A consensual resolution among all stakeholders is an important goal of any bankruptcy proceeding. But how can parties reach a consensual deal if financing is drying up quickly and the prospect of confirming a plan is grim? That was the issue facing the Rockport debtors (the “Debtors”) in their Delaware bankruptcy cases styled In re The RP Co. Liquidating, LLC. In this case, the Debtors filed a motion asking the bankruptcy court to approve a global settlement (the “Settlement”) with all parties-in-interest—except the Office of the United States Trustee (the “U.S. Trustee”). The Settlement offered general unsecured creditors the chance to receive a distribution in exchange for certain debtor and third-party releases.
But despite the parties’ ingenuity in Rockport, the U.S. Trustee objected to the Settlement and the bankruptcy court sustained the objection, finding that the Settlement was an impermissible “sub rosa plan.”
The unraveling of the Rockport Settlement serves as an important reminder of factors that should be considered while structuring global settlements in bankruptcy cases.
The Settlement was executed on October 3, 2023 by and among the Debtors, their secured prepetition and DIP lender Charlesbank (“Charlesbank”), their largest unsecured creditor Reef Lifestyles (“Reef”), and the official committee of unsecured creditors (the “UCC”). In sum, the terms of the Settlement were as follows:
- The UCC waived all claims against Charlesbank and Reef;
- The Debtors and the UCC would send a notice to all holders of general unsecured claims requesting that such creditors sign and return a mutual release agreement (the “Mutual Release Agreement”);
- The Mutual Release Agreement would provide that the consenting creditor release the Debtors, Charlesbank, and Reef from all claims in exchange for (1) the Debtors, Charlesbank, and Reef releasing all claims against the consenting creditor (including Chapter 5 claims), and (2) a pro rata share of a $500,000 segregated account from Charlesbank’s cash collateral (the “Unsecured Creditor Reserve”); and
- Neither Charlesbank nor Reef would be eligible to receive any portion of the Unsecured Creditor Reserve.
Citing Section 105 of the Bankruptcy Code and Bankruptcy Rule 9019, the Debtors argued that the Settlement was fair and reasonable and satisfied the factors Third Circuit courts should consider as outlined in In re Martin, 91 F.3d 389 (3d Cir. 1996). Specifically, the Debtors argued that:
- The probability that the UCC will be successful in any future litigation against Charlesbank and/or Reef was speculative, any recovery by the UCC will either be paid mainly to Charlesbank or Reef, and the Settlement provides a guaranteed recovery to consenting holders of general unsecured claims;
- The Settlement will save the Debtors’ estates significant expenses, avoid termination of the DIP facility by challenging Charlesbank’s loans, and avoid “the very real risk” of administrative insolvency by expediting the pace of closing the Chapter 11 cases;
- The Settlement is in the paramount interest of creditors because it conserves estate resources by circumventing litigation between the parties and providing the consenting creditors with a distribution from the Unsecured Creditors Reserve they almost certainly would not otherwise receive; and
- The Settlement will not impair any creditor who elects not to sign the Mutual Release Agreement, and that the non-consenting creditor would retain its right to assert claims against the Debtors, Charlesbank, and/or Reef.
In essence, the Debtors argued that the Settlement was a superior alternative to what could otherwise be lengthy, resource-intensive litigation related to the Debtors’ preference actions, Charlesbank’s $56 million secured claim, Reef’s $6.7 million claim for outstanding services owed by the Debtors, and the UCC’s claims against Charlesbank and Reef.
The U.S. Trustee’s Objection
The U.S. Trustee objected to the Settlement on various grounds, including that the Settlement violated Section 1129(a) of the Bankruptcy Code by making distributions to certain junior creditors ahead of administrative and priority claims without the court first confirming a plan. The U.S. Trustee also argued that in a Chapter 11 proceeding, Sections 1122, 1123, 1125, and 1141 of the Bankruptcy Code provide that estate assets are distributed through a court-approved plan to assigned classes of creditors, which only occurs after creditors receive a disclosure statement containing adequate information and have had an opportunity to vote on the plan. The U.S. Trustee argued that the Debtors sought to subvert these Bankruptcy Code requirements through the Settlement.
The Bankruptcy Court Denies the Settlement
Sustaining the U.S. Trustee’s objection, the bankruptcy court denied the Debtors’ motion, calling the Settlement a “sub rosa plan.” As the name indicates, a sub rosa plan is a transaction that acts as a de facto Chapter 11 plan but seeks to evade the Bankruptcy Code’s requirements for plan confirmation and the absolute priority rule. Thus, although the Settlement provided general unsecured creditors with a $500,000 distribution, provided for mutual releases among the parties, and reflected the threat that Charlesbank may not consent to the Debtors’ use of cash collateral to get through a plan process, the bankruptcy court held that the Settlement did not comport with the Bankruptcy Code and therefore must be denied.
Although the parties executed a creative, fulsome compromise to resolve several material issues and nearly all of the UCC’s concerns, the bankruptcy court held that the agreement did not comply with the strict requirements of the Bankruptcy Code. Importantly, the bankruptcy court’s ruling does not strike a death knell to the Settlement, but rather requires the parties to incorporate the Settlement into a Chapter 11 plan of liquidation, albeit at a higher price tag than Charlesbank desired. Thus, the Settlement may very well be approved by the bankruptcy court as part of a confirmed plan, instead of as a standalone settlement.
Due to the escalation of interest rates which raises the cost of capital, it is no surprise that bankruptcy practitioners will seek creative solutions that reduce the fees incurred in a Chapter 11 cases, promote efficiency, and avoid contentious confirmation battles. The bankruptcy court’s decision serves as a reminder that there is a risk that a global settlement executed outside of a plan may be rejected as a sub rosa plan. But parties should not let the Rockport decision dissuade them from seeking relief under Bankruptcy Rule 9019 when applicable caselaw supports approval of the settlement outside of a plan context. Creativity will always be a staple in the restructuring industry, but balancing such inventiveness with statutory requirements will forever be the proverbial tightrope.
 No order denying the Settlement motion has yet been entered as of the publication of this article.