Looking a ‘Gift’ Horse in the Mouth: The Latest on Section 363

Two Merry-Go-Round HorsesL. John Bird, a lawyer with Fox Rothschild LLP in Wilmington, Delaware, and a prolific blogger, writes that last month’s ICL Holding decision is, for “any organizations looking to purchase assets out of a bankruptcy proceeding … a must read.”

It is that important because, to begin with, section 363 sales have become the beating heart of the chapter 11 body.

Their mechanics are by now familiar: a stalking horse (or initial bidder, if you dislike metaphor); protections offered to that bidder in the event of a “higher and better” bid that reward the horse for getting things started; strict deadlines for such competing bids; eventual court approval and a closing on the sale.

Further, some of the attendant controversies are by now familiar. For example, does that statute allow “gift plans,” or does it not? In other words, can the buyer and the seller (debtor-in-possession) in a 363 agree on an arrangement that leaves certain assets of the estate unsold, and that distributes them in ways that ignore the traditional bankruptcy priority, gifting a junior creditor or even equity holders? The Second and Third Circuits both say that they cannot, and their agreement on this point excludes such plans from both Delaware and New York’s bankruptcy courts.

A Bit of a Twist

But now there’s a bit of a twist, one that gets us back to Bird’s point. Something that may look a bit like a “gift” in the prohibited sense may turn out to be permissible under 363 after all, according to this new ICL decision by a Judge Thomas Ambro for a three judge panel of the Third Circuit.

The opinion arose out of the collapse of LifeCare, an operator of acute care hospitals that was blown into insolvency by Hurricane Katrina. The hurricane destroyed three of LifeCare’s facilities. ICL’s buyer in a court-supervised auction was a group of its secured lenders, who bought the operation with a $320 million credit bid.

To ease court approval of the sale, the buying group decided to make a side deal with a party that would otherwise surely have contested the issue, the unsecured creditors’ committee, referred to in the opinion simply as “the Committee.”

The buyers agreed to pay off the Committee for its silence. Maybe that’s an unkind way of putting it. Here’s the kinder language employed by the circuit court’s panel: “In exchange for the Committee’s promise to drop its objections and support the sale, the secured lenders agreed to deposit $3.5 million in trust for the benefit of the general unsecured creditors.”

A Loss for the IRS

The bankruptcy court agreed to the sale, on a customary “melting ice cube” rationale.

The Internal Revenue Service objected. ICL would owe taxes, and the sale with this side-deal made no provision for payment thereof. The IRS contended that the sale should not go ahead, under the precedents I mentioned above, the ones banning gift plans.

The bankruptcy court disagreed with the tax agency. It deemed the $3.5 million that went into escrow for the eventual benefit of unsecured creditors not to be property of the estate. This, its distribution wasn’t a “gift plan.” A more pragmatic way of putting this ruling was: the IRS has no claim on it.

The appeals court has now agreed, saying that the code’s “creditor-payment hierarchy only becomes an issue when distributing estate property.”

The decision is an important one, in that it pumps a new level of flexibility into the 363 sales system, making that system seem an even better candidate to become the way in which corporate reorganizations get done.

The court also says that as a matter of formality the IRS had an impressive argument, but the formal arguments to which it appealed would have required the panel to “ignore the economic reality of what actually occurred.”

And in the words of Attorney Bird, with whom we began, “In some situations, the economics are the most important aspect of a deal.”

 

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