What better time than the holiday season to discuss “gifting” in the context of chapter 11 cases.  “Gifting” commonly refers to the situation where a senior creditor pays (or allocates a portion of its collateral for the benefit of) one or more junior claimholders.  Gifting is often employed as a tool to resolve the opposition of a junior class of creditors, who are typically out-of-the-money, to the manner in which the bankruptcy case is being administered.  For instance, creditors’ committees may seek gifts from senior creditors to guarantee a recovery for general unsecured creditors in cases where a debtor’s administrative solvency or ability to confirm a chapter 11 plan are in doubt.

While gifting may provide flexibility in certain chapter 11 cases, some have argued that the technique runs afoul of the so-called “absolute priority” rule embodied in Section 1129 of the Bankruptcy Code.  The absolute priority rule prohibits confirmation of a plan that provides for a distribution of property to junior creditors unless all senior creditors either receive the full value of their claims or consent to alternative treatment under the plan.

The Third Circuit Court of Appeals, whose rulings bind the Delaware bankruptcy courts in which a significant number of large chapter 11 cases are administered, first addressed gifting in 2005 in In re Armstrong World Industries, Inc.  In that case, the plan provided that if one class of general unsecured creditors rejected the plan, then another class of general unsecured creditors (asbestos personal injury claimants), would receive, but immediately waive receipt of, certain warrants, which would then be issued to equityholders.  While the Third Circuit concluded that such a plan violated the absolute priority rule, it reasoned that the carve out from the secured creditor’s collateral for the benefit of a junior claimant may not offend the absolute priority rule because the property belongs to the secured creditor, not the bankruptcy estate.  Delaware bankruptcy courts have relied onArmstrong and other cases to permit gifting outside of a chapter 11 plan.  This permits secured lenders and third-party purchasers to provide funds to general unsecured creditors where a recovery may not otherwise have been possible.

More recently, in September 2015, the Third Circuit confirmed that a gift made by a secured lender to junior creditors does not offend the absolute priority rule, at least under certain circumstances.  In ICL Holding Company, Inc., the debtors’ senior lenders credit bid approximately 90% of their claims for the purchase of the company.  The offer did not include any cash, though funds were escrowed to pay certain chapter 11 professionals.  Two parties objected to the sale: (i) the creditors’ committee, which argued that the sale only benefited the secured lenders and would leave the estates administratively insolvent, and (ii) the United States Government, which argued that the sale would result in capital gains taxes of approximately $24 million, giving the United States an administrative claim that would go unpaid while other administrative claims (namely professional fees) would be paid in full.  Before the court ruled on the objections, the creditors’ committee struck a deal, withdrawing its objection in exchange for a $3.5 million cash payment from the lenders for the benefit of general unsecured creditors.  The debtors did not reach an agreement with the government.

The Bankruptcy and District Courts rejected the government’s arguments, concluding that the funds set aside for general unsecured creditors and chapter 11 professionals were not property of the Debtors’ estates and therefore not subject to the absolute priority rule.  In an opinion written by Judge Ambro, a former bankruptcy practitioner, the Third Circuit agreed with the lower courts.   Judge Ambro reasoned that because the funds paid by the lenders to general unsecured creditors were not proceeds from the lenders’ liens, never belonged to the debtors, and would never become part of the debtors’ estate even as a pass-through, they were not property of the estates.  The Third Circuit also held that the funds set aside to pay professional fees and other wind down costs were similarly not property of the estates, because any unused escrowed funds were to be returned to the lenders, not the estates.

While the ICL Holdings decision authorizes a gift from a senior lender to a junior creditor, the facts present a fairly easy case, and there is dicta in the opinion indicating that gifts effectuated through means unlike those at issue in ICL Holdings may be more problematic.  Most notably, Judge Ambro’s opinion explains that a gift effectuated through a carve out of a secured lenders’ collateral for the benefit of a junior class would likely be a gift of property of the estate.  Such a gift may still be permissible, but after ICL Holdings, it will be harder for courts in the Third Circuit to conclude that it does not implicate property of the estate.