FacultyFaculty/Author Profile

Industry Issues continued


JOSEPH SAMET: Thank you, Christa. I'm delighted to have you with me two new panelists for the afternoon. To my immediate left is Jessica Liou, Weil, Gotshal, and Manges. Jessica is in the business finance restructuring department, represents debtors, creditors, multiple parties, and interests, and she's been a integral member of multiple teams involved in various industries.

She's also a regular contributor to the Wild Bankruptcy blog, which is very comprehensive and many of us have looked to over the years. And she has participated in a wide range of cases and also a significant amount of pro-bono work for which she has successfully overturned a death penalty conviction. And so we're delighted to have her.

And Keith Wofford, Ropes and Gray. Keith is a co-managing partner of the New York office and focuses on bankruptcy, creditors rights. Keith has participated in this program in recent years and has been a significant contributor to this program. He has gotten a wide range of awards. And prior to being in the bankruptcy field, he was a senior securitization analyst at Moody's and brings a significant perspective from the business side, as well as from the legal side.

Keith is one of the leaders on ILFR, and Best Lawyers of America, legal 500. And so he's been widely honored and we appreciate his continuing to do this program. So Keith and Jessica--

KEITH H. WOFFORD: Good afternoon, everyone. Thank you for having us. I would also like to think Joe for properly quoting that sponsored introduction, that had plenty of accolades exactly as I wrote them. This is a very, very interesting set of topics today. We're going to talk a little bit about releases. We're going to talk about the Jevic decision. We'll have some not so perfect plans, materials, talking about some of the interesting issues that come up in the context of getting everybody to play-- to the table and getting them across the finish line in the context of Chapter 11 plan.

But I guess I'd like to start with releases. And one of the things that we're going to come up against is paradigm as triangles. There seems to be all these love triangles and bankruptcy, whether it's in the context of releases, whether it's in the context of third party or triangular set offs. But for this purpose, we're going to talk about releases.

There are a couple of different types of releases. And I think it's instructive to talk about not just the types of releases, but also the different contexts in which they'll arise, and some of the differences among those contexts. So let's start with just the basic concept here of releases generally in the context of an estate, which are releases by the estate itself.

And it's pretty clear that a debtor, in chapter 11, can release claims that belong to the estate under a Chapter 11 plan. And if you look to the bankruptcy code, it clearly says that that's permitted, and an important part of what the debtor can do. They generally give those releases in exchange for value, bringing value into the estate to distribute to creditors, very akin to a contractual release among parties-- something that many of you, even from regular oil litigation, are familiar with.

Now the question is, what are the standards in order to do this? Well, the standards are governed by something called rule 9019, which again, many of you may be familiar with. And the question is, are those releases fair and equitable and in the best interests of the estate? So the 9019 test and approach is to canvas the issues and to basically ask the question of whether the settlement falls below the lowest point in the range of reasonableness.

It's a court discretion approval. Generally, the courts are very, very deferential to the 9019 standard and to the debtor's desire to settle, whether that settlement is in the context of a separate motion or in the context of a plan. The particular legal rubric is that the debtor's business judgment is to be factored into the court's analysis. Now, business judgment sounds super deferential. And in practice, it's quite deferential. But there is an important contrast to be drawn.

That is, business judgment, as we refer to it in bankruptcy, is not exactly the same as what you would refer to in the context of business judgment in a Delaware corporate context. That is, under Delaware corporate law, there is a perspective that-- and a purpose that is different from the purpose in bankruptcy. And courts have remarked upon this. In fact, there are two very prominent examples that we'll talk about today.

The first was in TXU, the bankruptcy case known as Energy Futures Holdings in Delaware. In that case, the debtor has sought approval-- some bidding procedures in connection with 363 sale. And they talked about business judgment. Judge Sontchi said something very useful, which is he said, the business judgment test here differs from the general corporate law business judgment rule, which protects corporate directors from liability when they have exercised due care and aren't self-interested in the transaction.

By contrast, he said, the bankruptcy court reviews the debtor's business judgment to determine independently whether the judgment is a reasonable one. So listen in on that difference in perspective. Delaware corporate business judgment, after the fact, you've got to show some sort of self-interest or self-dealing or personal interest in order to invoke a higher standard. Bankruptcy business judgment-- the court openly says same words, but slightly different emphasis. The court actually takes a fresh look.

Similarly, Judge Drain in Momentive-- case known in the reporters as MPM Silicones-- went into an even more detailed analysis in this. And this is important if you come up against it in court, and you have to fight one of these things. Which is-- Judge Drain said the following--

"On the other hand, I've never believed, given the plain terms of section 363(b), which require court approval of transactions out of the ordinary course, that the court should apply the non-bankruptcy business judgment test. In fact, the context is wholly different," and that's a quote-- totally different-- "the non-bankruptcy business judgment test is applied after the fact." And then he goes on to say that, where you are in the bankruptcy context, it's the court before the transaction looking at and reviewing that transaction. So the time frame is different and the level of potential court intervention is different.

So just something to keep in mind when people invoke business judgment rule and says that you should go to sleep and stop looking. So now, back to rule 9019-- back to those factors we were talking about. We said OK, there is the debtor's judgment that factors in business judgment, and the court has to look at a bunch of factors. Well I will quickly run you through the factors.

Bottom line is the court looks at the probability of success on the merits, how ugly and expensive the litigation is going to be, whether anybody is supporting the settlement, where do creditors come out as a result, whether the counsel knew what they were doing or were just freelancing-- I'm paraphrasing a bit here-- and, frankly, the product of which it's the conduct of a real arm's length bargaining rather than collusion.

In practice, again, it is very difficult to prevail over a rule 9019 settlement, when it's been proposed and teed up by a debtor. I have probably seen it happen 0 times in my entire 25 years of practice. It has been threatened and vigorously attempted only a couple of times in my experience. I think the best that I've seen is getting a debtor to withdraw a settlement out of embarrassment, rather than actually losing. But I don't believe I've seen a jurist actually say, no, it's below the lowest point.

JESSICA LIOU: So to your earlier point, Keith, I've had a situation once where we tried to get a 9019 settlement approved before Judge Sontchi in a case. And he did rely on the principle that he needed to make an independent judgment about whether or not we had met these factors.

What that meant from a practical perspective, was that we as the debtor's needed to make a judgment call about potentially disclosing information that we would otherwise view as privileged, regarding our assessment of the merits of the various claims that we had settled. And ultimately, we did have to make a judgment call to disclose that information and make a limited waiver of the attorney-client privilege in order to publicly file a declaration to help support some of these factors on the 9019 settlement that we had put before the court.

Ultimately, the plan got pulled for other reasons, among them the 9019 settlement. But we had already waived the privilege with respect to that particular litigation.

KEITH H. WOFFORD: Question for that-- which is, how did the judge police the quote, unquote limited waiver of privilege, because if I'm the adversary in that situation, I say, you can't show me half a loaf-- just show me the stuff that you like. How do I know that I'm actually getting a waiver that is the full expanse of what applies to the question at hand?

JESSICA LIOU: I think there we actually came to an agreement with the other party, so it wasn't necessarily a contested issue. But that is the danger that you face. You obviously want to make sure that you are not doing a full blown waiver of everything that's related. We certainly didn't waive, for example, work product related to internal discussions amongst attorneys. We made very, very clear from the very beginning we we're not going to waive that, but we would waive just certain communications between the attorney and the client.

KEITH H. WOFFORD: Let's move on and talk a little bit about the guts of releases themselves, because I think we've talked quite a bit about how a court would approve. Third-party releases, which we're going to come back to in detail-- and we'll skip past this slide-- are-- remember, I talked about a triangle-- releases not between the debtor and a potential defendant in debtor claims, but releases within a debtor plan of reorganization that actually purport to take away the claims of third parties against other non debtors, often in an attempt to get those third parties to contribute some value to the debtor's estates.

I'm going to come back to third-party releases in a little bit. I want to talk a little bit about the technical elements of releases. Hopefully, I'll figure out how to use the back button here, because I think it actually will help when we talk about third-party releases to have talked about some of the mechanical elements.

So when talking about releases themselves, as a basic matter, there is a New York view of releases, which tends to be to view the releases simply as products of contract, and they can be as extensive or not extensive as you like, with very, very little in the way of limitation. There are limited public policy exceptions that have been potentially imputed for certain types of bad acts-- bad faith, willful negligence, part willful misconduct, gross negligence.

New York law does allow those types of releases, although there are contractual constraints in other contexts on contractually limiting that sort of liability. It's a little bit of an open issue as to how much that creeps into releases. And that's why you commonly see those sorts of exemptions. But as a fundamental matter under New York law as opposed to California law, contracts are-- or pardon me--releases are contractual creatures.

And so, what you start with in the contract is who's releasing whom. Are the releasing parties when you look at a release just a corporation? Does if cover affiliates? Does it cover other employees? Within the releases that you see in chapter 11 plans, which tend to be as long as a phone book and in bold type, for California reasons that we'll talk about the moment, there is a very lengthy people-- lengthy list of releasing parties. Sometimes it refers to specific entities or people. Sometimes that list actually includes categories of people, and so you can't even identify their names.

Then there is the operative language of the release that comes next, which is what is going to be released and when and how. So some releases actually say this document hereby releases x for a certain corpus of conduct. Some release documents, and this is a mistake unless you intend to do this, talk about releasing in the future. That is, we agree to release. Well, are they released now, or are they not released now? So you'll sometimes see that. You should be careful of it.

You have to think about conditionality and qualifiers. That is, sometimes there is an agreement today to release, conditioned upon some later effectiveness or event. So on-- we agree to, on the settlement date or on the closing date or on the merger transaction date, to release.

Third element of the contractual language that is important to focus on is the description of the claims that are being released. Now, here is a contrast. In regular way litigation, you often have what's called a general release, and it is almost as if two strangers meet in the night and they say Joe Jones, I release you, John Smith, for anything that happened in the past, may happen in the future, between me and you. That is, there are-- any claims that there are between us, are gone. That's a general release. You see them in litigators documents pretty commonly.

Bankruptcy lawyers, like me, get scared when they see that. And so we like something a little more compartmentalized, which is a description of the released claims. So that release generally says we will release all claims related to company x or related to transaction x, and everything outside of that release, obviously, is not within that scope. So then the next question is you have claims relating to a subject matter. But the question is does that release cover everything now or in the future? Or does it cover just what currently exists?

So there is often language or common language about the timing of a release. The baseline is-- in a release-- that you sign a release on the date. You're releasing all the claims that exist as of that date. However, it is common, given the breadth of bankruptcy releases, to add extra bonus language that talks about future claims. That is, you're saying, today, we release all claims and now existing or hereafter arising. Now that will mean claims, whether they accrue, now or in the future, that relate to conduct that has already occurred.

And then finally, although some states differ on a proprietary of doing this, but New York law it is doable, you can release claims based on future conduct. That is, you say look, anything I have relating to this topic, whether it's now, here after, forever, it is released. Now, the practical problem with that, in terms of practice guidance, is that if you give a release of future claims, you are at a disadvantage in terms of being able to inform your client, because, of course, if you don't know what hasn't happen in the future, it's very difficult from a diligence perspective.

That is, you can't say, OK, the deal is, here are the claims we're giving up. You compartmentalize them. You give an estimate of them to your client. You say, is this consideration sufficient? With a release of future claims, you're pretty much at a diligence disadvantage.

So now what else comes up in these very, very long releases? Well, after all that broad language, not surprisingly, lawyers being lawyers, there are carve outs and exclusions. So classic example of baseline exclusions-- obviously, the agreement to settle and the plan agreements that are related to the settlement, those are going to be carved out. To the extent that the parties identify debt obligations or other freestanding commercial obligations that are outside of the scope of release, those will be carved out.

Finally, as I said earlier, you often have a carve out of what are called bad acts-- gross negligence, bad faith, willful misconduct, are the typical ones. In a more limited carve out, and I've seen this in Delaware pretty often in fact, we've had this for private equity sponsors, we'll limit the bad acts carve outs to criminal acts or fraud, so as to not get into any potential question down the road of whether something that was done that the counterparty was not informed of, could later be alleged to have been in bad faith or misconduct.

And then finally, you often have a conduct for-- or a carve out for direct fraud. So that's the carve out that you typically see. We've talked a little bit about some of those carve out issues. And now we're going to talk about a couple of corollary concepts. Again, more bonus language that you often see.

So covenants not to sue-- what is this? Well, often going alongside the release, you'll say, look, a release is great, but what if someone who isn't at the table decides to breach the release and go after me anyway? At that point, I'm still defending a lawsuit that I feel that I've paid good money to get out of, and that leaves you in a place of having to pay, for example, defense costs.

What you do to remedy that problem is that you include a covenant not to sue, so that if someone who signs a release, or perhaps someone who purchased a claim from a party that signed a release, gets cold feet or second thoughts and decides to try it anyway and sue you, you actually have a covenant that has been breached by virtue of that suit being brought, to the extent the suit is within the scope of the release, and you have a recourse to go back against them and say, look, you're breaching your covenant.

I'd like you to compensate me. Not only would I like to you would compensate me, perhaps, but I'd also like to actually potentially get you an injunction of you for breaching that covenant. So it gives you a couple of other legal rubrics to defend yourself if you feel someone is going back on the deal.

Lastly, exculpation, a variant or a relationship of releases that you see often alongside releases in chapter 11 plans. Generally, there is language that literally exculpates, or takes out from blame in the old Latin, the parties related to the estate-- creditors, committee members, members who are officers of the debtor's-- generally estate fiduciaries who have acted in connection with the plan for any acts undertaken in connection with that service. Now, why does this exist?

It exists for one reason, because you have these people, particularly in the context of creditor's committees, who are working without compensation. They're basically doing God's work. They are working to improve the lot of the estate, and you don't want them to be in a position of having to be sued. And frankly, they may not have provided particular consideration for a release. They're really in the nature of a director or officer who's trying to do their duty and service-- people who are not going to be by the court held responsible for effectively trying to move the ball forward unless they did, again, something that was an affirmatively bad act.

And so the exculpation is an independent rubric by which you can absolve a state fiduciaries for liability, that would be alleged in connection with their official acts.

JOSEPH SAMET: Creditor's committee members have at least qualified immunity, but that's not necessarily total immunity. So the creditor's committees have done their work during the case. People know what they've done. And so, it seems to me, that getting a release and exculpation, at the end of the day, is fair and reasonable.

KEITH H. WOFFORD: So we talked a little bit about the elements of releases. We've talked about New York and how New York has a contractual interpretation of releases. One of the questions you may have is why is there bold language on a lot of releases and very, very sort of specific California language referring to California Civil Code Section 1542.

And the answer is that California takes the normal contractual-- what I call the normal contractual based rule-- and basically flips it on its head. And says, look, waivers have to be explicit. A release is basically a waiver. And in California, we don't like unknowing waivers. And so, what happens as a result, is that when you have releases, generally, but particularly that may affect any California claimants or any California claims, you'll often see very explicit language saying, this is a release under California law, under the appropriate civil code statute. It's in bold.

It says, basically, warning. You may-- you are releasing claims if you go along with this, et cetera. So that is the source of that California language. So that's the contractual release context. That's hopefully useful information for you in the context of you either drafting a release and a settlement agreement, or in the context of reviewing a release that's contained in the context of a bankruptcy plan.

Let's talk about this issue of third-party leases. Because, again, the releases we've talked about are things that are being either done by an estate directly or signed by a party that is particularly signing on to do them. This concept of third-party releases is a little bit different. The third-party release concept is you're taking a non debtor who ostensibly has no entitlement to protection from the bankruptcy court and another non debtor who has a potential claim against the non-debtor potential defendant and saying, look, under a bankruptcy plan, you can get a release of that. Well why does that work?

Let's talk about why that even works at all. Because, admittedly, if you're going to be in bankruptcy, you're going to be in bankruptcy. If you're not going to be in bankruptcy, why are you entitled to what sounds a lot like a protection of bankruptcy. So if you go back to page six, here, we talked about this-- 105(a). How can we do this at all?

Well 105(a) says the court may issue any order or process or judgment that is necessary or appropriate to carry out the provisions of the bankruptcy code. Under this relatively amorphous broad provision, there were a line of cases that developed, starting here in the Second Circuit with Johns-Manville that said you can actually give third-party releases to someone who hasn't filed for bankruptcy.

That precedent was continued in the Drexel case. In the case of Drexel, I believe it was insurers contributing and cutting off indemnification claims. So the insurers were encouraged to put money into the pot, but they didn't want to put money into the pot under a policy, and then be sued by other parties, and then have to pay twice.

And so, the parties in Drexel went to the court following the precedent in Johns-Manville, and said, hey, can we can we have a similar injunction of people claiming against those who put money into the till. Having had the Johns-Manville precedent and the Drexel precedent, in 1984, Congress codified 524(g), which basically created the concept of a channeling injunction for a mass tort claims, and effectively, statutorily, approved the third-party release concept.

So there is continual-- because there is no statutory authority for other third-party releases besides the mass tort context in 524(g), there's this continuing tension under the code. Between 1123(b)(6) which pretty much gives a good light-- gives a green light to have any provision that isn't explicitly excluded by the title included in the plan, and 524(e) which says that discharge of a debtor, that is someone who comes in and seeks the protection of the code, doesn't affect the liability of everyone else.

So what have courts done with this? What courts have done with this, is they've been in somewhat of in two camps. There are those courts that allow non-consensual third-party releases. And then there are courts that say, no, that doesn't work. And among the courts that say, yes, are the Second Circuit. They've explicitly said yes. The Third Circuit has said kind of yes. And the lower courts have all, basically, gone along and approved dozens and dozens of non-consensual third-party releases, and actually promulgated a set of factors governing those releases. And then there are certain circuits, like the fifth the ninth, that have been more explicit in saying no, we're not going to allow non-consensually.

And so the question is, what constitutes opting into a release for purposes of complying with those edicts. So let's talk a little bit, if there's no dissent here, about the Second Circuit's non-consensual third-party release standard. That was promulgated in a case called Metromedia, which is pretty much the most important case for purposes of this discussion. And again, my clicker skills are going to be drawn into doubt here, but we're almost there. OK. Metromedia. And don't worry, you can look at the materials for the do and don't circuits.

So Metromedia standard-- so third-party releases are permissible in a narrow circumstance, which is that there's something unique to the success of the plan that allows you to go outside the normal rules of cutting off claims among two non-debtors. So the way that they list the factors are as follows.

The estate has to receive substantial consideration, the claims would impact the reorganization-- again, we talked about indemnity contribution in the context of Drexel. You see that re-emerge here in the Metromedia standard. That the plan provides for full payment of the claims that are being cut off-- that is, it fully treats the claims, not necessarily fully pays the claims, but certainly fully treats them, and it also says-- talks about third-party consent. Well, set that aside for a moment, because the way they deem consent or view consent is a little bit odd.

So let's talk about though, beyond the factors, the coloring language in Metromedia, which is very, very important. Metromedia said explicitly the following-- third-party releases are proper only in rare circumstances. Pardon me, that's not a quote. But it says the rare and unique circumstances are when they can be approved. Two reasons-- first reason that these are unique and shouldn't be approved, is that there is no explicit third-party release authorization outside of the statutory provision I just mentioned.

And second, the circuit was concerned that it's a device that lends itself to abuse. And that is a quote. Because it effectively operates as a discharge without the company or the beneficiary having to file. So when looking at the factors, the Second Circuit said, hey, the test is not a matter of factors in prong, because again, quote, "not a matter of factors in prongs." And that they will not be tolerated, quote, "absent findings of circumstances that may be characterized as unique."

So all of that surrounding language tells you that there is a very high standard to get a third-party release approval. And unlike some other standards in bankruptcy, which have really slid and slid and slid, this is one where the courts have been pretty firm in holding a line. To be able to get a third-party release, there generally has to be a contribution. There generally has to be a nexus between the contribution and the beneficiaries of that contribution in the creditor pool. And there generally has to be a nexus between the released claims. That is, the claims that are enjoined among the third parties and the reorganization itself.

I don't know-- Jessica, did you have any further thoughts on third-party releases. Or Joe?

JESSICA LIOU: No, and I'm sure you'll get to it about how consent is defined, because I think that's pretty important, and a lot of folks can try to-- I wouldn't say get around, but you can actually get the benefit of a third-party release by crafting certain opt in or opt out procedures, in order to avoid having to deal with the heightened standard of approval that you have to deal with in the Second Circuit, and also, correspondingly, some other circuits, as well. That's the only thing, and I'm sure we'll talk about that.

KEITH H. WOFFORD: So I think that's a fair segue-- that's a fair segue. So in the context of a plan of reorganization, there are three groups of creditors. And for purposes of releases, each of them has a different ramification.

Type number one of creditors are creditors who vote in favor. They are an impaired class, thus are entitled to vote. They vote yes. This group, if they vote yes, then one question becomes did they opt into the release or opt out? Generally, plans will provide that if you vote in favor, you opt into the releases. And the courts have generally been, within this circuit, fine with that.

If you don't vote in favor of the releases, well-- or if they're-- forgive me-- if there is an opt-out provision that allows you to have a separate check the box on a release-- well, then a creditor could opt out of a release. Debtors don't like to do that, but could happen.

Second category is those who don't vote at all, which is an important category, because other than the interested insiders and planned support parties, a lot of people don't vote. So there's a question of what to do with that bucket. Then the third bucket is creditors who vote no. Now generally, people who vote no to the plan, of course, will be deemed to vote no to the release. So much of the discussion, in subsequent cases, has been about does there have to be an opt out in the plan-- a specific opt out?

And in circuits that say no to third-party releases like the Fifth, and even in the Third Circuit, that says, more of a maybe to yes, you generally will have a third-party opt out right in those circuits. And the opt-out right, generally, in the Fifth Circuit allows you to take it out of the third-party release context, for purposes of Metromedia-style approval.

The courts and the Second Circuit have talked about the approvals and the opt-outs and what it means to not vote or to vote yes on the plan and opt out of the release or to not vote, and the judges who I would say have been most active on this front, and I would say amongst a group of generally vigilant Southern District judges and generally insightful and energetic judges, I think the most energetic and thoughtful on this issue, have been Judge Wiles, who wrote the decision in [INAUDIBLE] and Judge Bernstein who recently wrote the decision in SunEdison.

I don't know-- did you have impressions about particular judges and decisions? They have been willing to sua sponte, even where everybody standing in the courtroom in front of them is locking hands and agreeing, to raise their hands and say, well, wait a second, let's think about the opt-in versus opt-out and what it means in terms of a release to vote or not vote, and whether your consent should be deemed. Both of these judges, I think it's fair to say, don't like the word deemed very much. Whereas some others are willing to deem someone to be going along with the third-party release just by virtue of silence.

The general theory for those judges who do not deem silence to be assent is, I would say, first, a concept that waiver under Second Circuit law must be explicit. And under New York law, more specifically, must be explicit and silence is not deemed to be assent. And secondarily, I would say in the context, in particular of Judge Bernstein, that with respect to the claims between a non-debtor claimant and a non-debtor third party, there is a jurisdictional concern.

That is, to the extent that someone isn't opting into a release, that non-debtor claimant and the non-debtor defendant are not really before the court, in those judges eyes. And so, not only is silence an affirmative contractual concern, but it is also a jurisdictional concern, and that they would be by virtue of approving a third-party release, drawing into their court's jurisdiction a dispute that otherwise is not before them.

JOSEPH SAMET: I think Keith has given you an overview of the arguments, pro and con, and that there is controversy amongst the circuits on the releases. And if anybody has any questions after 5 o'clock on the subject of releases, you are welcome to come up here and we can talk more about that, so that we have a little bit of time now to discuss Jevic and other kinds of plan issues in the next 25 minutes.

KEITH H. WOFFORD: That sounds great.

JESSICA LIOU: So I don't know, Kieth, if you want to start with Jevic, or we can--


KEITH H. WOFFORD: Why don't we start-- why don't you start with Jevic. I'm sure people have had enough of hearing me for at least 30 or 40 seconds.

JESSICA LIOU: So we can with Jevic. And actually I'm not sure--

KEITH H. WOFFORD: I have some more slides after on that, if you want to go [INAUDIBLE]


JOSEPH SAMET: You have loading on the Jevic's slides, please?

JESSICA LIOU: Actually, why don't we start with-- this is not working. We can skip this slide. This generally lays out various Chapter 11 options. I can start a little bit with the concept of gifting, which actually is implicated a little bit by the Jevic decision. And we can talk about Jevic after we've talked a little bit about the concept of gifting. And I know we'll also talk a little bit about the concept of a structured dismissal. So both of those issues are implicated by the Jevic case that recently came down from the Supreme Court.

Generally speaking, the concept of gifting, which I'm sure many of you have already heard about, is implicated by the fair and equitable standard under section 1129(b)(2b) sub 2, under the bankruptcy code. Otherwise known as the Absolute Priority rule. And that basically says that if a plan is rejected by a particular class, it must provide that either the unsecure creditor retains value equal to the allowed amount of their claim or that a holder of junior interest or claim will not receive or attain property on account of that to junior claim or interest.

So that essentially means that absent consent, you can't have a recovery going to a junior class, if the senior class of creditors is not being satisfied in full. And what has happened in the past, is that there have been particular plans, or even pre-planned settlements proposed by debtors, that include a concept where one particular group, usually a senior class of creditors decides to give up a part of their recovery to another class in order to help facilitate a consensual settlement or a consensual plan process.

So I think everyone's familiar, generally, with the claims waterfall. You have priority laid out in the code for who gets to recover first, and who would, otherwise, recover last. We have super priority claims that obviously have priority over all other claims. And then you work your way down with priority claims including administrative and typically tax claims and other claims afforded priority, like 503(b)(9) claims and employee wage claims that recover next. And then you have a general unsecured claims, subordinated claims, and equity always recovers last.

JOSEPH SAMET: And we're assuming that the secured creditors have been paid off as secured creditors to the extent that the value of the collateral.

JESSICA LIOU: That's right. That's why they're not included here. So there are two types of gifting, generally. There's a class-skipping gifting, and that's what's depicted here. And we'll talk about that in a little bit. And there is the gifting where you have one class right above another that gives recovery to the class right below it.

Here, when you have class-skipping gifting, it's pretty self-explanatory. But you've got an under-secure creditor, so a creditor who had a pre-petition lien on certain collateral or assets of the debtor, but the value of that collateral is insufficient to satisfy in full their claim. And so they have an unsecured deficiency claim in addition to their secured claim.

And they choose to give a portion of their recovery to equity to help facilitate a settlement on the plan, or confirmation, generally. And they either do not provide a distribution to priority creditors or general insecure creditors, who then, ultimately, choose to reject the plan.

So the genesis of gifting starts with a case known as SPM Manufacturing Corporation. It's actually a case that took-- that was in the context of a Chapter 7. And there, a secure creditor entered into an agreement where they decided they would distribute some of their proceeds in a Chapter 7 liquidation to general unsecured creditors, but not to the IRS, who was a priority creditor.

And there, the First Circuit took a very, I would say, accommodating view, and basically said that to the extent that a creditor is receiving quote, unquote, "bankruptcy dividends," a recovery in the bankruptcy case, they were entitled to do what they wanted to do with those dividends, and they could share them with any creditor.

You then had some cases that followed that, including Armstrong World Industries under the Third Circuit, which looked at this issue and distinguished their particular case from SPM. So in Armstrong World Industries, you had a case where, for example, the plan was structured in such a way that you would either have, if the general unsecured creditors accepted the plan, they would have of recovery in the form of warrants-- sorry, they would have a 60% recovery.

And if the [INAUDIBLE] accepted the plan, there would be warrant's distributed to the equity holders there. If the [INAUDIBLE] rejected, the warrants would actually go to another class of creditors that were of equal priority, the asbestos's claimants. But then the plan automatically funneled that consideration to equity-- directly to equity.

And there, the court found that this was not permissible. And it was generally a way to sidestep the priority rules already encapsulated in the bankruptcy code. And key to their decision, was distinguishing SPM. And number one, the easiest way to distinguish SPM was that it was a Chapter 7 case. And so the absolute priority rule under section 1129 just didn't apply, as opposed to a Chapter 11 plan context where the court felt bound to consider the absolute priority rule.

The court also distinguished on the basis that in SPM you had a secure creditor that was basically-- had a perfected security interest in collateral. And theoretically, what they could do, is they could carve out a portion of their distribution, as secure creditors could do, and provide a part of the proceeds of their recovery on account of their lien to be paid to other creditors. And in addition to that, because the recovery was coming out of their collateral, arguably, you could say that that was not technically property of the estate, and it had to be pulled into and subject to the estate distribution scheme.

JOSEPH SAMET: I wonder if that's really the case. I mean, it seems that it's debtor's assets going to various creditors in order of priority. And if it is the debtor's property, at least until the minute it gets into the secured credit report, can you really deal with a transfer from the debtor of its property to the secured creditor. And isn't that violating, in effect, the absent priority rule?

JESSICA LIOU: Yeah, I think that those are all good counter arguments. Definitely. There are some other circumstances, which we'll talk about, where the distinction may actually be a little clearer. For example, in the context of, maybe-- maybe perhaps, in a sale situation where proceeds from the estate would otherwise go to the secure creditor, you could argue that you're essentially just trying to skip an intermediate step. These are amounts that would otherwise fall into the hands of the secured creditors pursuant to a consummated sale, and you're just skipping the intermediate step by now having the secure creditor provide a recovery to a particular party in connection with either a sale order or a plan of liquidation that later is confirmed down the line.

KEITH H. WOFFORD: But isn't the key distinction there between liquidation value and reorganization value? That is, to the extent that the secured creditors realizing upon the going concern valuation benefit with respect to its collateral, have they ceded the right effectively to gift?

JESSICA LIOU: That's a good point.

JOSEPH SAMET: I would argue, obviously, the other position. And secondly, it's not a distinction between going concern and liquidation value, but-- and that there is no distinction between section 363 sales and an 1129, because you've got to comply under 1129 to confirm a plan with all provisions of the Bankruptcy Code. So why should 363 money go to-- skip a generation of creditors? But that's why some of us are hired from time to time to argue these matters.

JESSICA LIOU: So why don't we talk a little bit about DBSD, which is another case, and this case is actually in the Second Circuit about gifting. And then I think, some of the concepts that we're talking about here, actually are implicated in the Jevic decision and also later in decisions that have followed Jevic, dealing with this gifting issue.

So the Second Circuit in DBSD joined the Third Circuit and, basically, limited, pulled back, on this gifting doctrine. There, the debtors have proposed a plan where an unsecured creditor would be gifted, essentially a 4.9% equity interest in the reorganized company. The general and secure creditors, there, were receiving a recovery as well, but that equated to about 0.15% of the equity of the reorganized company.

And the creditors that were doing the gifting were the second lien creditors who were under secured, at that point. So they were the fulcrum security and were otherwise entitled to the equity. There, Sprint, an unsecured creditor, objected to the plan and alleged that it violated the absolute priority rule. The Second Circuit reversed the lower court's decision and agreed that the gift violated the plain language of the absolute priority rule.

And they held there that, look, SPM only applied in a Chapter 7, again, and this is a Chapter 11 plan. So therefore, absolute priority needed to be followed. And they took the view, that you would mention Joe, which is that the property remained in the estate. So even though there was this argument that it actually was property that belonged to the second liens and they could do with it what they will, the court's view was that's not true. This is debtor's estate property, and it's being distributed pursuant to the plan, so it has to follow the distribution scheme under the code.

They also enumerated some other policy concerns, which I think was less important to the court, but theoretically could be used in other cases as well, which is when you've got a recovery going to equity, you've got shareholders that could try to use that as an opportunity for self-enrichment, because shareholders generally retain a lot of control during the pendency of a Chapter 11 case. And so for policy reasons, you probably don't want to provide an avenue for equity holders to continue to push for a situation where they get some kind of outsized recovery, but classes above them don't get a recovery, or equal recovery.

JOSEPH SAMET: I would go even further than referring to that as a policy reason. In fact, if I recall correctly, the decision may have referred back to the original case versus Los Angeles Lumber decision, which was a case about collusion between secured creditors and equity, involving Conrad Hilton. And in fact, that decision allowed the conclusion and the absolute priority rule is written now as a response to that case versus Los Angeles Lumber Supreme Court case, which I believe is back in 1939.

JESSICA LIOU: It's a very-- that's right.

JOSEPH SAMET: I can see a situation where the secured creditors security is being attacked and there's a perfection question or there's a conduct question, and maybe they shouldn't get 100 cents on the dollar, plus, plus. And therefore, they should drop off 5%, 10%, whatever the figure is as part of a settlement of controversies. Where there's appropriate disclosure, and that that money goes back into the estate or goes for the benefit of unsecured creditors or the next level of priority that hasn't been paid out in full and the money goes down. But to skip a class, to me, that's the problem. And to get it down to the equity.

Because if the unsecured creditors aren't being paid out in full, what is the equity argument and attack on the unsecured creditors going to be, absent something very substantive, I don't see that.

KEITH H. WOFFORD: I would tend to agree with that. Look, there are three strains going through the court of cases talking about the absolute priority rule in different contexts. One is in the context of settlements, there is a Fifth Circuit case called the AWECO, A-W-E-C-O case, that said that you have to adhere to the absolute priority rule in the context of settlements. There is the set of gifting cases that we've talked about here referring to absolute priority and plans, including DBSD and others.

And then there is a third context, which is Jevic, where this has been winding through the courts, which is in the context of structured dismissals, where you don't have a settlement [INAUDIBLE] bankruptcy and you don't have a plan, you merely have a non case or an after case.

And so, I guess that brings us to the second aspect of Jevic, which is whether this structured dismissal-- first of all, the court asked whether structured dismissals were appropriate at all and they said yes. But second, they were asked well, are there constraints on them? In particular, can you rearrange priorities in the context of a structured dismissal, or do you have to adhere, at least in terms of absolute priority, to the priorities that were invoked when the company went into bankruptcy in the first place.

And the Supreme Court concluded that you did have to adhere to priority and you could not skip a set of priority group claimants in the context of a structured dismissal. In the case of Jevic it was a group of warrant act claimants who had a priority claim judgment at that point.

JOSEPH SAMET: Any further thoughts about Jevic, which is now a Supreme Court decision, the law of our land, at least for structured dismissals and whether you see the same result from Jevic being applied to the gifting doctrine, if it should come up before the Supreme Court.

KEITH H. WOFFORD: I believe that the Supreme Court is going to, if they do decide this, come down in favor of preserving the absolute priority rule and enforcing it. It's going-- it would be very odd to have one rule with respect to application of the absolute priority rule and plans, another in structured dismissals, and another in the context of settlements. And so, I think ultimately, the right answer is that there should be a consistent answer among all three, which is that absolute priority should be observed.

JOSEPH SAMET: Jessica, any further thoughts on some of these cases?

JESSICA LIOU: Yeah, I just wanted to mention that post-- I'm not sure if we've gone through a lot of the details of Jevic, but post Jevic, there have been at least two instances in lower courts where judges-- bankruptcy judges, particularly, had to deal with the question of whether or not gifting was permissible in different contexts.

And there was at least one recent matter-- Judge Kevin Gross in the Short Bark proceeding in Delaware, where there was a settlement built into a final deporter-- a settlement between a secured creditor-- a pre-petitioned secure creditor that was also providing dip funding and the unsecured creditor's committee there. And in connection with that, they had agreed to a sale process and the UCC had originally objected to the sale process and both the dip funding.

But in exchange for their consent and support for the sale process and the entry of the final dip order, there was an agreement that to the extent there was a sale process, the first $110,000 of the sale proceeds would be escrowed and would go to unsecured creditors, in that case, and there would be some percentage of excess sale proceeds above the stalking horse amount that would also then be funneled to unsecured creditors.

The US trustee, there, objected to that settlement and basically said that it violated Jevic because there was no provision that allowed for some recovery going to priority creditors and even administrative expense creditors. So that would not be allowed. And there Judge Gross ultimately decided that, that was permissible, notwithstanding Jevic, for a number of reasons, which under the Jevic decision he had mentioned, look, this is a situation where the court-- Supreme Court in Jevic had mentioned that there are bankruptcy considerations that may allow you to approve some type of settlement that doesn't necessarily follow the absolute priority rule.

And, here, he believed that because the dip funding allowed the business to continue was a going concern, that there was a compelling reason to go ahead and approve this settlement. In addition to that, he distinguished that situation and basically said, look, it wasn't similar to Jevic because it wasn't a end of case type distribution. And here you were just getting in interim distribution pursuant to a sale process, and you still had to get a separate process, either a Chapter 7 or Chapter 11 liquidating plan approved connection with the end of the case.

JOSEPH SAMET: Was he also saying that, in all likelihood, the priority creditors who were being skipped were going to be paid out during the case or at confirmation based on the current financial information that was available?

JESSICA LIOU: So I don't know if he was that explicit, but that certainly is a really good point, because that was definitely one of the arguments raised by a different judge in case know as [INAUDIBLE], where basically the rationale was the disfavored creditor, the creditor that was not getting the special gift, wasn't worse off in the 11, than they otherwise would have been in a 7, necessarily.

And I think the assumption is they would otherwise get a recovery that would be at least equal to or better than what they would have gotten in a 7, so it was fine in this instance for there to be a recovery to a junior class.

JOSEPH SAMET: Some of these sound like reaches, but each case stands on its own, and some of the bankruptcy judges in diverse business districts, including Judge Gross, have sometimes made practical decisions based on the economics of a particular case and things worked out.

KEITH H. WOFFORD: It's difficult to reconcile, other than on pragmatic concerns and rationales, having an absolute priority rule, an equal treatment rule, but then also allowing gifting to junior classes non-consensually. It's difficult to reconcile.

JOSEPH SAMET: Any final thoughts before we take a question from the audience or to-- questions, here, please? Anybody on the web that would like to ask a question? And if, on the web, people have a question perhaps that they come up with in the next few minutes or so, by all means send it in and we'll try to respond to it in the short term after the program.

Otherwise, I'd like to thank each of the panelists for their participation, preparation of materials, which they do without compensation from the Practicing Law Institute. Thanks to the panelists for all their time and their busy practices. We enjoyed being with you today.

If you have any questions, you are welcome to come up here at 5 o'clock. And look forward, hopefully to seeing you at a future program. Thanks for your attention, your good questions, and camaraderie during the course of the day. Thank you.



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