In In re World Health Alternatives, Inc., Case No. 06-10166 (July 7, 2006), the Bankruptcy Court for the District of Delaware held that—notwithstanding the Third Circuit’s recent opinion, In re Armstrong World Indus., Inc., 432 F.3d 507 (3d Cir. 2005)—a secured creditor "give-up" or "carve out" that inures solely to the benefit of general unsecured creditors does not violate the Bankruptcy Code.

Concurrently with the commencement of their chapter 11 case, the debtors in World Health filed a series of motions to obtain postpetition financing and to facilitate the sale of substantially all of their assets. The Creditors Committee raised objections to the proposed sale as well as possible causes of action against the debtors’ secured lender and challenges to its claim. After extensive negotiations, the debtors, the Creditors Committee, and the lender entered into a global settlement of all disputes among the parties. A key term of the settlement was the lender’s agreement to cap its secured claim and to make available a $1.6 million collateral carve-out for the benefit of general unsecured creditors. The U.S. Trustee, however, objected to the settlement, arguing that Armstrong World prohibited the Court from approving a settlement that would pay anything to general unsecured creditors before priority tax creditors were paid (though no priority creditor had objected to the settlement).

The Court rejected the U.S. Trustee’s position, concluding that Armstrong World distinguished, but did not disapprove of, the line of authorities approving carve-out agreements. See Armstrong World, 432 F.3d at 514 (discussing In re SPM, 984 F.2d 1305, In re MCorp Fin., Inc., 160 B.R. 941 (S.D. Tex. 1993), and In re Genesis Health Ventures, Inc., 266 B.R. 591 (Bankr. D. Del 2001)). The Court likewise distinguished Armstrong World from the circumstances of World Health. First, Armstrong World dealt with a chapter 11 plan when it stated that the SPM line of cases did not provide creditors with carte blanche to distribute bankruptcy proceeds in contravention of the Bankruptcy Code’s absolute priority rule. In World Health, however, the absolute priority rule was not implicated because the settlement did not arise in the context of a chapter 11 plan. Second, SPM, like World Health, involved a creditor’s perfected security interest—property that was not subject to distribution under the Bankruptcy Code’s priority scheme—and a carve-out from its lien proceeds. The Court observed that "[a]lthough the general unsecured creditors will receive money before the priority creditors, that money does not belong to the estate—it belongs to [the secured lender]," a result that is not prohibited by the Bankruptcy Code or reported cases. (The Court further noted that, even if the absolute priority rule applied, an ordinary carve out that allows a secured creditor to give up a portion of its lien for the benefit of a junior creditor would not offend the rule.)

The Court therefore approved the settlement over the U.S. Trustee’s objection, noting that similar carve-out settlements frequently provide a resolution to liquidating chapter 11 cases where sale proceeds would otherwise provide little or no recoveries to general unsecured creditors. In so holding, the Court also pointed out that, if the settlement were not approved, the practical result would be to enable the secured lender to retain the $1.6 million carve out that would otherwise have been made available to general unsecured creditors. In such a scenario, it would be the secured creditor—not the priority claimants—that would be the only real "winner."

Authored by:

Mette H. Kurth

(213) 617-5501