Third Circuit Rules that "Reverse Cramdown" Plan Proposed by Armstrong World Industries Violates the Bankruptcy Code's "Absolute Priority Rule"
One very important issue sharply dividing courts and commentators alike is that of "reverse cramdown," whereby an undersecured creditor with a lien on the debtor's assets will join with debtor's management and existing equity holders (often dominated by insiders) in a reorganization plan that offers existing equity holders a piece of the reorganized debtor despite the fact that a non-consenting intervening class of unsecured creditors receives little or nothing under the plan.
In an article distributed at the November 2005 National Conference of Bankruptcy Judges in San Antonio, Hugh Ray and Jon Daly, of Houston's Andrews Kurth LLP, strongly criticized this "tip" by undersecured creditors to junior equity classes, writing:
Underlying the practice of reverse cramdown is the rationale that since the secured lender has a lien on all the debtors' property and is undersecured, the secured lender can share or "give up" a portion of the enterprise value of the debtor to which it would otherwise be entitled to under the plan to whoever it want to, including the debtor's existing equity interest holders, who, absent the secured lender's generosity, would otherwise receive nothing under the plan. Courts have applied this rationale to circumvent not only the absolute priority rule but the prohibition against "unfair discrimination" contained in 11 U.S.C. § 1129(b)(1) as well.
[We] contend, however, that this rationale is flawed. Secured creditors should not be permitted to collatorate with junior creditors or equity owners to squeeze out intervening classes of creditors who are not provided for in full under a plan of reorganization. The legislative history to 11 U.S.C. § 1129(b)(2) expressly prohibits the practice of reverse cramdown. Moreover, it was inequitable practice similar to reverse cramdown that led to the creation of the absolute priority rule in the first place.
In issuing its final opinion in a civil case for 2005, the Third Circuit Court of Appeals rejected on de novo review a "reverse cramdown" proposed in a plan of reorganization by Armstrong World Industries (AWI), stating that such a plan violated the absolute priority rule incorporated into 11 U.S.C. § 1129(b)(2)(B)(ii). In re Armstrong World Indus., Inc., 2005 WL 3544810 (3d Cir. 12/29/05) (pdf here). To understand the Court's ruling, one must first understand what was proposed in AWI's reorganization plan. The Third Circuit summarized the relevant plan provisions as follows:
Under the Plan, AWI's creditors were divided into eleven classes, and AWI's equity interest holders were placed into a twelfth class. Relevant to this appeal are Class 6, a class of unsecured creditors; Class 7, a class of present and future asbestos-related personal injury claimants; and Class 12, the class of equity interest holders who own AWI's common stock. The only member of Class 12 is Armstrong Worldwide, Inc. ("AWWD"), the parent company of AWI, which is in turn wholly owned by Armstrong Holdings, Inc. ("Holdings"). Classes 6 and 7 hold equal priority, and have interests senior to those of Class 12. All three are impaired classes because their claims or interests would be altered by the Plan. 11 U.S.C. § 1124.
The Plan provided that AWI would place approximately $1.8 billion of its assets into a trust for Class 7 pursuant to 11 U.S.C. § 524(g). Class 7's members would be entitled to an initial payment percentage from the trust of 20% of their allowed claims. Meanwhile, Class 6 would recover about 59.5% of its $1.651 billion in claims. The Plan would also issue new warrants to purchase AWI's new common stock, estimated to be worth $35 to $40 million, to AWWD or Holdings (Class 12). If Class 6 rejected the Plan, then the Plan provided that Class 7 would receive the warrants. However, the Plan also provided that Class 7 would automatically waive receipt of the warrants, which would then be issued to AWWD or Holdings (Class 12).
The bankruptcy court actually ruled that the proposed "reverse cramdown" terms of the plan did not violate the absolute priority rule, but the district court reversed. The Third Circuit described the procedural posture of the case as follows:
Following a hearing on November 17 and 18, 2003, the Bankruptcy Court recommended confirmation of the Plan to the District Court in its December 19, 2003 Proposed Findings and Conclusions. The Bankruptcy Court found that the absolute priority rule, as codified in section 1129(b)(2) of the Bankruptcy Code, was satisfied because the warrants were distributed to the holder of equity interests because of the waiver by Class 7, citing In re Genesis Health Ventures, Inc., 266 B.R. 591 (D. Del.2001), and In re SPM Mfg. Corp., 984 F.2d 1305 (1st Cir. 1993). In addition, the Bankruptcy Court found that UCC had waived its right to object to the Plan when it "entered into a consensual plan encompassing" the Plan provisions. Because the Plan included a channeling injunction under section 524(g) of the Bankruptcy Code, the District Court was required to affirm the Bankruptcy Court's Proposed Findings and Conclusions before the Plan could go into effect.
[The Unsecured Creditors Committee (UCC)] filed objections to the Bankruptcy Court's Proposed Findings and Conclusions with the United States District Court for the District of Delaware. The District Court held a hearing on the objections on December 15, 2004 and issued a memorandum and order on February 23, 2005 denying confirmation of the Plan. The District Court found that (1) the issuance of warrants to the equity interest holders violated the absolute priority rule, and (2) no equitable exception to the absolute priority rule applied. In re Armstrong World Indus., Inc., 320 B.R. 523 (D. Del. 2005)....
At the heart of this appeal is the Plan provision that distributes warrants to AWI's equity interest holders (Class 12) through Class 7 in the event that Class 6 rejects the Plan. Appellant AWI argues that this provision does not violate the absolute priority rule because (1) legislative history and historical context indicate that the rule does not prohibit the transfer of warrants to the equity interest holders under the current circumstances; (2) case law establishes that Class 7 can transfer part of its distribution under the Plan to another claimant; and (3) the Plan did not give the warrants to Class 12 "on account of" its equity interests. We address each of these contentions in turn.
In ruling, the Third Circuit expressly rejected a reading of the "MCorp-Genesis" line of cases (which both rely on the First Circuit's holding in SPM Mfg.) as "stand[ing] for the unconditional proposition that creditors are generally free to do whatever they wish with the bankruptcy proceeds they receive." The Court stated:
Creditors must also be guided by the statutory prohibitions of the absolute priority rule, as codified in 11 U.S.C. § 1129(b)(2)(B). Under the plan at issue here, an unsecured creditor class would receive and automatically transfer warrants to the holder of equity interests in the event that its co-equal class rejects the reorganization plan. We conclude that the absolute priority rule applies and is violated by this distribution scheme.
In addition, the structure of the Plan makes plain that the transfer between Class 7 and Class 12 was devised to ensure that Class 12 received the warrants, with or without Class 6's consent. The distribution of the warrants was only made to Class 7 if Class 6 rejected the Plan. In turn, Class 7 automatically waived the warrants in favor of Class 12, without any means for dissenting members of Class 7 to protest. Allowing this particular type of transfer would encourage parties to impermissibly sidestep the carefully crafted strictures of the Bankruptcy Code, and would undermine Congress's intention to give unsecured creditors bargaining power in this context. See H.R. Rep. No. 95-595, at 416, reprinted in 1978 U.S.C.C.A.N. 5963, 6372 ("[Section 1129(b)(2)(B)(ii) ] gives intermediate creditors a great deal of leverage in negotiating with senior or secured creditors who wish to have a plan that gives value to equity.").
Hugh Ray got the biggest laugh at the NCBJ [Tape 9] during a spirited exchange with K & E's Rick Wynne over the propriety of "reverse cramdown" when he pointed in the direction of the Alamo and shouted:
Those brave young men didn't give up their lives at the Alamo so that ... [guys like you can implement unjust "reverse cramdown" plans].
Looks like the Third Circuit now agrees that "reverse cramdown" offends those same notions of "truth, justice and sacrifice for a noble cause" that characterized the spirit of the defenders of our great national shrine.
© Steve Jakubowski 2006
Do you think the Supreme Court will take a writ of certiorari on this issue?