In Re Armstrong World Industries: In Denying Confirmation, Third Circuit Re-Affirms Commonly Used Chapter 11 Tools

Wednesday, March 1, 2006 - 00:00

On December 29, 2005, the United States Court of Appeals for the Third
Circuit rendered its decision in In re Armstrong World Industries, Inc.
The issue considered by the Court of Appeals involved the appeal by Armstrong
World Industries (" AWI ") of the decision of the United States District
Court for the District of Delaware denying confirmation of AWI's plan of
reorganization (the " Plan "). The District Court had concluded that the
Plan could not be confirmed because it violated the absolute priority rule and
no equitable exception to the absolute priority rule applied.

While the Third Circuit affirmed the District Court's denial of confirmation
based upon a relatively straightforward application of the Bankruptcy Code
mandated absolute priority rule, it reinforced two tools often utilized by
parties to confirm chapter 11 plans: (i) the ability of a secured creditor to
"gift" distributions to a junior class to obtain such party's consent to a
chapter 11 plan; and (ii) the distribution to a junior class in consideration of
the settlement of claims between the parties. In addition, while expressing the
need for compelling circumstances, the Third Circuit acknowledged the authority
of a court to review the equities of a case when considering a flexible
application of the absolute priority rule.

A. Facts

Under the Plan, AWI's creditors were divided into eleven classes and AWI's
equity interest holders were placed into a twelfth class. Relevant to the appeal
were Class 6, a class of unsecured creditors; Class 7, a class of present and
future asbestos-related personal injury claimants; and Class 12, the class of
equity interest holders who own AWI's common stock. Classes 6 and 7 held equal
priority, and had interests senior to those of Class 12. All three classes were

The Plan provided that AWI would place a portion of its assets into a trust
for Class 7 and Class 7's members would be entitled to an initial payment
percentage from the trust of 20% of their allowed claims. Meanwhile, Class 6
would recover a portion (approx. 59.5%) of its claims. The Plan also proposed to
issue new warrants to purchase AWI's new common stock to Class 12. If Class 6
rejected the Plan, then the Plan provided that Class 7 would receive the
warrants. However, the Plan also provided that Class 7 would automatically waive
receipt of the warrants, which would then be issued to Class 12.

Class 6 rejected the Plan. Since an impaired class objected to the Plan, the
Plan could only be "crammed down" if it was "fair and equitable" to the
objecting class. Pursuant to the "absolute priority rule" of section 1129(b) of
the Bankruptcy Code, a plan is fair and equitable with respect to an impaired,
dissenting class of unsecured claims if it (1) pays the class's claims in full,
or (2) does not allow holders of any junior claims or interests to receive or
retain any property under the plan "on account of" such claims or interests.

The United States Bankruptcy Court recommended confirmation of the Plan to
the District Court, finding that the absolute priority rule had not been
violated. The District Court refused to confirm the Plan, holding that (1) the
issuance of warrants to the equity interest holders violated the absolute
priority rule, and (2) no equitable exception to the absolute priority rule

B. Congressional Intent And The Plain Meaning Of The Absolute Priority

In its appeal, AWI first argued that the Court of Appeals should apply a
flexible interpretation of the absolute priority rule based on Congressional
intent. Specifically, AWI argued that Congress designed the absolute priority
rule to prevent the "squeezing out" of intermediate unsecured creditors. Class 6
was not an intermediate class (as it was equal to Class 7) and was not being
squeezed out by Class 7's transfer of warrants to Class 12. Therefore, AWI
argued, the absolute priority rule did not apply.

The Court of Appeals noted that the legislative history does show that
section 1129(b) was at least designed to address situations where a senior class
gave property to a class junior to the dissenting class. However, the Court of
Appeals further noted that other statements in the legislative history of
section 1129(b) appear to apply the statute more broadly (i.e., to
non-intervening classes). As such, the Court of Appeals determined that the
legislative history supports the notion that an impaired class may object to a
co-equal class's distribution of property to a junior class.

Furthermore, the Court of Appeals determined that the plain language of the
absolute priority rule makes it clear that a plan cannot give property to junior
claimants "on account of" such claim or interest over the objection of a senior
class that is impaired. Applying the plain meaning of the statute to the facts
at hand, the statute would be violated because the Plan would give property to
Class 12, which had interests junior to those of Class 6.

C. MCorp-Genesis Line of Cases Distinguished, but not Overturned

AWI further argued that Class 7 may distribute the property it will receive
under the Plan to Class 12 without violating the absolute priority rule, relying
on a line of cases that involved creditors who were permitted to distribute
their proceeds from the bankruptcy estate to other claimants without offending
the absolute priority rule (the " MCorp-Genesis Line of Cases ").

The Court of Appeals held that the MCorp-Genesis Line of Cases was
distinguishable from the facts at hand and that the reasoning set forth therein
remained intact. For instance, In re Genesis Health Ventures,
266 B.R. 591 (D. Del. 2001) and In re SPM Mfg. Corp., 984 F.2d
1305 (1st Cir. 1993) both involved a "carve out," a situation where a party
whose claim is properly perfected and secured by assets in the bankruptcy estate
allows a portion of its lien proceeds to be paid to others. To the contrary,
in Armstrong, Class 7 was not a secured class, and the proposed
distribution was not a "carve out."

The Court of Appeals noted further that the structure of the Plan clearly
conveyed that the transfer between Class 7 and Class 12 was devised to ensure
that Class 12 received the warrants, with or without Class 6's consent. The
distribution of the warrants was only made to Class 7 if Class 6 rejected the
Plan. In turn, Class 7 automatically waived the warrants in favor of Class 12,
without any means for dissenting members of Class 7 to protest. The Court of
Appeals concluded that allowing this particular type of transfer would undermine
the Bankruptcy Code. Through the absolute priority rule, Congress intended to
give intermediate creditors a great deal of bargaining power in negotiating with
senior or secured lenders who wish to have a plan that gives value to equity.
Allowing this type of transfer, the Court reasoned, would take such bargaining
power away from Class 6.

D. Transfer Of The Warrants "On Account Of" Class 12's Equity Interests

The absolute priority rule provides that a plan is fair and equitable if it
does not allow holders of any junior claims or interests to receive or retain
any property under the plan "on account of" such claims or interests. AWI argued
that the warrants would not be distributed to Class 12 "on account of" its
members' equity interests, but rather would be given as consideration for
settlement of its members' intercompany claims.

In making this argument, AWI relied on In re PWS Holding Corp ., 228
F.3d 224 (3d Cir. 2000). In PWS, the debtors released their legal claims
against various parties to facilitate their reorganization, including an
avoidance claim that would have allowed them to avoid certain aspects of a
previous recapitalization. Id. at 232-35. The appellants in PWS
argued that releasing the avoidance claim resulted in a prohibited transfer of
value to equity interest holders who had participated in the recapitalization.
The Court of Appeals held that "without direct evidence of causation, releasing
potential claims against junior equity does not violate the absolute priority
rule in the particular circumstance [where] the claims are of only marginal
viability and could be costly for the reorganized entity to pursue." Id.
at 242.

The Court of Appeals distinguished PWS from the Armstrong
facts. The warrants had an estimated value of $35 to $40 million, while the
intercompany claims held by the members of Class 12 were only valued at
approximately $12 million, resulting in a substantial benefit for Class 12. AWI
gave no adequate explanation for the difference in value, leading the Court of
Appeals no alternative but to conclude that Class 12 would receive the warrants
"on account of" their status as equity interest holders.

F. Equitable Considerations

Citing In re Penn Central Transportation Co ., 596 F.2d 1127 (3d Cir.
1979), AWI argued that the Court of Appeals should apply equitable
considerations to allow an exception to the absolute priority rule. To prevent a
railroad crisis and to address the difficulties of the Penn Central
reorganization, Congress passed the Regional Rail Reorganization Act of 1972,
which directed that major portions of Penn Central's rail assets be conveyed to
Conrail, a new company formed under the Act to continue operation of some of the
routes served by Penn Central. Id . at 1134. In Penn Central, the
Court of Appeals held that "[o]ur construction and application of precedents
such as the absolute priority rule must necessarily take account of the unique
facts of this Plan and proceed in an environment pervaded more by relativity
than by absolutes." Id . at 1142.

AWI analogized Penn Central to its own case, arguing that the facts
were unique and warranted a more equitable and flexible application of the
absolute priority rule. The Court of Appeals disagreed, finding that AWI's
bankruptcy due to asbestos liabilities simply did not involve the kind of
exigent circumstances present in Penn Central. In so holding, the Court
of Appeals did not determine that exceptions to the absolute priority rule do
not exist, but rather found that no such exceptions applied to AWI's Plan.

Michael R. Nester and Pauline K. Morgan are
Partners and Kara H. Coyle is an Associate in the bankruptcy and
Corporate Restructuring Department of Young Conaway Stargatt &Taylor, LLP in
Wilmington, Delaware.

Please email the authors at, or with questions about this