Absolute Priority: The Blog for Business Bankruptcy, Insolvency and Restructuring

In re: American Capital Equipment LLC and Skinner Engine Co., the issue before the United States Third Circuit Court of Appeals was whether a bankruptcy court can determine at the disclosure statement stage that a Chapter 11 plan is unconfirmable without first holding a confirmation hearing, and covert the case from a chapter 11 to a case under chapter 7.  After considering the issue, the Third Circuit held that a bankruptcy court has the authority at the disclosure statement hearing to convert a bankruptcy case from a chapter 11 to a chapter 7 if it is obvious that the proposed plan is patently unconfirmable, such that no dispute of material fact remains and defects cannot be cured by creditor voting.

Skinner was founded in 1868 as a manufacturer of steam engines for merchant ships. From the 1930s through the 1970s, Skinner manufactured ship engines and parts allegedly containing asbestos. In 1998, American Capital Equipment, LLC acquired all of Skinner‟s common stock, and secured a lien on Skinner’s assets from PNC Bank to finance the purchase. Based on Skinner’s lack of cash flow to maintain operations or service its secured debt, Skinner and American Capital each filed petitions for bankruptcy relief under Chapter 11 in 2001. At the time that Skinner filed for bankruptcy, there were over 29,000 asbestos claims pending against Skinner; however, contrary to a mass tort insolvency, these asbestos claims, most of which were dismissed prior to the chapter 11, were not the reason for Skinner’s Chapter 11 filing, rather, it was the lack of Skinner’s cash flow that was the primary cause for the bankruptcy filing.

Prior to the bankruptcy petition filing, Skinner’s primary insurers defended the asbestos claims against Skinner. The parties entered into a defense cost-sharing agreement under which the primary insurers and Skinner each agreed to pay a portion of the costs. During the course of Skinner’s bankruptcy, it sold substantially all of its assets and filed five plans; it was the fifth plan (“Fifth Plan”) that was determined to be patently unconfirmable by the Bankruptcy Court at the disclosure statement hearing.  By the time the Fifth Plan was proposed, the Debtors had no operations and no employees.

The Fifth Plan included a twenty percent surcharge (the “Surcharge”) for asbestos claimants who decided to opt in to the plan‟s settlement process. The Surcharge would be used to pay creditors through a Plan Payment Fund, and fund the claims resolution process called the “Court Approved Distribution Procedures” (“CADP”). Specifically, the CADP provideed that:

“[e]ach Asbestos Claimant shall maintain full and complete ownership of his or her Asbestos Claim, including, without limitation, the right to prosecute or settle any Asbestos Claim, but upon the Asbestos Claimant submitting his or her claim to the CADP, he or she shall thereby have agreed to pay the Surcharge Cash from any amounts paid on account of the Asbestos Claim under and through the CADP.”

Skinner acknowledged that the Plan would not work without the Surcharge.

After considering the Fifth Plan at the disclosure statement hearing, the Bankruptcy Court found that the Fifth Plan was facially unconfirmable, because it was not proposed in good faith and was forbidden by law in contravention of 11 U.S.C. § 1129(a)(3), and was not feasible pursuant to 11 U.S.C. § 1129(a)(11). Finding that the Debtors would be unable to propose a confirmable plan, the Bankruptcy Court converted the chapter 11 case to a case under chapter 7. The Debtors appealed and the District Court affirmed.

On appeal to the Third Circuit, the appellants argued, among other things, that the Bankruptcy Court erred in finding the Fifth Plan to be unconfirmable without first holding a confirmation hearing, and in finding that the Fifth Plan was patently, or facially, unconfirmable.  After addressing these issues, the Third Circuit affirmed the Bankruptcy Court and District Court.

Appellants first argument that the Bankruptcy Court erred in deeming its plan to be unconfirmable without first holding a confirmation hearing, the Court noted that while confirmation issues are ordinarily reserved for the confirmation hearing, they need not be so and that “if it appears there is a defect that makes a plan inherently or patently unconfirmable, the [Bankruptcy] Court may consider and resolve that issue at the disclosure [statement] stage before requiring the parties to proceed with solicitation of acceptances and rejections and a contested confirmation hearing.”  The Third Circuit also held that a bankruptcy court may address the issue of plan confirmation where it is obvious at the disclosure statement stage that a later confirmation hearing would be futile because the plan described by the disclosure statement is patently unconfirmable.  A plan is patently unconfirmable where (1) confirmation “defects [cannot] be overcome by creditor voting results” and (2) those defects “concern matters upon which all material facts are not in dispute or have been fully developed at the disclosure statement hearing.”

Appellants then argued that even if a Bankruptcy Court is permitted to make a confirmability determination at the disclosure statement stage, it erred in doing so here, because the Fifth Plan was confirmable. The Third Circuit disagreed.

The Third Circuit stated that a Bankruptcy Court shall confirm a plan only if, inter alia, it “has been proposed in good faith and not by any means forbidden by law[,]” and if it is feasible. The debtor has the burden of proving that a disclosure statement is adequate, including showing that the plan is confirmable or that defects might be cured or involve material facts in dispute.  Both the Bankruptcy and District Courts found that the Fifth Plan did not meet the § 1129 requirements for confirmation.

The Third Circuit found that the Fifth Plan is not confirmable on two separate and independently sufficient bases under § 1129(a): (1) it is not feasible, and (2) it has not been proposed in good faith.  In addressing feasibility, the Third Circuit noted that a plan is confirmable only if it is feasible, that is, if “[c]onfirmation of the plan is not likely to be followed by the liquidation, or the need for further financial reorganization, of the debtor or any successor to the debtor under the plan, unless such liquidation or reorganization is proposed in the plan.” 11 U.S.C. § 1129(a)(11). Even a planned liquidation “must be feasible.”  However, feasibility does not mean that the plan’s success is guaranteed.

However, a plan will not be feasible if its success hinges on future litigation that is uncertain and speculative, because success in such cases is only possible, not reasonably likely.  Critically, in this case, the Third Circuit pointed out that the Fifth Plan’s sole source of funding was the Surcharge, which would be obtained from wholly speculative litigation proceeds. The Fifth Plan also depended on the assumption that Asbestos Claimants will choose to use the CADP rather than the court system, and even then, the Plan could succeed only if enough Asbestos Claimants who used the CADP won recoveries and contributed sufficient Surcharge funds to the Plan Payment Fund. All of this made the Third Circuit find that the Fifth Plan was “highly speculative”, and “simply not reasonably likely to succeed and therefore, not feasible.”  The Court also pointed out that the feasibility issue of the Fifth Plan could not be cured, and no dispute of material fact remained, because Appellants admitted that no plan will work without a Surcharge. Thus, the Third Circuit found that the feasibility issue rendered the Plan to be patently unconfirmable pursuant to § 1129(a)(11), and thus, conversion was appropriate.

In reviewing the Bankruptcy Court’s decision to convert the chapter 11 proceedings to a case under chapter 7 pursuant to 1112(b), the Third Circuit did so under the abuse of discretion standard.  Section 1112(b) provides a non-exhaustive list of grounds for finding “cause” to convert or dismiss, and the Third Circuit also noted that a court may find cause where there is not “a reasonable possibility of a successful reorganization within a reasonable period of time.”

The Third Circuit found that the Bankruptcy Court did not abuse its discretion in determining that there was cause to convert on the basis that Appellants were unable to propose a confirmable plan, and would be unable to do so in the future.   The Fifth Plan was not feasible, and Appellants were unable to create a plan that was not contingent on future litigation with an uncertain and speculative outcome. Additionally, Appellants conceded that the plan could not be successful without a Surcharge, which, as the Third Circuit noted in this case, created an inherent conflict of interest.

Appellants argued that they did not have reasonable time to effectuate a plan, however, the Third Circuit did not buy the Appellants argument since as they noted that the case was not “truly a mass-tort bankruptcy case”, delays were caused by the Debtors (among others), and the Debtors filed five plans in as many years and were still unable to propose a feasible plan.  Accordingly, the Third Circuit held that the Fifth Plan simply was not confirmable, and given the apparent futility in the Debtor’s pursuit of a plan under Chapter 11, the Bankruptcy Court did not abuse its discretion by converting the case to Chapter 7.

The holding of Skinner is clearly case specific, and while Debtors need to be aware that they run the risk of having their chapter 11 case converted to a chapter 7 case at the disclosure statement stage if they propose a plan that is not feasible or capable of being cured, the harsh result here was clearly because there was no possible cure to the feasibility issue of the proposed plan.

The Third Circuit recently ruled In re Calabrese (click to read the full opinion) that New Jersey sales taxes, which are required to be collected by an owner of a restaurant, are entitled to trust fund priority under the United States Bankruptcy Code, and thus, are not dischargeable in bankruptcy.  This opinion is in line with Second, Seventh and Ninth Circuits.

Appellant Michael Calabrese operated “Don’s What a Bagel, Inc.,” which filed for reorganization under Chapter 11 of the Bankruptcy Code. As proprietor of a restaurant, Calabrese was required by New Jersey law to collect sales tax from his customers. N.J. Stat. Ann. §§ 54:32B-3(c)(1), 54:32B-12(a), 54:32B-14(a). After failing to confirm a reorganization plan, the bankruptcy was converted to Chapter 7.  Calabrese also filed for personal bankruptcy under Chapter 13.

The State of New Jersey Department of Taxation (New Jersey) filed several secured proofs of claim in Calabrese’s individual bankruptcy. Calabrese moved to have the claims reclassified as unsecured, and the Bankruptcy Court granted his motion. New Jersey thereafter filed amended proofs of claim alleging that Calabrese owes $63,437.19 in taxes collected while operating his business from 2003 to 2009.

Calabrese moved to expunge the claims, and after briefing and a hearing, the Bankruptcy Court held the taxes at issue are trust fund taxes under 11 U.S.C. § 507(a)(8)(C) rather than excise taxes under § 507(a)(8)(E). Calabrese appealed that decision to the District Court, which affirmed.

The Third Circuit was required to decide whether the sales taxes held by Calabrese are “trust fund” or “excise” taxes under 11 U.S.C. § 507(a)(8). Excise taxes receive priority, and are nondischargeable, if they are less than three years old, as measured from the date of the bankruptcy petition.  See 11 U.S.C. § 507(a)(8)(E) (priority); 11 U.S.C. § 523(a)(1)(A) (“A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt . . . for a tax or a customs duty . . . of the kind and for the periods specified in section 507(a)(3) or 507(a)(8) of this title, whether or not a claim for such tax was filed or allowed . . . .”). Trust fund taxes are always prioritized and are never dischargeable irrespective of the age of the debt. See 11 U.S.C. §§ 507(a)(8)(C), 523(a)(1)(A).

After considering the statutory framework and the legislative history, the Third Circuit stated that “[w]e also find significant the fact that third-party sales taxes resemble trust fund taxes more than other sales taxes even though the source of taxation is a sales transaction. After all, such taxes are owed not by the debtor, but are merely held by the debtor on behalf of the party that owes the tax to be transferred to the taxing authority at a later time.”  The Court then looked at New Jersey’s own treatment of its sales tax and stated that “[u]nder New Jersey law, “the vendor collects the tax from its customers, and holds it in trust until it is reported and turned over to the State. This is not a tax imposed on the vendor but on the vendor’s customer, and as such is what is commonly called a ‘trust fund’ tax.” [citations omitted].

Based on this analysis, the Court finally concluded that “public policy concerns weigh against Calabrese, primarily because sales taxes collected by a retailer never become the property of the retailer…”  That is, the Court said that the sales taxes are retained by the retailer in trust for the state.  Accordingly, the Court affirmed the District Court (which affirmed the Bankruptcy Court) and held that Calabrese’s sales-tax obligation is subject to Section 507(a)(8)(C) and is not dischargeable. 

This case may have an important consequence on owners of New Jersey retail businesses if they do not pay their sales tax.  First, lenders need to understand that the Third Circuit (in line with NJ state Courts) have held that sales taxes in NJ are entitled to trust fund status, and thus, collected sales taxes arguably are not subject to a lender’s lien.  Secondly, there may be personal liability for any person who is responsible to collect sales taxes, and the failure to remit those sales taxes will not be dischargeable in bankruptcy.  The failure to pay sales taxes in NJ could have a substantial adverse impact, and thus, owners and lenders would be wise to understand consequences of not paying those taxes.