Third Circuit Allows 363 Purchaser’s Funds to Bypass IRS and Satisfy Certain Administrative and General Unsecured Claims

In re ICL Holding Company, Inc., No. 14-2709, 2015 WL 5315604 (3d Cir. Sept. 14, 2015), aff’g sub nom United States v. LCI Holding Co., Inc., Nos. 13-924 (SLR), 13-1188 (SLR), 2014 WL 975145 (D. Del. March 10, 2014)

As discussed by the Delaware Bankruptcy Insider in March of last year, in ruling on a motion for stay the Delaware District Court determined that the Delaware Bankruptcy Court did not err when it approved a sale of substantially all of the assets of LCI Holding Company, Inc. and its affiliated debtors (the “Debtors”) and a settlement between the purchaser (the Debtors’ prepetition senior lender), the official committee of unsecured creditors, and the Debtors that (a) provided for the creation of an escrow from non-estate purchaser funds to, among other things, satisfy certain fees and expenses of professionals and certain expenses expected to be incurred by the Debtors in connection with their wind down and provide a distribution to allowed general unsecured claims and noteholder claims and (b) excluded the Internal Revenue Service (the “IRS”) from those creditors entitled to share in the escrowed funds.  The IRS, which asserted an administrative claim for tax liability resulting from the sale, appealed the approval of the sale and settlement to the Third Circuit Court of Appeals asserting that the sale and settlement violated the absolute priority rule by favoring creditors with an equal or lesser priority under the Bankruptcy Code’s distribution scheme.

At the outset of its Opinion, the Third Circuit held that the appeal was neither constitutionally, statutorily, nor equitably moot.  Despite the fact that the purchaser possessed a significant first priority lien on all estate property stemming from its prepetition lien and was thus entitled to recover from all escrowed funds deemed estate property, the Court did not consider the appeal constitutionally moot given that the IRS possessed a claim and thus, a prospect of recovery, albeit a remote one.  Moreover, it did not view section 363(m) as a bar to review because such section does not bar challenges to every sale term (despite how integral) but rather only those that would claw back a sale from a good-faith purchaser.  And finally, the Court did not find equitable mootness applicable to the appeal as it did not involve a plan of reorganization.

In determining that the sale and settlement were properly approved by the Bankruptcy Court, the Third Circuit held that they did not implicate the Bankruptcy Code’s creditor-payment hierarchy because the funds placed into escrow were not estate property.  This threshold determination was critical to the appeal because “[t]he Code’s distribution rules don’t apply to nonestate property.”  Op. at *6.  The IRS argued that the escrowed funds were “proceeds of or from property of the estate”, see 11 U.S.C. § 541(a)(6) (defining property of the estate), because (a) with respect to sums distributed to unsecured creditors, they were an increased bid to secure the sale and (b) with respect to sums distributed to professionals and other administrative expense creditors, they were acknowledged in the asset purchase agreement to be sale consideration.  The Court was “not persuaded.”  Id. at *7.  The evidence indicated that the money paid to creditors never entered the Debtors’ estates, was not paid at the Debtors’ direction, and consisted of the purchaser’s own funds.  Moreover, despite the form of the asset purchase agreement, the Court elevated form over substance given the economic reality that upon the closing of the sale, the purchaser became the owner of all of the Debtors’ assets.  Accordingly, no property was left in the estates to distribute to creditors.  Thus, the Court held, “as a matter of substance, we cannot conclude that the escrowed funds were estate property.”  Id. at *8.