On July 25, 2012, the Third Circuit Court of Appeals held in In re American Capital Equipment, LLC and Skinner Engine Companies, Inc., 2012 WL 3024202 (3d Cir. July 25, 2012) that a bankruptcy court can determine at the disclosure statement stage that a Chapter 11 plan is unconfirmable without holding a formal confirmation hearing. Typically, the Chapter 11 process reserves contested confirmation issues for the confirmation hearing rather than the disclosure statement stage unless the confirmation hearing is held jointly with the hearing on approval of the disclosure statement. The practical implication of this decision is that it will allow participants in a bankruptcy case that are faced with a patently unconfirmable plan to short circuit the often lengthy, expensive and involved plan voting and confirmation process where no material facts are in dispute and the plan defect cannot be cured by creditor voting.

Debtors American Capital Equipment and Skinner Engine Company filed for bankruptcy protection in 2001 in response to cash flow issues and inability to service their secured debt. At the time of filing, there were over 29,000 asbestos claims pending against Skinner, all of which were consolidated and assigned to the Judicial Panel on Multidistrict Litigation in the Eastern District of Pennsylvania. The asbestos cases had been largely unsuccessful, and none of them had resulted in a settlement or judgment against Skinner. Skinner’s insurers were defending the asbestos suits at the time of the bankruptcy filing.

The Debtors proposed five bankruptcy plans over the period of 2001 to 2005. During this period, all of Skinner’s assets were sold to satisfy the debt to its secured lender with the exception of a $35,000 carve-out towards the cost of processing asbestos claims. The crux of the Debtors’ Fifth Amended Plan was to pay creditors, including asbestos claimants, out of the proceeds of insurance recoveries and the $35,000 carve-out. By the time of the filing of the Fifth Plan, the Court had already denied a prior plan which proposed the creation of a Section 524(g) asbestos trust on the grounds that the Debtors were no longer a going concern. The Fifth Amended Plan dropped the Section 524 trust and instead provided Court Approved Distribution Procedures (“CADP”) for settling asbestos claims with a trustee and a 20% surcharge for asbestos claimants who decided to opt in to the plan’s settlement process. The surcharge would be utilized to fund the plan payments to non-asbestos creditors and professionals. The Bankruptcy Court held that the plan was facially unconfirmable because it was not proposed in good faith in contravention of Section 1129(a)(3) of the Bankruptcy Code and was not feasible pursuant to Section 1129(a)(11). The District Court affirmed the decision and the Debtors appealed.

The Third Circuit held “that a bankruptcy court has the authority to [determine at the disclosure statement stage that a Chapter 11 plan is unconfirmable] if it is obvious that the plan is patently unconfirmable, such that no dispute of material fact remains and defects cannot be cured by creditor voting,” as was the situation in the current case warranting conversion to Chapter 7. “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.” The Third Circuit ultimately agreed with the lower courts’ determinations that the Fifth Amended Plan was neither feasible nor proposed in good faith as separately and independently required under Section 1129(a).

The Court noted that a plan will not be feasible if its success hinges on future litigation that is uncertain and speculative. In the present case, the sole source of funding the plan was the surcharge to asbestos claimants, which would be reliant solely upon “wholly speculative litigation proceeds,” as well as a sufficient number of asbestos claimants agreeing to opt in to the CADP process. The Court determined that the feasibility issue was uncurable because there could be no plan without the surcharge and no material factual dispute remained because the Appellants admitted that the surcharge would be a requirement of any plan proposed by the Debtors.

On the issue of lack of good faith, the Court held that “the Fifth Plan will not fairly achieve the Bankruptcy Code’s objectives because it establishes an inherent conflict of interest under circumstances that are especially concerning,” namely, the plan’s source of funding – the surcharge – only generates funds to pay the Debtors’ creditors and professionals when asbestos litigants win settlements against Skinner, thereby setting up a system in which Skinner is financially incentivized to sabotage its own defense. Among additional contributing factors leading to the Court’s finding of a lack of good faith under Section 1129(a)(3) were: (1) the fact that the CADP system would strip the insurers of certain procedural and substantive rights without the protection of a channeling injunction of Section 524(g) and (2) the fact that the filing of the Debtors’ cases was unrelated to asbestos litigation and the Debtors would not contribute to the plan payment fund but, rather, would pull from it to pay its non-asbestos creditors and professionals.

This decision allows participants in a bankruptcy case that are faced with a patently unconfirmable plan to short circuit the lengthy, expensive and involved plan voting and confirmation process in cases where the defect cannot be cured through creditor voting and those defects concern matters upon which all material facts are not in dispute or have been fully developed the disclosure statement hearing, particularly where the participants are being held hostage by a plan predicated upon uncertain and speculative litigation.