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Payments Made by Secured Creditors to Unsecured Creditors Not Subject to Priority Scheme

The United States Court of Appeals for the Third Circuit recently ruled that payments made by a secured creditor to unsecured creditors and their professionals were not property of the estate and, thus, not subject to the Bankruptcy Code’s priority scheme. In In re LCI Holding Co., 802 F.3d 547 (3rd Cir. 2015), lenders to an operator of long-term acute care hospitals credit bid $320 million of the $355 million of secured debt that they had lent to the debtor. In connection with the bid and to resolve objections, the lenders agreed to pay the debtor’s unsecured creditors $3.5 million and the unsecured creditors committee’s professional fees. The bankruptcy court approved the sale over the United States Government’s objection that the payments made to the unsecured creditors and their professionals violated the Code’s priority scheme. The bankruptcy court held that the funds placed in escrow by the secured lenders were not property of the estate and not subject to distribution to the debtor’s creditors. The Government appealed the decision. The 3rd Circuit affirmed the bankruptcy court’s decision, holding that the funds were not property of the estate or proceeds of the lenders’ collateral, but were instead the lender’s property. As a result, the Bankruptcy Code’s priority scheme was not violated.

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