In In re ICL Holding Co., Inc., et al., the Third Circuit Court of Appeals held that funds escrowed by the secured lender for the payment of professional fees and other administrative expenses in connection with a Section 363 sale were not property of the estate, and, therefore, not subject to the absolute priority rule.

Factual Background

The Debtors (LifeCare Holdings, Inc.), once a leading operator of long-term acute care hospitals, encountered financial troubles in 2012 and sought Chapter 11 protection in the Bankruptcy Court for the District of Delaware. The day before the filing, the Debtors and their secured lenders executed an asset purchase agreement pursuant to which the secured lenders would credit bid for the Debtors’ assets as well as pay the professional fees of both the Debtors and creditors’ committee and the Debtors’ wind-down costs. Because some of the professional fees had not yet been earned, the agreement also directed the purchaser to deposit cash funds into separate escrow account for the coverage of these fees and expenses.

After an auction, the bid submitted by the Debtors’ secured lenders was deemed the highest and best bid. To resolve an objection raised by the unsecured creditors’ committee, the secured lenders agreed to deposit $3.5 million into a trust for the benefit of the general unsecured creditors. The Debtors sought approval of this agreement through a separate 9019 motion.

The U.S. government objected to both the sale and the settlement agreement. The government opposed the sale because it would result in a $24 million capital gains tax that would remain unpaid but other priority claims, such as the expenses for estate professionals and the Debtors’ wind-down costs, would be paid. The U.S. government objected to the settlement with the creditors’ committee arguing that it violated the absolute priority rule, because general unsecured creditors would receive payment while higher priority tax claims, like the capital gains tax, would go unpaid.

The bankruptcy court overruled both objections on the ground that neither the escrowed funds nor the trust funds for the creditors’ committee were property of the estate and were therefore not subject to the code-based fairness or absolute priority rules.

Analysis

On appeal, the U.S. government pursued its objections to both the sale and the settlement agreement. The government again challenged these, because the escrowed fees used to pay estate professionals and wind-down costs and to finance the settlement with the committee were funds utilized to acquire the Debtors’ assets and should have been distributed according to the code’s payment structure.

Addressing the settlement proceeds first, the Third Circuit held that the cash paid by the secured lenders to the creditors’ committee was never property of the estate and noted that the settlement sums were not proceeds of collateral subject to the secured lenders’ liens. In reaching this conclusion, the Third Circuit focused on whether the settlement proceeds were given as consideration for the assets purchased at the Section 363 sale and concluded that the evidence showed they were not.

Turning to the escrowed funds, which the Third Circuit deemed a slightly more complicated analysis than the settlement proceeds, the Court held that these funds were also not property of the estate. The government argued, and the Third Circuit acknowledged, that the asset purchase agreement included the escrowed funds as part of the purchase price, but the Court focused on the economic reality of what occurred as opposed to the language in the asset purchase agreement. Because the asset purchase agreement provided for the Debtors’ to surrender all of their assets to the secured lenders, including their cash, the Court found that no property of the estate remained once the sale closed. The Court went on to note that the escrowed funds were not consideration for the assets, but instead, were to facilitate a smooth transition of the sale. The fact that these funds were paid through escrow arrangements bolstered the Third Circuit’s reasoning.

The Third Circuit’s treatment of the escrowed funds and its focus on the “economic realities” of the sale, as opposed to the language of the asset purchase agreement, opens the door for new sales transactions as a Chapter 11 exit option.