACTIVITIES:

Dallas Bar Association, Member Dallas Asian-American Bar Association, Member Dallas Young Lawyers Association, Member American Bankruptcy Institute, Member Turnaround Management Association, Member

EDUCATION:

Tulane Law School, J.D., cum laude, 1996 University of Florida, B.S., Business Administration, 1993

COURTS OF PRACTICE:

United States Court of Appeals for the Fifth Circuit and the Tenth Circuit United States District Courts for the Northern, Southern, Eastern and Western Districts of Texas All State Courts in the State of Texas

Emerging Plan Issues: Third Party Protections, Absolute Priority Post-LaSalle, Classification and Res Judicata Chapter 10

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TABLE OF CONTENTS

I. INTRODUCTION....................................................................................................................................... 1

II. THIRD PARTY PROTECTIONS................................................................................................................. 1 A. Overview ............................................................................................................................................. 1 B. The Minority View............................................................................................................................... 1 C. The Majority View ............................................................................................................................... 2 D. Seatco and Bernhard............................................................................................................................. 2

1. Seatco I and II............................................................................................................................... 3 2. Bernhard....................................................................................................................................... 4

E. Where Seatco and Bernhard Leave the Law............................................................................................ 4 F. Channeling Injunctions for Unknown Plaintiffs ...................................................................................... 5

1. Dow Corning................................................................................................................................. 5 2. Combustion Engineering ................................................................................................................ 5 3. Application in the Fifth Circuit ....................................................................................................... 6

III. ABSOLUTE PRIORITY POST-LASALLE .................................................................................................. 6 A. The Absolute Priority Rule .................................................................................................................... 6 B. The New Value Exception or New Value Corollary to the Absolute Priority Rule ..................................... 7 C. 203 North LaSalle ................................................................................................................................. 7 D. The Aftermath of LaSalle ...................................................................................................................... 8

1. The “Because Of” Test................................................................................................................... 8 2. Determination of What Constitutes Old Equity ................................................................................ 8 3. The Market Test: Termination of Exclusivity v. Bid Procedures ....................................................... 9 4. Standing to Object....................................................................................................................... 10

IV. CLASSIFICATION................................................................................................................................... 11 A. The Fifth Circuit: General Background ................................................................................................ 11 B. Bernhard and Sentry Operating............................................................................................................ 11 C. Notable Recent Decisions From Other Circuits ..................................................................................... 12 D. Conclusion ......................................................................................................................................... 12

V. IT’S NOT OVER: OBTAINING RES JUDICATA...................................................................................... 12 A. One Hurdle Down…........................................................................................................................... 12 B. Shoaf ................................................................................................................................................. 12

1. The Facts .................................................................................................................................... 12 2. The Opinion................................................................................................................................ 13 3. What Shoaf Means After Its Progeny ............................................................................................ 13

C. Conclusion ......................................................................................................................................... 15

VI. CONCLUSION......................................................................................................................................... 15


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EMERGING PLAN ISSUES: THIRD PARTY PROTECTIONS, ABSOLUTE PRIORITY POST-LASALLE, CLASSIFICATION AND RES JUDICATA I. INTRODUCTION

The law regarding Chapter 11 plans is constantly evolving to change with the times and needs of various debtors, creditors, and third parties. These relatively new waters require care, though, to avoid the many pitfalls that surround the Chapter 11 process. This paper will address various emerging plan issues, many of which have yet to be answered with bright-line standards but instead are being developed through the litigation of “creative plans of reorganization” and ultimately, the courts. II. THIRD PARTY PROTECTIONS A. Overview

As the use of Chapter 11 is expanded to address a broader range of economic calamities, many sections of the Bankruptcy Code have also been stretched beyond their likely original import. The effort to extend the scope of discharge to non-debtor parties through plan provisions that purport to either temporarily or permanently limit liability is one such expansion currently being debated by debtors, creditors and courts. The intended beneficiaries of these extraordinary plan discharges include corporate insiders—shareholders, officers, plan funders, affiliates and subsidiaries—as well as non-insiders such co-obligors, indemnitors and insurers.

Use of the term “non-debtor discharge” is a misnomer inasmuch as the release of the Debtor rarely takes the form of a “discharge”. Rather, plans attempting to provide for non-debtor relief incorporate plan provisions releasing the non-debtor target, often in conjunction with a permanent injunction to enforce the release.

Those courts that have addressed the propriety of non-debtor releases are decidedly split on the question. Some circuits have toed the line of only granting discharges to debtors while others have refused to read § 524(e) as prohibiting non-debtor discharges and have recognized the need for creativity in crafting a successful plan, especially for large, complex cases.

Until recently, the Fifth Circuit was considered to be a member of the minority, prohibiting non-debtor releases. Recent cases emanating from the Northern District of Texas appear more receptive to a more flexible approach to non-debtor relief.

B. The Minority View Court’s holding that third party releases are

prohibited rely upon a strict interpretation of various sections of the Bankruptcy Code. Section 524(e) of the Code states that “the discharge of a debt of a debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt.” The discharge limitations of § 524(e) coupled with the express provisions of § 524(g) authorizing the issuance of an injunction in favor of third parties in asbestos cases (albeit under limited circumstances) evidences Congress’ intention that third party releases are prohibited under the Code.

Strict constructionists further contend that incorporation of third party releases in a plan runs afoul of section 1123(b)(6) which permits the inclusion in a plan of “appropriate” provisions that are not inconsistent with the Bankruptcy Code. Moreover, since a plan may not be confirmed if it fails to comply with applicable provisions of the Code, the inclusion of a third party release renders a plan unconfirmable. 11 U.S.C. § 1129(a)(1).

The Ninth Circuit adopted this position in American Hardwoods v. Deutsche Credit Corp. (In re American Hardwoods), 885 F.2d 621 (9th Cir. 1989) rejecting the argument that a permanent injunction issued under § 105 to prevent the enforcement of a judgment against a non-debtor guarantor was substantively different from a discharge. In Resorts Int’l v. Lowenschuss (In re Lowenschuss), 67 F.3d 1394 (9th Cir. 1995) the Ninth Circuit applied its holding in American Hardwoods to a plan which proposed to release a variety of non-debtors from certain debts.

Similarly, the Tenth Circuit has declined to approve a plan that proposed to release all claims against the debtor as well as “any affiliate of the debtor and any insider of the debtor.” Underhill v. Royal, 769 F.2d 1426 (10th Cir. 1985).

A number of courts have followed the lead of the Ninth and Tenth Circuits in finding third party releases to be impermissible. See, e.g., In re Davis Broadcasting, Inc., 176 B.R. 290, 292 (M.D. Ga. 1994); Bill Roderick Distrib., Inc. v. A.J. Mackay Co. (In re A.J. Mackay Co.), 50 B.R. 756, 764 (D. Utah 1985); In re Future Energy Corp., 83 B.R. 470, 486 (Bankr. S.D. Ohio 1988); In re L.B.G. Props., Inc., 72 B.R. 65, 66 (Bankr. S.D. Fla. 1987); In re Scranes, Inc., 67 B.R. 985, 989 (Bankr. N.D. Ohio 1986); In re Bennett Paper Corp., 68 B.R. 518, 520 (Bankr. E.D. Mo. 1986); In re Eller Bros., Inc., 53 B.R. 10, 12 (Bankr. M.D. Tenn. 1985).

The Fifth Circuit’s holding in In re Zale Corp., 62 F.3d 746, 760 (5th Cir. 1995) is often considered to place the Fifth Circuit alongside the Ninth and Tenth Circuit Court’s as strict constructionists, prohibiting


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the issuance of third party releases and injunctions. A close reading of the case reveals that such an interpretation is a gross overstatement of the holding of the Court.

The Zale Court reversed the approval of a settlement among a debtor, the debtor's D&O insurers, and the creditors' committee that would have permanently enjoined a variety of claims against the settling defendants on the ground that the injunction impermissibly discharged non-debtor liabilities. While it is true the Zale Court found that the permanent injunction exceeded the trial court’s powers under § 105, the Court left the door open to the issuance of a temporary injunction under appropriate circumstances. Judge Houser and Judge Hale have recently pushed this door wide open in the Seatco and Bernhard Steiner Pianos cases discussed below. C. The Majority View

Currently, five Circuit Courts are considered to be “pro-release” courts, having authored opinions holding that bankruptcy courts have the power under § 105(a) to issue third party releases or permanent injunctions under appropriate and limited circumstances. These courts have concluded that the plain language of § 524(e) does not bar non-debtor releases and that § 105 grants bankruptcy courts broad power to issues order necessary to advance the bankruptcy process. In In re Dow Corning Corporation, 280 F.2d 648, 657 (6th Cir. 2002), the Sixth Circuit stated that § 524(e) “explains the effect of a debtor’s discharge. It does not prohibit the release of a non-debtor.”

The Second Circuit upheld confirmation of plans incorporating third party releases and permanent injunctions in both the Drexel and Manville cases. In each of these cases, the plans also provided significant distributions to the parties affected by the releases and injunctions. See Securities and Exchange Commission v. Drexel Burnham Lambert Group, Inc. (In re Drexel Burnham Lambert Group, Inc.), 960 F.2d 285, 293 (2nd Cir. 1992); Kane v. Johns-Manville Corp. (In re Johns-Manville Corp.), 843 F.2d 636, 640, 649 (2nd Cir. 1988).

In Robins, the Fourth Circuit similarly upheld non-debtor releases that were a key element for plan confirmation, where those same non-debtors made significant financial contributions that were to be paid to personal injury claimants under the plan. See Menard-Sanford v. Mabey (In re A.H. Robins Co.), 880 F.2d 694, 702 (4th Cir. 1989).1

1 An excellent overview of the majority and minority views is set out in Gillman v Continental Airlines (In re Continental Airlines), 203 F.3d 203 (3rd Cir. 2002).

A central focus of these and other cases permitting non-debtor releases is the global settlement of massive liabilities against the debtors and co-liable parties. Additionally, in each case the non-debtor released party made significant financial contributions to the plan in exchange for the release, and in each instance, the plan would not have been feasible, but for that contribution.

After concluding that a particular case is sufficiently extraordinary or unusual that a non-debtor release might be warranted, courts that have upheld such releases have generally analyzed the following factors to determine whether a particular release is permissible:

(1) There is an identity of interest between the

debtor and the third party, usually an indemnity relationship, such that a suit against the non-debtor is, in essence, a suit against the debtor or will deplete assets of the estate.

(2) The non-debtor has contributed substantial assets to the reorganization.

(3) The injunction is essential to reorganization. Without it, there is little likelihood of success.

(4) A substantial majority of the creditors agree to such injunction, specifically, the impacted class, or classes, has ‘overwhelmingly’ voted to accept the proposed plan treatment.

(5) The plan provides a mechanism for the payment of all, or substantially all, of the claims of the class or classes affected by the injunction.

See In re Master Mortgage Inv. Fund, 168 B.R. 930, 935 (Bankr. W.D. Mo. 1994); In re Zenith Electronics Corp., 241 B.R. 92, 110 (Bankr. D. Del. 1999).

The factors listed above are not intended to be

exclusive, exhaustive or conjunctive. Rather, the courts have engaged in a fact specific review, weighing the equities of each case. In re Master Mortgage Inv. Fund, 168 B.R. at 935. The Sixth Circuit added the following two additional factors to consider: “the plan provides an opportunity for those claimants who choose not to settle to recover in full and . . . [t]he bankruptcy court made a record of specific factual findings that support its conclusions.” In re Dow Corning Corp., 280 F.3d 648, 658 (6th Cir. 2002). D. Seatco and Bernhard

In re Seatco, 257 B.R. 469 (Bankr. N.D. Tex. 2001) [“Seatco I”], In re Seatco, 259 B.R. 279 (Bankr. N.D. Tex. 2001) [“Seatco II”], and In re Bernhard Steiner Pianos, 292 B.R. 109 (Bankr. N.D. Tex. 2002)


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are the latest in the line of cases adjudicating the discharge of a Debtor’s shareholder guarantors. Both opinions allowed the putative “discharges” under a theory that they were permissible temporary injunctions rather than true discharges. 1. Seatco I and II a. The Facts

The Debtor, an automobile seat manufacturer, entered into an agreement with its primary secured creditor, CIT, for a revolving and a term loan. Both were secured by all of its assets and guaranteed by its president. After suffering from the borrowing costs and loss of business due to faulty materials from its supplier, Seatco filed for bankruptcy.

The Plan included two injunctions, one permanent and one temporary. The permanent injunction purported to enjoin all claims against any entity wherein prosecution of the claim could result in a claim being asserted against the reorganized debtor. Id. at 473. The temporary injunction sought to enjoin creditors who had allowed claims paid for under the plan from proceeding against any officer, director, shareholder, employee, or other responsible person of Debtor to collect any portion of those claims. Id. at 474. CIT objected to both injunctions. b. The Opinion (1) The Permanent Injunction

Apart from indicating that courts in “large, complex, mass tort-type bankruptcy cases” have approved of broad permanent injunctions, the first opinion did not reach a decision on its propriety. Id. at 474-75. It found instead that the Plan was internally inconsistent, as the permanent and temporary injunction provisions overlapped. Id. at 475.

Upon modification of the plan — which removed all language affecting CIT out of the permanent injunction paragraph and into the temporary injunction paragraph — the court in Seatco II found CIT’s objection to have no merit as the permanent injunction language no longer affected CIT at all. 259 B.R. at 283. Rather the language was the usual instruction to courts not familiar with the Code that the Debtor’s discharge from debt was permanent. Id. (2) The Temporary Injunction

The court made three analytical moves in determining whether a Plan may issue what amounts to an injunction that extends beyond confirmation. 257 B.R. at 476-79. It first looked at the unusual circumstances test articulated by the Fifth Circuit in In re Zale, 62 F.3d 746 (5th Cir. 1995). Id. at 476-77.

In Zale, the Fifth Circuit held that an injunction that extended post-confirmation was not improper so long as it was not extended to become a permanent

injunction that effectively discharged a non-debtor from liability. Id. A temporary injunction, on the other hand, was permissible. Id.

The Seatco court then applied Zale’s test of a temporary injunction’s propriety: confirming that one of two circumstances existed:

(1) when the non- debtor and the debtor enjoy such an identity of interest that the suit against the non-debtor is essentially a suit against the debtor, and (2) when the third-party action will have an adverse impact on the debtor's ability to accomplish reorganization.

Id.

The test was easily met, according to the court, as

CIT’s successful pursuit of Kester on the Guaranty would mean that Kester would be unable to satisfy the claim and that CIT could execute against his stock in the Debtor. As the court found that the Debtor’s successful business operations depended on Kester acting as president, the execution against his business could derail the reorganization. Id.

The court’s second move was to look to the traditional factors governing the issuance of injunctions:

(1) a substantial likelihood that the movant will prevail on the merits; (2) a substantial threat that the movant will suffer irreparable injury if the injunction is not granted; (3) that the threatened injury to the movant outweighs the threatened harm an injunction may cause to the party opposing the injunction; and (4) that the granting of the injunction will not disserve the public interest.

Id. (quoting In re Commonwealth Oil Ref. Co ., 805 F.2d 1175, 1188-89 (5th Cir. 1986). Central to the court’s finding that this multi-factored test was met was the Debtor’s solid plan of reorganization, including a 100% distribution to its secured creditors over six years and 35% to its unsecured. Id. A liquidation, in contrast, would produce no distribution to the unsecured creditors. Id.

In relation to the third and fourth factor, the court found that the debtor’s successful reorganization outweighed the harm of CIT’s delayed gratification and that successful reorganization of debtors was in the public interest. Id.

The court’s analysis of procedural due process was a hazier scrutiny. Id. at 478. CIT initially complained that it was not afforded its procedural due


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process because the debtor did not obtain the injunction through an adversarial proceeding per Bankruptcy Rule 7001. Id. Essentially, however, CIT admitted in oral argument that it had been afforded these protections, and the court upon noting this, cites Zale and In re American Dev. Int'l. Corp., 188 B.R. 925, 935 (N.D. Tex. 1995) for the proposition that a party does not need to have an adversary proceeding to be afforded its protection. Id. This question is still open, however, as the court held that CIT did not have standing to argue that other creditors were not afforded due process. Id. at 478, n. 3.

2. Bernhard a. The Facts

Bernhard Steiner Pianos (“BSP”) was founded by Ivan Kahn as part of the Kahn Pianos Group. Subsequently, the Kahn family funds were depleted in a construction project in Nigeria; after political upheaval, the new Nigerian government refused to pay, and the Kahns were forced to pursue it for payment litigate. Ivan Kahn depleted his own assets in funding this litigation and began a floor-plan leasing arrangement with the Objecting Creditors in order to acquire more capital, signing on as guarantor for the loans. Kahn then borrowed funds from his company, the Debtor, to help his family.

When its debt exceeded its capital, the Debtor filed for bankruptcy. It managed to continue operations by obtaining agreements with third parties to provide pianos to the Debtor and pay for operation costs in exchange for 50% of the profits.

The resultant Plan endeavored to pay the Objecting Creditors 100% of their claims; however, it also limited their recovery to the terms of the Plan so long as it was not in default. Should the Debtor fall into default, the plan provided that any statute of limitations for a cause of action against Kahn would be tolled until that time.

b. The Opinion

The court adhered to the Fifth Circuit doctrine that a plan of reorganization cannot be confirmed if it purports to discharge non-debtor parties; however, it then found that the supposed “discharge” of which the Objecting Creditors complained was merely a control over the process and timing of their claims. Id. at 116. This control amounted to what was in effect, like Seatco, a temporary injunction or a post-conformation stay between the creditors and Kahn that was not permanent and that could be lifted should the Debtor fall into default. Id. at 117.

Critical to the court’s allowance of the discharge was the plan successfully overcoming the three Seatco tiers of analysis—the Zale unusual circumstances test, the traditional temporary injunction factors, and due

process protections. Here, the unusual circumstances test was met because (in accord with Seatco), as sole shareholder whose reputation was the engine behind the company’s success, Ivan Kahn “[f]or all practical purposes, at this time,…is the Debtor.” Id. Likewise, the traditional temporary injunction factors were met. The Debtor provided a plan wherein the creditors would be paid in full were offered an “out” should the debtor default. E. Where Seatco and Bernhard Leave the Law

Although the Fifth Circuit has aligned itself with the circuits holding fast that § 105 does not give bankruptcy courts power to permanently discharge non-debtor parties, Zale when read with Seatco and Bernhard seems to allow some flexibility if the discharge provision can be construed to only control the process and the timing by which the claimants can pursue the party. This has the effect of permanently discharging debt, since the plan when carried out without a debtor’s default will satisfy the claims of the potential complaining creditors. If the Seatco and Bernhard reorganizations succeed and the debts are paid through the plan, the insiders who guaranteed their corporations’ loans will have been insulated from suit.

So what are the limits of controlling timing and process? Seatco suggests that a plan might be able to tick away the statute of limitations so that if the plan results in default, rather than suing the insider guarantors, creditors might be stuck with the debtor. While Bernhard did involve a tolling of the limitations period, the court considered the tolling only in finding that non-debtors were granted a kind of stay that was less than even a temporary injunction.

In the present case, Debtor does not expressly seek even a temporary injunction. Instead, [the plan provision] purports to act as a stay to the pending state court actions against Kahn by directing recovery first through the Plan process, and tolling the Objecting Creditors' claims against Kahn during the pendency of the Plan.

292 B.R. at 116-17.

Thus, the court looked to the tolling provision as

one of several factual circumstances that allowed the release to meet the four traditional temporary injunction factors; and, since it is the tolling provision that makes this stay something less than a temporary injunction, it cannot logically be read as necessary to meeting the test. Further, because Seatco, on which Bernhard relies, does not contain such a provision, it seems even more needless.


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If Seatco and Bernhard are read in this way, the release of a non-debtor party finds its analog in a novation. The creditors and debtor have committed themselves to replace the older debt with a new one, one in which the creditor may only look to the reorganized debtor vis-à-vis the plan for satisfaction. Characterizing non-debtor discharge in this way, particularly when dealing with non-debtor guaranteed debt, may provide a means of escaping the Fifth Circuit’s constrictive reading of § 524(e). F. Channeling Injunctions for Unknown Plaintiffs

The waters are murkie r in the Fifth Circuit when it comes to non-debtor parties seeking to channel insurance and debtor funds as well as their own into a fund to satisfy current and future plaintiffs. Two recent cases in other circuits provide a good starting point to the inquiry: In re Dow Corning, 280 F.3d 648 (6th Cir. 2002) and In re Combustion Engineering, 295 B.R. 459 (D. Del. 2003). 1. Dow Corning a. The Facts

Dow Corning, the predominant manufacturer of silicone gel breast implants, was pushed into bankruptcy after medical studies indicated that the silicone gel caused auto-immune diseases and tens of thousands of women sued, claiming these injuries. In re Dow Corning, 280 F.3d 648, 653 (6th Cir. 2002). Litigation was consolidated by the Judicial Panel of Multidistrict Litigation and a settlement reached; however, hundreds of thousands more suits were anticipated. Id.

The bankruptcy court, on the parties’ motions, transferred the causes of action against Dow, its shareholders, and other implant manufacturers (to whom Dow sold silicone) to the bankruptcy court’s jurisdiction. Id. at 654. The Trustee appointed committees to represent the claimants and eventually a plan was confirmed. Id. Under the plan, a fund was established for payment of claims with funds pooled from Dow’s insurers, shareholders and cash reserves. Id. at 654-55. The bankruptcy court determined, based on non-bankruptcy law, that these releases applied to consenting creditors only. Id. The district court disagreed broadening the releases to all creditors. Id. b. The Opinion

While non-consensual, non-debtor releases were beyond the traditional equity jurisprudence, the Sixth Circuit disagreed with the bankruptcy court’s reasoning that Grupo Mexicano de Desarrollo v. Alliance Board Fund, Inc., 527 U.S. 308, 322 (1999) prohibited such as use of equitable power. Id. at 657. When read correctly, the court argued, Grupo Mexicano stands for the proposition that a bankruptcy

court cannot exercise broader powers unless there was a statutory basis for it. Id. Section 105(a) supplies such a basis. Nevertheless, as a non-debtor release of non-consenting parties is a dramatic measure, the court chose to follow its sister circuits who require a seven-factor “unusual circumstances” test. See supra, Section II.C.

(1) There is an identity of interests between the debtor and the third party, usually an indemnity relationship, such that a suit against the non-debtor is, in essence, a suit against the debtor or will deplete the assets of the estate; (2) The non- debtor has contributed substantial assets to the reorganization; (3) The injunction is essential to reorganization, namely, the reorganization hinges on the debtor being free from indirect suits against parties who would have indemnity or contribution claims against the debtor; (4) The impacted class, or classes, has overwhelmingly voted to accept the plan; (5) The plan provides a mechanism to pay for all, or substantially all, of the class or classes affected by the injunction; (6) The plan provides an opportunity for those claimants who choose not to settle to recover in full and; (7) The bankruptcy court made a record of specific factual findings that support its conclusions.

Id. at 658.

The Dow plan failed the “unusual circumstances” test for three reasons. First, the bankruptcy court found that non-consenting creditors need not be enjoined from suit in order for the reorganization to be successful. Id. at 659. The Sixth Circuit construed this to mean that the release and injunction were not essential to reorganization. Id. Second, the bankruptcy court failed to make “particularized factual findings” that the non-debtor parties made “significant contributions” to the reorganization. Id. And finally, the Sixth Circuit found that the court’s determination that the non-consenting creditors would be paid in full to be erroneous. Id. 1. Combustion Engineering a. The Facts

Asea Brown Boven (“ABB”) is the parent of US ABB and Combustion Engineering. In re Combustion Engineering, 295 B.R. 459, 462 (D. Del. 2003). Combustion Engineering was pushed into bankruptcy due to its asbestos problems and filed with a prepackaged plan. Id. Due to its insurers reimbursing fewer of its asbestos claims, Combustion Engineering


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had received capital contributions from US ABB in order to make good on its claims. Id. When the insurance was exhausted, Combustion Engineering had to rely completely on ABB and US ABB, which in turn forced them to refinance. Id. at 463. Subsequently, ABB’s lenders required it to resolve Combustion Engineering’s asbestos liabilities as a condition to any further financing. Id.

The prepackaged plan that was negotiated and crafted had three essential parts: a pre-petition settlement fund, a post-petition asbestos PI trust, and a release of the debtor as well as other non-debtor parties. Included in this injunctive release were claims against ABB, Lummus Global, Inc. (“Lummus”)—an affiliated company—and the Oil, Gas, and Petrochemical (“OGP”), a division of ABB.

In order to ensure its future financial viability, ABB needed to sell its interest in Lummus and OGP. Unless potential asbestos claims against Lummus and OGP could be resolved, ABB would not be able to realize any value for them. b. The Opinion

The Court utilized the analysis set out in Dow Corning and applied the seven-factor “unusual circumstances” test. Id. at 483. It found factors two, three, six and seven were met, based on the evidence in the record: the non-debtors contributed all of their shared insurance and thus provided access to funds not depleted by litigation of co-insureds. An identify of interest existed as ABB’s need to sell Lummus and OGP provided reason to contribute to Combustion Engineering’s plan funding. The suits against affiliates are derivative of Combustion Engineering’s alleged liability. Id. at 484. Amounts in the “pot” of the non-accepting creditors were “sufficient to provide the opportunity to pay” them. Id. at 484.

Evidence was unavailable to establish factors four and five. In regard to factor four, the court ordered affidavits to be filed establishing whether “direct notice” was provided to those holding non-derivative claims against the non-debtors. Id. And for factor five, the court required evidence establishing a separate “pot” for the non-debtors’ creditors. Id. Thus the court approved the confirmation in theory but gave the parties ten days to remedy the evidentiary failings of factors four and five. 3. Application in the Fifth Circuit

In In re Vitek, Inc., 51 F.3d 530, 538 n.39 (5th Cir. 1995), the court “wonder[ed] ‘out loud’” in not only dicta but a footnote whether injunctions were appropriate when creditors of non-debtor parties oppose them and cautioned bankruptcy courts against trampling on those creditors’ rights. Nonetheless, the court seemed not to question “§ 105 injunctions in

mass tort situations” only their application to guaranty and partnership contexts. Id.

This footnote was subsequently referenced in In re Zale, Corp., 62 F.3d 746 (5th Cir. 1995). There, the court held that a permanent injunction was improper, but that an unusual circumstances analysis might permit a temporary one. 62 F.3d at 761. It then cited to a Sixth Circuit case — Dow Corning predecessor — Patton v. Beardon, 8 F.3d 343, 349 (6th Cir. 1993).

Seatco and Bernhard have already chipped away some of the judicial resolve against guaranty releases by construing them as temporary injunctions, and this flexibility might forecast favorable treatment of the Dow Cornings and Combustion Engineerings in the Fifth Circuit.

The following components — which are not necessarily apparent from the bare recitation of the seven-factor unusual circumstances test — appear essential to satisfy the Code and due process concerns:

• Appointment of committees or fully funded

and independent representatives to represent the interests of pending and future litigants;

• Due diligence reviews conducted by financial professionals and overseen by independent parties, such as the representatives of pending and future claimants. These reviews should investigate the accurateness of the projected need for the fund and the ampleness of the “pots”;

• Contribution by the non-debtor parties of funds that would not otherwise be available the settlement and litigation funds. In Combustion Engineering, the funds contributed by the non-debtor parties would be at risk of depletion by co-insured litigation if the plan release deal had not been struck;

• A separate and adequate “pot” for those parties who do not consent to the plan; and

• Direct notice must be given to the impacted classes and parties (who are required to “overwhelmingly” approve of the plan). Combustion Engineering suggests that it is the aggressive attempt that is important, which can be established by affidavits describing the process. No doubt this process would be stronger if subjected to the independent review described above.

III. ABSOLUTE PRIORITY POST-LASALLE A. The Absolute Priority Rule

Section 1129 of the Bankruptcy Code governs confirmation of plans in Chapter 11 cases. Section 1129 mandates, inter alia, that a court may only confirm a plan if all impaired classes of creditors vote


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to accept the plan. 11 U.S.C. § 1129(a)(8). If the plan proponent cannot meet the requirements of Section 1129(a)(8), the plan proponent must resort to Section 1129(b) of the Bankruptcy Code, more commonly known as the “cramdown” provision.

Section 1129(b) states that a plan can be confirmed if all other requirements of Section 1129(a), other than Section 1129(a)(8), are met and (1) the plan is fair and equitable and (2) does not unfairly discriminate with respect to each class of impaired claims or interests that has not accepted the plan. 11 U.S.C. § 1129(b).

A plan is fair and equitable to secured creditors only if

(1) the holder of the secured claim retains its lien(s) to the extent of the allowed amount of its claim and also receives deferred cash payments totaling at least the allowed amount of the claim that equals the present value of the secured creditor’s interest in the secured property on the effective date of the plan;

(2) it provides for the sale free and clear of liens securing the claim with liens to attach to the proceeds from the sale, subject to the credit bid provisions of Section 363(k) of the Bankruptcy Code, and provides for treatment of the replacement liens on proceeds in accordance with (1) and (3) herein; or

(3) provides for the realization by the secured creditor of the indubitable equivalent of the secured claim.

A plan is fair and equitable to unsecured creditors only if

(1) the allowed unsecured claim is paid in full on the effective date or

(2) it complies with the absolute priority rule, i.e. the holder of any claim or interest that is junior to the claims or interests of unsecured creditors will not receive or retain under the plan any property “on account of such claim or interest.”

Thus, in order to obtain cramdown of a plan, creditors must be paid in full before equity interest holders can receive any distribution under the proposed plan on account of their prior equity position in the debtor. B. The New Value Exception or New Value

Corollary to the Absolute Priority Rule The “new value exception,” also referred to as the

“new value corolla ry,” is a common law exception to the absolute priority rule and allows old equity interest

holders to participate in a cramdown plan and receive equity interests in the reorganized debtor without payment in full to all creditors if they make an equity contribution to the reorganized debtor (1) in money or money’s worth, (2) that is reasonably equivalent to the value of the new equity interests received in the reorganized debtor, and (3) that is necessary for successful reorganization of the restructured debtor. Bank of Am. Nat’l Trust and Sav. Ass’n v. 203 N. LaSalle St. P’ship , 526 U.S. 434, 442, 119 S. Ct. 1411, 1416, 143 L.Ed.2d 607 (1999).

Circuit courts are split on the continued viability of the new value exception after the enactment of the Bankruptcy Code. The Seventh and Ninth Circuit Court of Appeals have ruled that the new value exception is viable. See Bonner Mall P’ship v. United States Bancorp Mortgage Co. (In re Bonner Mall P’ship), 2 F.3d 899, 910-16 (9th Cir. 1993), cert. granted, 510 U.S. 1039, 114 S. Ct. 681, 126 L. Ed. 2d 648, vacatur denied and appeal dismissed as moot, 513 U.S. 18, 115 S. Ct. 386, 130 L. Ed. 2d 233 (1994); Bank of Am. Nat’l Trust and Sav. Ass’n v. 203 N. LaSalle St. P’ship , 126 F.3d 955 (7th Cir. 1998), rev'd without deciding issue, 526 U.S. 434, 119 S. Ct. 1411, 143 L. Ed. 2d 607 (1999). The Second and Fourth Circuits have not explicitly rejected the new value exception, but have expressly doubted its existence. See In re Coltex Loop Cent. Three Partners, L.P., 138 F.3d 39, 44-5 (2nd Cir. 1998); In re Bryson Props., XVIII, 961 F.2d 496, 504 (4th Cir.), cert. denied, 506 U.S. 866, 113 S. Ct. 191, 121 L. Ed. 2d 134 (1992). Other circuit courts, including the Fifth Circuit Court of Appeals, have declined to rule on the existence of the doctrine. John Hancock Mutual Life Ins. Co. v. Route 37 Bus. Park Assocs., 987 F.2d 154, 162 n.12, (3rd Cir. 1993); In re Greystone III Joint Venture, 948 F.2d 134, 142 (5th Cir.), modified, 948 F.2d 142 (5th Cir.), cert. denied, 506 U.S. 821, 113 S. Ct. 72, 121 L. Ed. 2d 37 (1992); In re Lumber Exch. Bldg. Ltd. P’ship , 968 F.2d 647, 650 (8th Cir. 1992); Unruh v. Rushville State Bank , 987 F.2d 1506, 1510 (10th Cir. 1993). C. 203 North LaSalle

In Bank of Am. Nat’l Trust and Sav. Ass’n v. 203 N. LaSalle St. P’ship, 526 U.S. 434, 119 S. Ct. 1411, 143 L.Ed.2d 607 (1999), the Supreme Court was expected to resolve the split among the circuit courts regarding the existence of the new value exception to the absolute priority rule. While the Supreme Court acknowledged that the new value exception may exist, it held that new value plans that provide junior interest holders (old equity interest holders) with the exclusive opportunity, free from competition and without market valuation, to obtain equity interests in the reorganized entity violate the absolute priority rule. Id. at 458.


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The Court reasoned that old equity’s exclusive opportunity to invest in the reorganized entity and receive equity in return must be considered property received “on account of” its junior claim. On account of should be read as meaning “because of.” Id. at 451. The Court interpreted because of to mean a “causal relationship between holding the prior claim or interest and receiving or retaining property.” Id. The Court implied that a greater degree of causal link between possession of the old equity interest and receipt of the new equity interest would be necessary to satisfy the because of standard, stating

[c]ausation between the old equity’s holdings and subsequent property substantial enough to disqualify a plan would presumably occur . . . whenever old equity’s later property would come at a price that failed to provide the greatest possible addition to the bankruptcy estate, and it would always come at a price too low when the equity holders obtained or preserved an ownership interest for less than someone else would have paid. A truly full value transaction, on the other hand, would pose no threat to the bankruptcy estate not posed by any reorganization, provided of course that the contribution be in cash or be realizable money’s worth.

Id. at 453-54 (footnote omitted).

The Court further stated that old equity would not need an exclusive opportunity to obtain the new equity interests if it was offering top dollar for the new equity. Id. at 456. Thus, the Court surmised, the exclusiveness of the opportunity to obtain new equity in the reorganized debtor, “with its protection against the market’s scrutiny of the purchase price by means of competing bids or even competing plan proposals” can only arise “to do old equity a favor.” Id. Therefore, it is the exclusive opportunity to acquire the new equity interests that amounts to a property interest given only on account of the old equity position, which runs afoul of the absolute priority rule. Id.

With respect to whether the bankruptcy estate would receive the greatest possible return in exchange for the new equity interests, the Supreme Court noted

[i]t would thus be necessary for old equity to demonstrate its payment of top dollar, but this it could not satisfactorily do when it would receive or retain its property under a plan giving it exclusive rights and in the absence of a competing plan of any sort. Under a plan granting an exclusive right, making no provision for competing bids or

competing plans, any determination that the price was top dollar would necessarily be made by a judge in a bankruptcy court, whereas the best way to determine value is exposure to a market.

Id. at 457 (footnote omitted). The Court declined, however, to decide whether “a market test would require an opportunity to offer competing plan or would be satisfied by a right to bid for the same interest sought by old equity.” Id. at 458. Thus, the debate rages on regarding whether the new value exception does exist, and if so, how the market test is satisfied post-LaSalle. In addition, new issues have cropped up to further tangle the absolute priority/new value web. D. The Aftermath of LaSalle 1. The “Because Of” Test

In In re PWS Holding Corp., 228 F.3d 224 (3rd Cir. 2000), the plan proposed to release equity interest holders from potential fraudulent transfer claims arising from a leveraged recapitalization. The Third Circuit held that the plan provision releasing equity holders from liability did not violate the absolute priority rule. The Third Circuit interpreted the LaSalle “because of” standard as requiring a “causal connection between holding the prior claim or interest, and receiving or retaining property.” Id. at 238. The Court held that because the objecting unsecured creditor failed to present “direct evidence of causation,” the release of potential claims against equity holders did not violate the absolute priority rule. Id. at 242. The Court specifically noted that the estate’s potential fraudulent transfer claims were of “marginal viability and could be costly for the reorganized entity to pursue.”

In In re 4C Solutions, Inc., 302 B.R. 592, 599 (Bankr. C.D. Ill. 2003), the court found that where old equity interests had the exclusive opportunity to retain the ownership interests in the reorganized debtor without a contribution of new value, the causal relationship between ownership of the debtor and the receipt of the new equity is presumptive. The court also noted that causation was “all the more obvious” since the plan proposed to vest all equity in the sole shareholder of the parent company of the debtor, effectively eliminating one tier of ownership, and dissolve the parent company post-confirmation, although the parent company was not a debtor in bankruptcy. Id. at 600, n.7. 2. Determination of What Constitutes Old Equity

In Beal Bank v. Waters Edge Ltd. P’ship (In re Waters Edge Ltd. P’ship), 248 B.R. 668 (D. Mass. 2000), the court distinguished new value corollary


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cases based on the fact that the debtor’s plan proposed the infusion of new value from a third party, albeit an insider, the old equity interest holder’s son-in-law. The court held that the absolute priority rule does not bar the sale of new equity to anyone other than existing equity holders in the debtor. Id. at 680. Instead, the court found, the Bankruptcy Code relies on the confirmation requirements as the safety net to ensure fair and equitable treatment of the creditors. Id. The Court did note that since the third party in this case was an insider, the transaction required “greater scrutiny by the bankruptcy court to ensure fairness” since it would not be subject to market valuation or competitive bidding. Id. The court found that “[w]hile old equity could certainly not use an insider as a straw to retain its investment,” the objecting creditor had failed to show that the insider third party had been funded by or acted on behalf of the old equity interest holder. Id. Thus, under a Beal Bank analysis, absent the sale of new equity to an insider of the old equity interest holders being considered a straw transaction, the sale is not subject to the absolute priority rule.

However, in In re Global Ocean Carriers, Ltd., 251 B.R. 31 (Bankr. D. Del. 2000), the Delaware District Court disagreed with the Beal Bank court. In Global Ocean, the debtor proposed to sell all of the stock in the reorganized debtor to the sister/daughter of the two largest shareholders of the debtor in exchange for substantial new value to be contributed to the reorganized debtor. The Global Ocean court rejected the Beal Bank court’s narrow reading of LaSalle and therefore, did not reach the straw-man transaction analysis. Instead, the court found that the prior equity interest holder’s exclusive opportunity to determine who would receive the equity interests in the reorganized debtor and at what price, free from competition or market valuation, violated the absolute priority rule. Thus, insider transactions are subject to the same absolute priority rule requirements as if the old equity interest holders were retaining interests in the reorganized debtor. See also Bank of Am. Commercial Fin. v. CGE Shattuck, LLC (In re CGE Shattuck, LLC), Nos. 99-12287-JMD, CM99-747, 1999 WL 33457789 (Bankr. D.N.H. 1999) (absolute priority rule violated where 100% of new equity is from “new entity organized by a pre-petition equity holder who alone, or with its affiliates, is contributing a majority of the new value”); In re Suncruz Casinos, LLC, 298 B.R. 833 (Bankr. S.D. Fla. 2003) (noting “conflict of interest” of insider parties in contributing new value for equity in reorganized debtor).

In In re 4C Solutions, Inc., 302 B.R. 592 (Bankr. C.D. Ill. 2003), the court addressed whether the equity interest holder of a non-debtor holding company which owned the debtor company was the “holder of a claim or interest” sufficient to trigger application of the

absolute priority rule. The court found that although in most instances the holder of an equity interest is the current shareholder of the debtor company, in cases where the debtor is owned by a holding company, “it is necessary and appropriate to look beyond the mere identity of the holder of the debtor’s stock.” Id. at 597. In this Court’s view, this is necessary to fully effectuate the policy against allowing insiders to use the advantage of their insider status to acquire new equity for less than fair value.” Id. The court, under the facts, found that the equity interest holder of the holding company was an interest holder in the debtor by virtue of the fact that he exercised control over the corporations affairs, by and through his control of the board of directors, and the fact that he shares in the profits of the debtor company, which flow through the holding company. Id. at 598.

For a discussion of capacity in which former equity interest holder and creditor of debtor receives new equity, see In re Zenith Electronics Corp., 241 B.R. 92 (Bankr. D. Del. 1999), appeal dism’d, 250 B.R. 207 (D. Del. 2000), discussed supra, Section III. C. 4. 3. The Market Test: Termination of Exclusivity v.

Bid Procedures One of the unresolved LaSalle issues is

“[w]hether a market test would require an opportunity to offer competing plans or would be satisfied by a right to bid for the same interest sought by old equity.” LaSalle, 526 U.S. at 458.

In In re Situation Mgmt., 252 B.R. 859 (Bankr. D. Mass. 2000), the debtor’s new value plan proposed a bidding procedure for interested parties, including old equity interest holders, to acquire the equity interests in the reorganized debtor. A creditor filed a section 1121(d) motion to terminate exclusivity in light of the debtor’s plan, which the debtor opposed. Id. The court held that the filing of a new value plan in the case formed sufficient cause to terminate exclusivity so that the debtor could “gain acceptance of its plan.” Id. at 865. The court reasoned that the debtor had forfeited its right to exclusivity since any party could bid on the new equity interests and “assume control of the Debtor if the bidder is successful.” Id. The court further reasoned that by terminating exclusivity and allowing competing plans, and the corresponding disclosure statements, the debtor’s creditors and any interested bidders on the new equity interests would be afforded a more “informed process” than in the auction scenario envisioned in the debtor’s plan. Id. at 865-66. Accordingly, the court granted the creditor’s motion to terminate exclusivity. The Situation Management court found that allowing competing plans is a better method of market valuation than allowing a bid procedure,


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For some decisions holding alternatively, see Matter of Homestead Partners, Ltd., 197 B.R. 706, 716-17 (Bankr. N.D. Ga. 1996) (auction process is superior market valuation method since it does not disrupt the plan negotiation process); In re Davis, 262 B.R. 791, 799 (Bankr. D. Ariz. 2001) (individual chapter 11 case noting that LaSalle suggests that either the termination of exclusivity or a bid procedure will suffice to meet the market valuation test but declining to extend exclusivity); Bank of Am. Commercial Fin. v. CGE Shattuck, LLC (In re CGE Shattuck, LLC), Nos. 99-12287-JMD, CM99-747, 1999 WL 33457789 (Bankr. D.N.H. 1999) (“the precise means of achieving market competition will be determined on the facts in a given case, but will involve either competing plans of reorganization or a right for third parties to bid for the same interest sought by old equity”). 4. Standing to Object

In In re Zenith Electronics Corp., 241 B.R. 92 (Bankr. D. Del. 1999), appeal dism’d, 250 B.R. 207 (D. Del. 2000), the debtor’s plan proposed that one hundred percent of the equity in the reorganized debtor would vest in the debtor’s single largest creditor (and majority shareholder). In exchange, the debtor would receive new value in the form of cash and forgiveness of substantial debt. Id. The minority shareholders objected. The court found that the plan did not violate the absolute priority rule of either section 1129(b)(2)(B) or (C).

The plan did not violate section 1129(b)(2)(C) because the entity receiving the equity interest in the reorganized debtor was receiving it in its capacity as “a substantial secured and unsecured creditor who is being given that right.” Id. at 106-7. The Zenith court limited LaSalle to its facts – the retention of equity interests by existing shareholders – and limited LaSalle’s application to 1129(b)(2)(B). Id. In fact, the Zenith court noted that had the plan offered the new equity interests to the minority shareholders, it would have raised LaSalle absolute priority issues. Id. The court reasoned that to extend LaSalle beyond its facts would

require in all cases that a debtor be placed “on the market” for sale to the highest bidder. Such a requirement would eliminate the concept of exclusivity contained in section 1121(b) and the broad powers of the debtor to propose a plan in whatever format it desires.

Id.

Further, the plan did not violate section 1129(b)(2)(B) because all classes of creditors had

voted to accept the plan. Thus, section 1129(b)(2)(B) did not even apply under the facts of the case. Conceivably, the court’s ruling would foreclose an objection even by a dissenting unsecured creditor on absolute priority grounds pursuant to section 1129(b)(2)(B) since the court found that the former majority shareholder was receiving the equity in its capacity as a creditor.

Another bankruptcy court has found that a fully secured creditor lacks standing to make an absolute priority objection. In re New Midland Plaza Assoc., 247 B.R. 877 (Bankr. S.D. Fla. 2000). The court reasoned that section 1129(b)(2)(A) excludes the absolute priority rule just as (b)(2)(B) and (C) expressly includes it. Id. at 894. The court noted that “Congress was obviously aware of the absolute priority rule” as it included the rule with respect to classes of unsecured creditors and classes of interests, yet it excluded it from the subsection relating to classes of secured claims. Id. The Midland Plaza court also rejected an argument that section 1129(b)(2)(A) implicitly includes the absolute priority rule. Id. at 894-95. See also In re Arden Properties, 248 B.R. 164 (Bankr. D. Ariz. 2000) (holding that the absolute priority rule does not apply to secured claims).

One court has found that the bankruptcy court has “an independent duty to determine whether a plan complies with § 1129,” including the absolute priority rule. In re MJ Metal Products, Inc., 292 B.R. 702 (Bankr. D. Wyo. 2003). In MJ Metal, there was no class of impaired creditors objecting on absolute priority grounds. The court went on hold that the plan, which allowed only old equity interest holders to bid for the equity of the reorganized debtor without termination of exclusivity, violated the absolute priority rule. Thus, the court denied confirmation even though there was no impaired senior creditor or interests objecting on the basis of absolute priority.

In In re Genesis Health Ventures, Inc., 266 B.R. 591 (Bankr. D. Del. 2001), the plan proposed to provide to officers and directors of the debtor a distribution of stock, forgiveness of loans, waivers, releases and exculpations as an incentive to remain in the employ of the reorganized debtor. The officers and directors did not have to contribute any other value. Although the court conceded that the payments to former management “borders on payments to management on account of their pre-petition equity interests,” the court concluded that because the distributions to former management “represents an allocation of the enterprise value” otherwise distributable to senior secured lenders, who consented to such distribution, the absolute priority rule (and the fair and equitable standard) were not violated. Thus, the absolute priority rule is not violated where the property retained by old equity interest holders under


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the plan comes from property otherwise attributable to a senior class with the senior class’ consent.

In In re Made in Detroit, Inc., 299 B.R. 170, 181-82 (Bankr. E.D. Mich. 2003), one bankruptcy court stated, in dicta, that even if the plan provided for payment in full to unsecured creditors, the absolute priority rule would be violated by the retention of the equity in the reorganized debtor by old equity interest holders when payment in full to the unsecured creditors is speculative. Thus, the result is that the unsecured creditors would have standing to object on the basis of the absolute priority rule even though the plan technically provided for payment in full. IV. CLASSIFICATION A. The Fifth Circuit: General Background

11 U.S.C. § 1122(a) provides, in relevant part, that a plan “may place a claim or an interest in a particular class only if such claim or interest is substantially similar to the other claims or interests of such class.” Thus, dissimilar claims may not be classified together. Section 1122 goes on to provide that unsecured claims that are small in overall dollar value may be separately classified from other unsecured claims for administrative convenience, also known as the convenience class. 11 U.S.C § 1122(b).

In Phoenix Mut. Life Ins. Co. v. Greystone III Joint Venture (In re Greystone III Joint Venture), 995 F.2d 1274 (5th Cir. 1992), vacated in part on reh’g per curium, (1992), the Fifth Circuit noted that section 1122(a) only governs permissible inclusions of claims in a class rather than requiring that substantially similar claims be grouped together. Id. at 1278. The Court then focused on the existence of section 1122(b) and ruled that interpreting section 1122(a) to allow unqualified classification of like claims in separate classes would render section 1122(b) superfluous. Id. Thus, the court found that section 1122 “must contemplate some limits on classification of claims of similar priority.” Id.

The Fifth Circuit then issued the commandment: thou shalt not separately classify substantially similar claims “in order to gerrymander an affirmative vote on a reorganization plan.” Id. at 1279. Thus, the court articulated one purpose of separate classification that is impermissible. The court stated that because classification of claims affected the “integr ity of the voting process,” “if claims could be arbitrarily placed in separate classes, it would almost always be possible for the debtor to manipulate ‘acceptance’ by artful classification.” Id. at 1277.

The Court went on to hold that a non-recourse deficiency claim arising under section 1111(b) cannot be separately classified from general unsecured claims. This is because separate classification of the unsecured

deficiency claim would render the unsecured deficiency claimant’s right to vote meaningless.

Plan proponents could effectively disenfranchise the holders of such claims by placing them in a separate class and confirming the plan over their objection by cramdown. With its unsecured voting rights effectively eliminated, the electing creditor’s ability to negotiate a satisfactory settlement of either its secured or unsecured claims would be seriously undercut. It seems likely that the creditor would often have to “elect” to take an allowed secured claim under § 1111(b)(2) in the hope that the value of the collateral would increase after the case is closed. Thus, the election under § 1111(b) would be essentially meaningless.

Greystone, 995 F.2d at 1280. The Court found the separate classification to be an impermissible attempt to gerrymander an affirmative vote by the general unsecured creditors and therefore, found the plan unconfirmable.

The Fifth Circuit in Greystone recognized that separate classification may be justified for good business reasons. Id. at 1280-81. See also Heartland Fed. Sav. & Loan Ass’n v. Briscoe Enterprises, Ltd., III (In re Briscoe Enterprises, Ltd., III), 994 F.2d 1160 (5th Cir. 1993) (applying business justification standard enunciated in Greystone and In re U.S. Truck, 800 F.2d 581 (6th Cir. 1986)). However, the Greystone court rejected the separate classification proposed by the debtor because the separate classification did not treat the separately classified creditors any differently – thus, it did not have the practical effect of achieving any legitimate purpose. B. Bernhard and Sentry Operating

In In re Bernhard Steiner Pianos USA, Inc., 292 B.R. 109 (Bankr. N.D. Tex. 2002), the bankruptcy court upheld the separate classification of otherwise similar unsecured claims based on the business justification exception. In Bernhard Steiner, the debtor operated a piano store, selling new and consigned pianos. Id. at 111. The debtor’s plan separately classified the claims of the consignment creditors from other general unsecured creditors. Id. at 113. The court found that accelerated repayment to this class of creditors over other unsecured creditors was necessary to “repair [the debtor’s] tarnished consignment name in a small market” which was necessary to secure consigned pianos post-confirmation. Id. at 114. Future sales of consigned pianos were an “integral part” of the debtor’s future. Id. Further, the court found that because the plan did contemplate different repayment


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terms to the separate classes, there was no evidence the separate classification was for the impermissible purpose of gerrymandering an affirmative vote. Id. Instead, the separate classification would ultimately help the debtor achieve the desired result – the post-confirmation return of a significant portion of the debtor’s business.

In In re Sentry Operating Co. of Texas, Inc., 264 B.R. 850 (Bankr. S.D. Tex. 2001), the bankruptcy court considered the separate classification of trade creditors from general unsecured. The debtor in Sentry Operating operated funeral homes. Id. at 853. The trade creditor class included certain creditors with claims of minimal value, i.e. ministers, organists and florists, but also contained creditors with a national market with whom the debtor’s parent company did business. Id. at 856-57. The debtor presented testimony that the repayment of these creditors was necessary to ensure the continued provision of services that are essential to the operation of the debtor’s business post-confirmation. Id. at 856.

The court found that the stated purpose for the classification scheme – the preservation and enhancement of the value of the debtor’s assets – to be a permissible purpose for separate classification. Id. at 861. Under the facts, though, the court found that the separate classification achieved dual purposes – the permissible purpose of preserving and increasing value and the impermissible purpose of gerrymandering an affirmative vote. Id. The court rejected the separate classification because the classification was not “sufficiently narrowly drawn to achieve the stated purpose.” Id. C. Notable Recent Decisions From Other Circuits

In re Mahoney Hawkes, LLP, 289 B.R. 285 (Bankr. D. Mass. 2002) – The debtor was entitled to insurance proceeds from liability policy for legal malpractice. The court held that separate classification of malpractice claimants from unsecured creditors does not violate section 1122 because malpractice claimants had superior right to insurance proceeds and were “in effect, multiple secured creditors having claims against a single fund.” Id. at 295.

In re American Homepatient, Inc., 298 B.R. 152 (Bankr. M.D. Tenn. 2003) – The court held that separate classification of unsecured deficiency claim from general unsecureds did not violate section 1122 pursuant to U.S. Truck. See also Beal Bank v. Waters Edge Ltd. P’ship (In re Waters Edge Ltd. P’ship), 248 B.R. 668 (D. Mass. 2000) (separate classification of unsecured deficiency claim allowed because claim is not substantially similar to other unsecured claims); but see In re Suncruz Casinos, LLC, 298 B.R. 833, 836-38 (Bankr. S.D. Fla. 2003) (separate classification of

unsecured deficiency claim invalid without sufficient business reason).

In re Snyders Drug Stores, Inc., __ B.R. __, No. 03-44577, 2004 WL 626270 (Bankr. N.D. Ohio March 10, 2004) – The court upheld the separate classification of reclamation creditors, trade vendors and landlords from other general unsecureds as being supported by a legitimate business reason. The court found that, under Sixth Circuit law, the reclamation creditors potentially held different repayment rights from other unsecured creditors, therefore the separate classification was based on a legitimate difference. The court also found because the debtor hoped to do business with the trade vendors in the future, while the debtor did not hope to maintain an ongoing relationship with the landlords, a separate classification of those classes was warranted. D. Conclusion

At a bare minimum, to support a separate classification of a class that would otherwise be subject to a gerrymandering objection, the practitioner should:

• Be prepared to develop a record that clearly shows a legitimate business purpose for the separate classification.

• Narrowly tailor the separate class to achieve the stated legitimate business purpose.

• Be prepared to show that the separate class is entitled to a different payment scheme and/or holds different rights than members of the other class of creditors in which they otherwise should have been placed thereby warranting differential treatment.

Consider preparing and serving a separate notice specifically advising creditors of the additional relief sought through the plan. V. IT’S NOT OVER: OBTAINING RES

JUDICATA A. One Hurdle Down…

…but one big one to go. Supposing there are no creditor objections or that a successful objection was overturned by appeal, there is still a possibility that a creditor may sue the “discharged” non-debtor party and overcome a res judicata defense. The Fifth Circuit has left somewhat of a quagmire in the wake of its seminal bright-line case, Republic Supply Co. v. Shoaf, 815 F.2d 1046 (5th Cir. 1987). Thus, it is necessary to take a brief history lesson. B. Shoaf 1. The Facts

Command Energy Company (“Command”) was in the business of drilling oil wells. Dr. Shoaf and Fred


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Mergner were the principals of Command. Republic Supply Company (“Republic”) sold supplies to Command Energy on an unsecured basis. Republic had the good business judgment to obtain a guaranty from Dr. Shoaf. Upon his departure from Command following a disagreement with Mergner, Shoaf sold his interest in Command and terminated his continuing guarantees, including his guaranty of Republic’s debt. At the same time, Republic obtained a new guaranty from Mergner. 815 F.2d at 1048.

Shortly after Shoaf’s departure, Command defaulted on its debts to Republic exceeding $900,000. Free-for-all litigation ensued, with Republic suing Shoaf on his guaranty and Shoaf suing Command in connection with the buyout of his interest in Command. While those suits were pending, Command filed a voluntary Chapter 11 petition. Id.

The sole source of funds available to Command’s creditors consisted of the proceeds of a life insurance policy on Mergner, which had matured due to his death. A dispute arose over entitlement to the insurance proceeds between Mrs. Mergner, who was the named beneficiary, and Command, which had paid the policy premiums. That dispute was ultimately resolved in a settlement, which was implemented through the plan of reorganization.

The settlement provided that Mrs. Mergner would release $850,000 of the $1 million in insurance proceeds to Command in exchange for Command’s release of all liabilities owed or guaranteed by Mr. Mergner and a release of all other guarantors. Shoaf also agreed to release his claims against Command as part of the settlement. The plan proposed to pay fifty cents on the dollar to unsecured creditors. The settlement with Mrs. Mergner accounted for 80% of the distributions to unsecured creditors. Id.

This settlement proposal was incorporated into Command’s plan and disclosure statement. At the hearing on Command’s disclosure statement, Republic’s representative (who also happened to be president of the Unsecured Creditor’s Committee) advised the court of Republic’s opposition to the plan based on the proposed release of third-party guarantors provided for in the plan. The court reserved this issue for consideration at the confirmation hearing. However, no creditor, including Republic, objected to confirmation of the plan. Consequently, the plan was confirmed without opposition, and the confirmation order specifically incorporated the release of third-party guarantors. Id. at 1048-49.

After confirmation of Command’s plan, Shoaf amended his answer in Republic’s suit on his guaranty in include the defense of res judicata . At trial, the U.S. District Court entered judgment in favor of Republic, holding that the bankruptcy court was without

authority under the Bankruptcy Code to release a third-party guarantor. Shoaf appealed to the Fifth Circuit. 2. The Opinion

The court analyzed the issues by applying the four-part test for res judicata set out in Nilsen v. City of Moss Point, Miss., 701 F.2d 556, 559 (5th Cir. 1983)(en banc):

[T]he parties must be identical in both suits, the prior judgment must have been rendered by a court of competent jurisdiction, there must have been a final judgment on the merits and the same cause of action must be involved in both cases.

The court dispensed with each element of the test, focusing primarily upon the question of whether a final judgment was rendered by a court of competent jurisdiction. Republic contended that the bankruptcy court lacked subject matter jurisdiction to release Shoaf’s guaranty, relying on § 524(e) of the Code. 815 F.2d at 1050. Since the court lacked authority to grant the relief provided for in the plan and confirmation order, Republic argued, the court also lacked subject matter jurisdiction.

The Fifth Circuit declined to accept the proposition that § 524 precludes release of guarantors, but assumed for the purpose of the opinion that it was a correct statement of the law. Id. at n. 5. Notwithstanding the presumption that the confirmation order and plan were beyond the bankruptcy court’s statutory authority, the Fifth Circuit still concluded that the bankruptcy court had subject matter jurisdiction. Consequently, the court concluded res judicata barred Republic’s suit to enforce Shoaf’s guaranty. 3. What Shoaf Means After Its Progeny

It is crucial to note that Shoaf has not opened the door for a confirmed plan to serve as res judicata to all matters decided in the plan. The release provision in Shoaf was an integral part of a multi-party settlement. As the court notes, it was a condition to the settlement. Id. at 1048. The settlement itself was the nucleus of the plan. Eighty percent of the distributions to unsecured creditors in the case were directly attributable to the settlement proceeds.

The open and notorious nature of the release was known to Republic. Its representative was the president of the Creditors Committee. Republic noted its opposition to the release at the disclosure statement hearing in detail, yet declined to objection to the confirmation. Finally, Republic contested the release endorsement on its disbursement check from the bankruptcy estate. Upon succeeding in having the endorsement removed, Republic cashed the check.


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Republic appeared to want to enforce the benefits of the settlement while opposing the obligations imposed upon it by the settlement.

Shoaf had developed a shaky instability, as its successor cases have failed to provide analyses framed by the elements of res judicata . Instead, these cases regress to an application of the prior law and craft more and more exceptions based on inadequate notice.

In the earlier Simmons v. Savell (In re Simmons), 765 F.2d 547 (5th Cir. 1985), a construction lien creditor filed a proof of claim registering a secured claim while the debtor listed the claim as unsecured and disputed. The plan paid ten percent to its unsecured creditors, including the construction lien creditor, who accepted the plan with a notation indicating his objection to classification. When the creditor later opposed the sale of the debtor’s homestead, the court held that the plan could not be used as a means for objecting to proofs of claims and expressed severe reservations over the lack of due process. The court noted that the plan contained no statement that it was intended as an objection to the creditor’s claim. Id. at 553.

Relying on Simmons, in Sun Finance Company, Inc. v. Howard (In re Howard), 972 F.2d 639 (5th Cir. 1992), the court did not allow a discharge provision to bar a lien creditor suit post-confirmation because it found that notice was lacking. It held that a secured creditor had a “right to stay outside the bankruptcy process by relying solely on the value of one’s lien.” Id. at 641. It then concluded:

[This right] would be meaningless, however, if the creditor's claim can be compromised away without further notice and he is bound by that compromise. Strict adherence to the requirement that an objection be filed to challenge a secured claim is necessary to protect this important interest under the Code.

Id.; see also, IRS v. Taylor (In re Taylor), 132 F. 3d 256 (5th Cir. 1998)(“in the context of a secured claim, a confirmed plan does not substitute for an objection to a proof of claim”).

The Fifth Circuit has also more recently narrowed its Shoaf holding in terms of the specificity it requires of the discharge language. In Applewood Chair Co. v. Three Rivers Planning & Dev. Dist. (In re Applewood Chair Co.), 203 F.3d 914 (5th Cir. 2000), Three Rivers Planning loaned $100,000 to Applewood Chair and the Spiveys, its president and his wife, which was secured by all the company’s equipment parts and inventory and by a mortgage on the Spiveys’ real property. The bankruptcy court approved a sale order selling almost all of Applewood’s assets to NewCo, to which

Applewood’s indebtedness was also transferred. Included in these assets was the equipment securing Three River’s loan. The confirmed plan and sale order designated that equipment was sold to NewCo in exchange for NewCo assuming “all of the existing obligors’ obligations.” Confusion then ensued as to what portion of the obligations and whose. Three Rivers argued that the indebtedness as to the equipment only was transferred and that all the Spiveys’ obligations remained intact; Applewood Chair countered that since the going concern value of the equipment equaled the debt, all obligations of all parties were transferred.

To further complicate matters, NewCo became Allcreek (and then later Applewood Furniture) and entered into an assumption agreement with Three Rivers. The language seemed to indicate that only the indebtedness of Applewood Chair to Three Rivers was assumed by NewCo:

That this assumption agreement shall in no way be considered a novation nor shall it be construed in any way to impair any of the current existing collateral taken by Three Rivers at the time of the initial execution of the Promissory Note. The parties further agree that the individual guarantees shall not be impaired and that this shall not be considered to be a novation with regard to the individual guarantees of said note.

Id. at 916-17. During the next two years the following events occurred: Applewood Furniture and the Spiveys defaulted on their payments, Applewood Furniture ceased doing business, the equipment serving as collateral vanished, and Three Rivers began to foreclose on the Spiveys’ mortgage. Id. at 917. The Spiveys’ defense was that their obligation was discharged in the plan, as they were members of the categories named — directors and principals. Id.

The Fifth Court held that res judicata did not bar Three Rivers’ foreclosure and that this case was distinguishable from Shoaf by its lack of specificity. In Shoaf, the court argued, there was a paragraph in the plan that expressly and particularly released Shoaf’s guaranty. Further, this paragraph substituted for the usual, stock paragraph providing for general release. Thus a paragraph purporting to release the very roles the non-debtor plays vis-à-vis the debtor (shareholder, officer, etc.) is not enough.

Although the Fifth Circuit has not expressly so held, its quarrels in Howard, Taylor and Applewood concern the fourth element of res judicata, whether the same claim or cause of action was raised in the plan confirmation and the subsequent litigation, that is: notice.


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The factors relied upon in the Simmons, Howard, and Taylor opinions support the conclusion that claims allowance, lien avoidance, and the determination of tax claims are matters that should not be litigated in conjunction with plan confirmation and cannot be litigated effectively in that setting. Consequently, in each of those cases, the debtor’s attempts to bar the later claims or causes of action would fail to satisfy each of the elements required for application of res judicata.

Application of the same framework supports the conclusion reached by the court in Shoaf. In Simmons, Howard and Taylor the plan provisions at issue were extraneous to the overall terms of the plans.

The same does not hold true for the release of guarantees in the Shoaf case. On several occasions the court noted that the release was a condition to the settlement of the dispute over the insurance proceeds and was an “integral” part of the plan. Since eighty percent of the distributions to creditors were derived from this settlement, it can be fairly concluded that without the settlement and the attendant release of guarantees, there would not have been a plan.

Based upon the holding in Shoaf and the limitations noted above, it is apparent that plans may still be used as a means for resolving disputes with creditors (beyond the obvious disputes over time and amount of payment) and seeking to bind creditors to creative contractual solutions prescribed in a confirmed plan.

The degree to which these objectives can be accomplished requires an assessment of how central the objective is to the essential or core purposes of the plan. In addition, consideration should be given to how far the objective strays from the fundamental purpose and scheme of plan confirmation. The further the objective strays from the essential purposes of plan confirmation and the less instrumental that objective is to the success of the plan, the less likely it is to be considered something which could and should have been litigated at plan confirmation. And now, Applewood indicates that the court will be miserly in its construction of what paragraphs in the plan mean. Any non-debtor release must be extremely specific and not sketched by general umbrella language—in other words, the actual names of the parties and the extent of the debt must be identified. C. Conclusion

Even if the objective to be accomplished grades high with respect to the measures suggested above, a prudent debtor’s counsel will take some or all of the following steps to insure the likelihood that the additional relief sought through the plan is binding upon the creditors:

• The additional relief should be open and notorious. If, as in Taylor, the plan seeks the determination of a tax claim, the plan should specifically state the tax year, type of tax in question and outline the issues and requested relief relating to the tax in question. The plan might even separate the requested relief from other plan provisions to ensure that the affected creditor is put on notice of the relief sought.

• The additional relief sought in the plan should be correlated as closely as possible to elements necessary under the Code to confirm the plan.

• Consider preparing and serving a separate notice specifically advising creditors of the additional relief sought through the plan.

• Where the number of creditors implicated are limited in number or where the importance of the non-debtor relief is paramount, consider invoking the adversary rules in conjunction with plan confirmation and serving each creditor with a summons along with the plan packages.

• Where subject matter jurisdiction might be at issue, withdraw the reference to the District Court. Consider a joint proceeding before the bankruptcy court and the district court to consider plan confirmation.

• If appropriate, consider including a written release of non-debtor parties on the face of the ballot. Obtain prior court approval of all such non-conforming ballots before mailing them as part of a plan package.

VI. CONCLUSION Third party protections through a plan, the absolute priority rule, classification of claims, and res judicata present challenging issues for courts and practitioners in the coming years. It will be interesting to see the development of the case law and Congress’ response, if any, as the case law surrounding these issues continues to develop.

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