Third Circuit Upholds Denial of Armstrong Bankruptcy ConfirmationAbsolute Priority Rule At Issue/ SPM Mfg. Case Distinguished

The U.S. Court of Appeals for the Third Circuit has upheld a district court ruling denying plan confirmation in the chapter 11 bankruptcy case of Armstrong Worldwide Industries, Inc.

At issue in In re Armstrong World Industries, Inc., Case No. 05-1881 (3rd Cir., Oct. 24, 2005) were warrants to be issued under the proposed plan to the equity holding class to purchase new common stock in Armstrong World Inc. (AWI). A class of unsecured creditors objected to the plan, arguing that because the creditors’ claims would not be paid in full, the plan’s distribution of warrants to the class of equity interest holders violated the absolute priority rule.

While the bankruptcy court approved the plan, the district court held the plan could not be confirmed, and the Third Circuit agreed.

AWI, which designs, manufactures and sells flooring products, kitchen and bathroom cabinets, and ceiling systems, along with two of the company’s subsidiaries, filed for chapter 11 bankruptcy in the U.S. Bankruptcy Court for the District of Delaware in December 2000 to address the company’s asbestos liabilities.

The U.S. bankruptcy trustee appointed two committees of unsecured creditors: the Official Committee of Asbestos Personal Injury Claimants and the Official Committee of Unsecured Creditors.

Following negotiations, AWI filed a Fourth Amended Plan of Reorganization in May 2003, under which AWI’s creditors were divided into 11 creditor classes and a 12th equity holder class. The Armstrong case concerned Class 6, a class of unsecured creditors; Class 7, a class of present and future asbestos-related personal injury claimants; and Class 12, the equity holding class, the sole member of which was AWI’s parent, Armstrong Holdings Inc.

The plan provided that AWI would place approximately $1.8 billion of its assets into a trust for Class 7, and Class 6 would recover about 59.5 percent of its $1.651 billion in claims. The plan also would issue new warrants to Class 12 to purchase AWI’s new common stock, estimated to be worth between $40 million and $35 million. The dispute involved a provision that if Class 6 (the unsecured creditors) rejected the plan, then Class 7 (the asbestos claimants) would receive and automatically waive the warrants, which then would be issued to Class 12 (Armstrong Holdings).

The official committee of unsecured creditors initially approved the plan, but later filed a conditional objection based on the greater potential distribution to creditors if federal asbestos legislation was passed (the FAIR act), and the possible applicability of the absolute priority rule.

The absolute priority rule, established through judicial rule and codified in the U.S. Bankruptcy Code, provides that "‘creditors…be paid before the stockholders could retain [equity interests] for any purpose whatever,’" the Third Circuit noted, citing U.S. Supreme Court precedent from 1913.

Class 6 eventually voted against the plan and the bankruptcy court opted to approve the plan in a cramdown over the objections of Class 6.

On appeal, AWI made several arguments that its plan did not violate the absolute priority rule.

First, the debtor argued that application of the absolute priority rule in the case at hand would be contrary to Congress’s intention in codifying the rule in the Bankruptcy Code, which was to prevent the "squeezing out" of intermediate unsecured creditor classes. In the instant case, Class 6 is not an intervening (or intermediate) class and is not being "squeezed out" by Class 7’s transfer of warrants to Class 12, AWI claimed.

The Third Circuit rejected this reasoning. "[W]e will apply the plain meaning of the statute," the court stated, referring to the Bankruptcy Code. "Under this reading, the statute would be violated because the Plan would give property to Class 12, which has claims junior to those of Class 6."

AWI also contended that Class 7 was entitled to distribute the property it received under the plan without violating the absolute priority rule. AWI relied on the well-known decision in In re SPM Mfg. Corp., 984 F.2d 1305 (1st Cir. 1993), where the court permitted senior secured creditors to share bankruptcy proceeds with junior unsecure creditors while skipping over priority tax creditors.

However, the cases AWI cited in support of this contention "do not stand for the unconditional proposition that creditors are generally free to do whatever they wish with the bankruptcy proceeds they receive," the Third Circuit stated. "Creditors must also be guided by the statutory prohibitions of the absolute priority rule."

The Armstrong plan clearly devised a transfer between Class 7 and Class 12 to ensure that Class 12 received the warrants, with or without the consent of Class 6, the court noted. "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…."

AWI further argued that the warrants were not to be distributed ‘on account’ of Class 12’s equity interests, but rather as consideration for the settlement of intercompany claims.

The Third Circuit quickly dispatched this argument, pointing out that the disclosure statement accompanying the plan estimated the intercompany claims at approximately $12 million—far less than the estimated value of the warrants, which was stated to be between $40 million and $35 million.

In addition, the court rejected AWI’s claims that the warrants should be allowed under principles of equity because of the unsecured creditors’ committee involvement in crafting the plan, its initial endorsement of the plan, the relatively small value of the warrant compared with the estate, and the delay caused by objections to the plan.

This article is presented for informational purposes only and is not intended to constitute legal advice.