On September 14, 2015, the US Court of Appeals for the Third Circuit, in In re ICL Holding Co., Inc., held that, in connection with a secured lender group’s purchase of all of a debtor's assets at a section 363 sale, escrows it created to pay wind-down expenses and the debtor’s and creditors’ committee’s professional fees and settlement sums it paid to unsecured creditors, were not property of the estate and therefore were not required to be distributed in accordance with the Bankruptcy Code’s priority scheme (No. 14-2709, (3d Cir. Sept. 14, 2015)).

In 2012, LifeCare Holdings, Inc. (Debtor), once a leading operator of long-term acute care hospitals, was struggling financially. The Debtor carried a $484 million debt load, of which about $355 million was secured. The Debtor considered a sale or a restructuring of its balance sheet. The sale did not happen initially because no bidder offered an amount that exceeded the Debtor's debt obligations.

As an alternative to a sale, the Debtor considered a restructuring option, which required the support of the Debtor's secured lenders. However, the secured lenders wanted to purchase all of the company's cash and assets outright, rather than support a restructuring. They offered to credit $320 million of the $355 million debt they were then owed.

In addition to their credit bid, the secured lenders agreed to pay:

The parties agreed that the secured lender group would place these amounts into separate escrow accounts (Escrowed Funds), and that any unused amounts would be returned to it.

In December 2012, the secured lender group and the Debtor entered into an Asset Purchase Agreement. One day later, the Debtor and its 34 subsidiaries filed for bankruptcy. Shortly thereafter, the Debtor requested to sell substantially all of its assets through a court-supervised auction under section 363(b)(1) of the Bankruptcy Code. In the end, the secured lender group’s $320 million credit bid remained the most attractive offer.

The creditors' committee and the US government objected to the sale. The creditors' committee criticized the sale as a "veiled foreclosure" that would leave the bankruptcy estate so insolvent that even administrative expenses would not be paid. The government argued that the sale would result in capital-gains tax liability of about $24 million, giving it an administrative claim that would go unpaid. The government claimed that this was unfair because under the proposed sale arrangement equally situated administrative claimants (primarily the bankruptcy professionals) would get paid from the Escrowed Funds if the sale was approved.

Before the court resolved these objections, the creditors’ committee promised to drop its objections and support the sale in exchange for the secured lender group’s agreement to deposit $3.5 million in trust for the benefit of unsecured creditors (Settlement Sums). The government objected to this settlement on the same grounds as it had objected to the sale and the use of the Escrowed Funds, arguing that the settlement attempts to distribute estate property to junior creditors over the objection of senior creditors in violation of the absolute priority rule.

On April 2, 2013, the bankruptcy court approved the section 363 sale and held that the Escrowed Funds were not property of the estate and therefore were not subject to distribution to the Debtor's creditors, including the government.

At a later hearing, the bankruptcy court overruled the government’s objection that the Settlement Sums were property of the estate to be distributed in accordance with the Bankruptcy Code’s priority scheme. The bankruptcy court rejected this argument, explaining that because the settlement agreement permitted the purchasers to distribute the Settlement Sums directly to a trust for the unsecured creditors, this indicated that these funds were not property of the estate, therefore not implicating the Bankruptcy Code’s priority scheme.

The government appealed both the sale order and the settlement approval order, and sought a stay pending appeal. The court denied the stay request, which the government appealed to the district court. The district court also denied the stay request, finding that the government did not make the threshold showing of a sufficient likelihood of success on the merits.

The government appealed the approval of the sale order and the settlement to the Third Circuit.

The Third Circuit affirmed the ruling of the lower courts, holding that:

This ruling could significantly affect the structure of future section 363 sales, especially in cases where there are substantial priority claims. It demonstrates a flexibility in the section 363 sale process that allows a purchaser to use its own funds to pay certain creditors and not others that are senior or similarly situated, which is not possible when purchasing assets under a Chapter 11 plan (see Practice Note, Buying Assets under a Chapter 11 Plan).

Further, this decision is consistent with the Third Circuit’s previous ruling in Jevic Holding Corp. v. CIT Group/Business Credit Inc. (In re Jevic Holding Corp.), in which it held that under certain circumstances, a Chapter 11 case may be resolved in a "structured dismissal" that deviates from the Bankruptcy Code’s priority scheme (see 787 F.3d 173 (3d. Cir. 2015) and Legal Update, In re Jevic Holding Corp: Third Circuit Allows Structured Dismissal of Chapter 11 Case that Violates the Bankruptcy Code's Priority Scheme).

For more information on section 363 sales, see: