Although the concept dates back several decades, in recent years “gifting” plans have become popular vehicles for avoiding the Bankruptcy Code’s absolute priority rule: a portion of the senior creditor’s recovery is “gifted” to a more junior class (skipping an intermediate class or classes) to gain the approval of stakeholders whose approval is strategically important, but who would otherwise receive no distribution under a plan. On February 7, 2011, the Second Circuit Court of Appeals in In re DBSD North America, Inc.,1 declared that such a plan violated the absolute priority rule. Although the Third Circuit had weakened the gifting doctrine in the 2005 decision of In re Armstrong World Industries, Inc.,2 the recent DBSD decision may have eliminated it in the context of a Chapter 11 plan.
In the First Circuit case In re SPM Mfg. Corp.,3 frequently cited as establishing the “gifting” doctrine, SPM’s secured creditor and the unsecured creditors agreed that the assets of the estate would be sold pursuant to Section 363, the case converted to a Chapter 7, and the proceeds shared among the secured and unsecured creditors. However, before distributions from the 363 sale could be made, SPM objected, claiming that the sharing arrangement impermissibly violated the absolute priority rule by skipping over priority tax creditors, who were not parties to the sharing agreement and who would receive nothing from it. The First Circuit held the arrangement valid, stating that the secured creditor was free to “gift” its recoveries to other creditors once the bankruptcy estate was liquidated.
Later courts extended the gifting doctrine in a variety of contexts, such as from senior unsecured creditors to junior (and subordinated junior) creditors4 as well as from senior creditors directly to old equity.5 In 2005, however, the Third Circuit in Armstrong World Industries reviewed the doctrine in the context of a proposed plan granting warrants to the existing shareholder.
The court held that this arrangement violated the absolute priority rule, stating that SPM Mfg. and its progeny “do not stand for the proposition that creditors are generally free to do whatever they wish with the bankruptcy proceeds they receive.”6 According to the court, section 1129(b)(2)(B)(ii) “makes it clear that a plan cannot give property to junior claimants over the objection of a more senior class that is impaired[.]”7 Despite the plan proponents’ claims that the new warrants were provided in exchange for the existing shareholder’s release of an intercompany claim, the court determined that the value of the warrants so far exceeded the value of the intercompany claim that the warrants must have been at least partly on account of the existing shareholder’s interest in the debtor. Accordingly, unless the general unsecured creditors consented to the plan, or their claims were satisfied in full, the plan could not be confirmed.
DBSD North America gave the Second Circuit the opportunity to consider the gifting doctrine, and it determined that a plan in which a senior creditor class gifted new equity to the existing shareholder where an intermediate class was not paid in full and did not consent, violated the absolute priority rule.8
The DBSD plan provided that general unsecured creditors would participate in a tiny portion (0.15%) of the new equity of DBSD on a pro rata basis. The second lien noteholders would receive the remaining new equity. Based on an agreement between the debtor’s second lien noteholders and the existing shareholder entered into before the bankruptcy was commenced, the second lien noteholders would retain approximately 95% of all of the equity remaining after distribution to the general unsecured creditors, while the existing shareholder would take the other 5% as a “gift” from the distribution otherwise allocable to the second lien noteholders. This resulted in an actual distribution of 4.99% of the new equity to the existing shareholder, and a mere 0.15% to the general unsecured creditors. Sprint Nextel, an unsecured creditor, challenged this distribution scheme. The court’s threshold inquiry was whether Sprint Nextel had standing to appeal. Despite the argument that Sprint Nextel, as an out-of-the-money creditor, was not harmed by the plan (as it could not count on any recovery), the court found that as an unsecured creditor Sprint Nextel did have standing to pursue the appeal. The court took the broad view that any impaired creditor in a case, whether in or out of the money, has standing to appeal.
Turning to the merits, and quoting section 1129(b)(2)(B)(ii), the Second Circuit stated that “the plan may be confirmed. . .only if the existing shareholder, whose interest is junior to [the objecting creditor], does ‘not receive or retain’ ‘any property’ ‘under the plan on account of such junior interest.’”9 Despite the characterization of the distribution as a gift from the second lien noteholders, and without challenging the estimation of value of the distribution to the second lien noteholders (which did not pay them in full), the court nonetheless held that Section 1129(b)(2)(B)(ii) prevented the junior stakeholder from obtaining, under the plan, any distribution on account of its equity interest in the absence of payment or consent of all senior classes.
Questions remain as to what extent the gifting doctrine may survive the Second Circuit’s decision. Is the limitation applied in DBSD only relevant to a plan in a Chapter 11 case, leaving open the possibility of gifting in a Chapter 7 case? Does the 363 sale process still provide a possible avenue for gifting, as in SPM Mfg.? Will stay relief and stipulations regarding ownership, specifically addressing that property distributed by gift is no longer property of the estate under Section 541 become more common as a technique to add certainty to the “gifting” senior creditor’s assertions that it is merely dealing with its own property, and not property of the estate? Can the secured creditor take its recovery, and share it after the fact (outside of the plan) with junior classes? And following DBSD, does the need to convince all senior classes to consent to a junior class distribution within a plan simply reinforce the appropriate relative bargaining positions of the various classes of claims in a case?
In distinguishing SPM Mfg., the court gives a few clues. First, it focuses on section 1129 (which is absent in the Chapter 7 context) as the basis for its ruling. By drawing attention to the distinction, and not criticizing SPM Mfg., the court shows a route to a different result in a Chapter 7 case. Second, the court notes the distinguishing feature of relief from stay granted in SPM Mfg., leaving open the possibility of accomplishing the ends of a gifting plan once the assets being distributed are no longer part of the debtor’s estate. In the Chapter 11 context, this approach could perhaps most easily be distinguished from DBSD in the case of a Section 363 sale of less than all assets, minimizing the risk that an allocation to junior stakeholders could be characterized as part of a sub rosa plan, and thus within the reach of DBSD.
DBSD clearly stands for a strong and literal interpretation of the absolute priority rule under Section 1129. And its holding is consistent with the historical derivation of the absolute priority rule which addressed old railroad reorganization cases in which the secured bondholders would conspire with and "gift" a portion of their recoveries to the old equity holders and "squeeze out" intermediate creditors. On the other hand, resolution of Chapter 11 cases often requires creativity to provide the incentives that may be needed to implement a plan that is both confirmable and results in a healthy reorganized entity. When those incentives are not perfectly aligned with the absolute priority rule, we can count on creative stakeholders and their advisers to test all of the possible approaches noted above, and more.
For additional information concerning this alert, please contact the following lawyers:
Jeffrey S. Sabin, Partner
This article was originally published by Bingham McCutchen LLP.