On March 7, 2007, the Second Circuit Court of Appeals held that "in the Chapter 11 context, whether a pre-plan settlement’s distribution plan complies with the Bankruptcy Code’s priority scheme will be the most important factor for a Bankruptcy Court to Consider in approving a settlement under Bankruptcy Rule 9019."  In re Iridium Operating LLC, No. 05-2236 (2d Cir. March 7, 2007)

In the Iridium case, the Official Committee of Unsecured Creditors (the "Committee") was authorized by the Bankruptcy Court to commence adversary proceedings on behalf of the estate against the debtor’s lenders and Motorola, Inc., the debtor’s former parent company.  Each of the litigations which the Committee was authorized to undertake were complicated and expensive.  Additionally, the estate had limited resources.  Accordingly, the Committee decided to settle with the lenders (conceding, among other things, that the lenders’ claims were properly perfected and secured upon entry of an order approving the settlement) and to use the funds from the settlement with the lenders to pursue the litigation against Motorola. 

Among other things, the Committee’s settlement with the lenders divided up the estate’s cash by giving the lenders $92.5 million and putting $37.5 million into Iridium Litigation LLC (the "Litigation LLC") to pursue the lawsuit against Motorola.  Motorola objected to the settlement, arguing that if Motorola (an administrative creditor) prevailed in the lawsuit or its administrative claims exceeded its liability in the litigation, the payment to the Litigation LLC would violate the absolute priority rule.

In deciding whether the settlement complied with Bankruptcy Rule 9019, the Second Circuit declined to follow the rigid per se test set forth in the Fifth Circuit in United States v. Aweco, Inc. (In re AWECO, Inc.), 725 F.2d 293, 298 (5th Cir. 1984).  Rather, the Second Circuit stated that "[i]n our view, a rigid per se rule cannot accommodate the dynamic status of some pre-plan bankruptcy settlements", and held that "whether a particular settlement’s distribution scheme complies with the Code’s priority scheme must be the most important factor for the bankruptcy court to consider when determining whether a settlement is ‘fair and equitable’ under 9019."

The record was silent as to why any balance left in the Litigation LLC would not be distributed pursuant to the absolute priority rule.  Accordingly, the Second Circuit remanded the case to the bankruptcy court for clarification of why the settlement had the potential of deviating from the absolute priority rule.

Author:  Mary L. Johnson