One of the fundamental principles of bankruptcy law is the absolute priority rule, which provides that the proceeds of a bankruptcy estate should be distributed first to creditors in order of priority and, if and when creditors are paid in full, to equity holders. While this appears to be a simple and straightforward legal doctrine, bankruptcy courts often are presented with difficult questions regarding when distributions would violate the rule, such as when creditors agree to “gift” part of their distributions to others under a plan of reorganization.

Recently, the issue of whether the absolute priority rule would be violated by the approval of a settlement between a Chapter 7 bankruptcy trustee and the U.S. Securities and Exchange Commission (SEC) was reviewed by the U.S. Bankruptcy Court for the Eastern District of Pennsylvania. In a decision, dated Dec. 2, 2015, by U.S. Bankruptcy Judge Stephen Raslavich in In re Covenant Partners LP, Bankruptcy No. 14-17568 (Dec. 2, 2015) (Eastern District of Pennsylvania), the court approved a settlement that fixed the amount of an unsecured claim filed by the SEC against the debtor for violation of federal securities laws. The objecting creditors alleged that the SEC would receive preferential treatment vis-à-vis other creditors, that the limited partners effectively would receive a distribution before creditors in violation of the absolute priority rule, and the settlement was not in the best interest of the creditors. They also argued the trustee did not adequately investigate the SEC’s claim.

SEC Asserts Claim Likely to Benefit Defrauded Investors

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