Second Circuit opinion
The Second Circuit recently issued an opinion that addressed two separate appeals in In re DBSD North America, Inc.(1) The first ruling could make it more difficult for a secured creditor to resolve disputes with junior constituents over plan distributions, while the second may provide leverage to debtors in negotiations with strategic investors attempting to block or propose a plan of reorganisation. In DBSD Sprint-Nextel Corporation appealed lower court orders confirming a plan that made a partial distribution to Sprint's unsecured creditor class and also provided for distributions to DBSD's parent company on account of its ownership of stock in the debtor. Sprint argued that the absolute priority rule codified in Section 1129(b)(2)(B) of the Bankruptcy Code forbids distribution of any property to a bankrupt company's equity holders on account of their stock when a class of unsecured creditors that voted against the plan is not paid in full.(2) DBSD's plan was confirmed on the grounds that the distributions to equity and unsecured creditors were 'gifts' from second lien secured creditors that were absolutely entitled to the property because the value of DBSD's assets was less than the amount of its secured debt.(3) The Second Circuit overruled confirmation of the plan and agreed with Sprint, ejecting the gifting doctrine that had previously been recognised by courts in the Southern District of New York. The DBSD court also rejected the appeal of DISH Network Corporation from the ruling that its vote against DBSD's plan of reorganisation was cast in bad faith and should be "designated" – effectively, disqualified – pursuant to Section 1126(e) of the Bankruptcy Code.(4) DISH had acquired all of DBSD's first lien debt, at par, after DBSD filed its plan. The evidence showed that DISH acquired the secured debt specifically to vote against DBSD's plan and to propose its own plan to acquire DBSD's assets.(5) The Second Circuit agreed with the lower courts and affirmed the designation of DISH's vote.
DBSD was formed to "develop an integrated mobile satellite and terrestrial services network".(6) In May 2009 DBSD filed for Chapter 11 relief to reorganise a debt structure that included, among other things, approximately $40 million of first lien secured debt and $740 million of undersecured second lien convertible notes.(7) At the same time, ICO Global Communications (Holdings) Limited, DBSD's non-debtor parent company and sole shareholder, entered into a plan support agreement with holders of second lien debt. The support agreement contemplated a plan of reorganisation that would convert the second lien debt into new common stock of reorganised DBSD and distribute to the parent shares and warrants representing nearly 5% of the new common stock.(8) In July 2009 DBSD filed an amended plan of reorganisation consistent with the support agreement that reinstated the first lien debt through a modified promissory note.(9)
In addition to the gift to the parent, the plan provided that the class of unsecured creditors that included Sprint – which held an unliquidated, unsecured claim allowed at $2 million for voting purposes – would receive new common stock estimated to represent a recovery of between 4%and 46%.(10) Sprint objected to the plan on the grounds that the absolute priority rule prevents distributions to holders of stock in a debtor unless unsecured creditor classes either vote for a plan or receive the full value of their claims. The bankruptcy court overruled Sprint's objection to the plan, finding that the holders of the second lien debt could 'gift' part of their distribution to the parent to secure the parent's support of the plan. According to the bankruptcy court, if a creditor is entitled to property from the estate, "it may generally do whatever it wishes with such property, including transferring it to other holders of claims or interests", whether it agrees to do so during or after the bankruptcy case.(11)
After the plan was filed, DISH purchased the entire principal amount of the first lien debt at par, as well as part of the second lien debt.(12) The bankruptcy court found that "DISH's actions and intent [could] be observed and inferred from the circumstances and its own documents".(13) That intent was to acquire DBSD's secured debt as a strategic investment in an attempt to attain a blocking position in the plan approval process, and ultimately to propose a competing plan under which it would acquire DBSD's assets.(14) Consistent with this intent, DISH voted all of its claims against confirmation of the plan.(15) The bankruptcy court ruled that DISH had acquired the first lien debt and cast its votes in bad faith because it "sought to advance interests apart from recovery under the Plan".(16) The court then granted DBSD's motion to designate DISH's vote of its first lien debt claims pursuant to Section 1126(e) of the Bankruptcy Code and, because DISH was the sole member of its class, ignored the vote of the class of first lien debt holders for plan confirmation purposes.(17) The US District Court for the Southern District of New York affirmed the bankruptcy court's decisions with respect to both Sprint and DISH.(18)
On February 7 2011 the Second Circuit issued an opinion explaining its reasons for granting Sprint's appeal and affirming the lower courts' decisions with respect to DISH's appeal.(19) Before reaching the merits of Sprint's appeal, the Second Circuit considered arguments that Sprint had no standing to appeal because it was an out-of-the-money unsecured creditor recovering under the plan only through a gift from second lien debt holders. The court ruled that standing to appeal the orders of a bankruptcy court should not be based on projected creditor recoveries. Rather, any creditor with a valid, impaired claim has the right to appeal.(20) Having established Sprint's right to appeal, the Second Circuit next concluded that the gift to the parent violated the absolute priority rule because it allowed the parent to receive property under the plan on account of its equity interests before unsecured creditors were paid in full.(21) In reaching this decision, the Second Circuit looked to historic Supreme Court decisions that prevented senior creditors and equity holders of railroad trusts (which were often the same people) from colluding to wipe out unsecured creditors.(22) These decisions were codified in the Bankruptcy Code and its predecessor statute as the absolute priority rule. UnderSection 1129(b) of the Bankruptcy Code, a plan of reorganisation cannot be confirmed over the objections of a class of creditors unless the plan is, among other things, "fair and equitable" with respect to that class. Section 1129(b)(2)(B) provides that with respect to a class of unsecured claims, the condition that a plan is fair and equitable includes the requirement that it provide that either:
- each holder of a claim of such class receives property of a value equal to the amount of the claim; or
- "the holder of any claim or interest junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property".
The court reviewed the text of the absolute priority rule and found that Sprint was impaired and did not vote in favour of the plan, while the parent, "on account of" a stock interest junior to Sprint's claim, would recover "property" in the form of new common stock "under the plan".(23)
The plan specifically provided that "the Holder of such Class 9 Existing Stockholder Interest shall receive the Existing Stockholder Shares and Warrants".(24) The court rejected arguments that the parent was not receiving the new common stock on account of its junior interest, but rather to secure its continued support in management of the reorganised company. The court relied on Supreme Court precedent to find that recovery by a junior creditor that is even partly on account of its claim violates the absolute priority rule.(25)
DBSD and other appellees argued that the plan satisfied the absolute priority rule because the parent received its distribution as a "gift" from the holders of second lien debt. The value of DBSD's assets was less than the amount of its secured debt. Accordingly, the value of Sprint's unsecured claim was zero and, under the plan, Sprint was getting more than the value of the allowed amount of its claim.(26) The Second Circuit recognised that gifting is a tool that can accelerate efficient bankruptcies, but found that in light of the clear and codified language of the absolute priority rule, gifts provided on account of a junior interest holder's claim through a plan of reorganisation are impermissible.(27) The Second Circuit also noted the "substantial policy arguments" against gifting. These include preventing shareholders that control the debtor from enriching themselves through gifting at creditors' expense.(28) Finally, the court specifically refrained from deciding whether a senior creditor could agree to provide a "gift" to a junior creditor if that gift were granted in a private agreement outside of a bankruptcy plan.(29)
The Second Circuit next turned to DISH's appeal and decided that a creditor's votes may be designated if they are cast with a motive other than "mere self-interested promotion of their claims".(30) Not all ulterior motives constitute bad faith, but "DISH purchased the claims as votes it could use as levers to bend the bankruptcy process toward its own strategic objective of acquiring DBSD's spectrum rights, not toward protecting its claim".(31) This conclusion was bolstered by statements in DISH's internal documents, its position as DBSD's competitor, its willingness to "overpay for the claims it bought" and its attempt to propose its own plan.(32) Based on that evidence, the Second Circuit held that DISH's claim was properly designated.(33) The court also found that disregarding DISH's class for voting purposes following the designation of its claims was logical because DISH was the sole member of its class.(34) In its opinion, the Second Circuit noted that it was not foreclosing strategic transactions in bankruptcy, but rather "simply limit[ing] the methods by which parties may pursue them".(35) The court refrained from deciding whether a "preexisting" creditor could vote with strategic intentions and stressed that the opinion was not a "categorical prohibition on purchasing claims with acquisitive or other strategic intentions", noting that "[o]n other facts, such purchases may be appropriate".(36) Finally, the court dismissed claims by DISH that the bankruptcy court erred in finding the plan to be feasible, noting that there was sufficient proof in the record to reasonably support the conclusion that DBSD would avoid further reorganisation or liquidation following implementation of the plan.(37)
The Second Circuit's opinion in DBSD limits strategic options for senior creditors and debtors in the bankruptcy context. It is now clear that senior creditors may not agree to transfer any part of their distribution to junior class members through a cramdown bankruptcy plan proposed in Second Circuit courts. However, gifting is not an issue if all impaired classes vote to accept a proposed plan. Therefore, gifting strategies may still be available to senior creditors, although any intermediate classes that are not paid in full under such a plan will have significantly more leverage to extract their own gifts, since they could defeat proposed gifts to junior classes and make a gifting plan unconfirmable simply by voting against it. The DBSD decision also affirms that strategies to acquire bankruptcy claims with the intent of defeating an existing bankruptcy plan or proposing a competing plan for strategic, rather than merely monetary, value to the proponent may lead to disqualification of votes.
However, the Second Circuit's decision on DISH's appeal is limited by the "bad facts" of the case. The court appeared particularly troubled by the fact that DISH purchased its claim after DBSD had already filed its proposed plan of reorganisation. The court made clear in its opinion that not all strategic investments in claims against a debtor are in bad faith. Nonetheless, the Second Circuit's opinion on DISH's appeal may give leverage to debtors in negotiation with strategic investors, since they could rely on DBSD as precedent to litigate the good faith of any plan proposed by such an investor and in an attempt to disqualify such an investor's vote against any other plan. The DBSD opinion provides a cautionary example of the manner in which long-held expectations of bankruptcy investors and practitioners can be upset overnight. Bankruptcy stakeholders and practitioners often focus their strategies and negotiations on the practical goals of getting deals done quickly, with a minimum of litigation, conflict and risk. This can lead to the adoption of approaches that do not always square perfectly with the plain meaning and intent of the Bankruptcy Code. Bankruptcy courts have often indulged practitioners by approving these approaches, turning them, over time, into rules or doctrines that conflict with the Bankruptcy Code. Circuit courts of appeal, by contrast, appear to have far less appetite for allowing deviations from the plain meaning of the Bankruptcy Code and are willing to strike down even longstanding lower court doctrines when they are inconsistent with the plain language of the statute. DBSD provides a clear example of this dynamic.(38) The Third Circuit's recent opinion in In re Philadelphia Newspapers, LLC(39) provides yet another example. There, the Third Circuit shocked the bankruptcy bar by ruling that a secured creditor could, under certain circumstances, be deprived of its right to credit bid in a sale process conducted pursuant to a plan. The Third Circuit arrived at this result through a very technical interpretation of the applicable statutory language, disregarding the widespread view that such an interpretation was at odds with the general statutory scheme and the protection of the rights of secured creditors in particular.(40) Because strict construction of the Bankruptcy Code has been mandated by the Supreme Court, there is no cause to believe that this trend will change. That being the case, bankruptcy investors and practitioners should consider whether their reliance on other unwritten rules and practical conventions is well placed, or whether such rules might suffer the same fate as the gifting doctrine.
For further information on this topic please contact James L Garrity Jr at Shearman & Sterling LLP by telephone (+1 212 848 4000), fax (+1 212 848 7179) or email ([email protected]).
(1) DISH Network Corp v DBSD N Am, Inc (In re DBSD N Am, Inc), Nos 10-1175, 10-1201, 10-1352, 2011 WL 350480 (2d Cir Feb 7 2011).
(4) Id at *16. The Bankruptcy Code provides that "on request of a party in interest... the court may designate any entity whose acceptance or rejection of such plan was not in good faith" (11 USC § 1126(e)). Claims designation is a method of disqualifying a creditor's bad-faith votes. The concept of good faith is not defined by the Bankruptcy Code, however, and courts have been left to interpret its meaning through case law.
(6) In re DBSD N Am, Inc, 421 BR 133, 134 (Bankr SDNY 2009).
(7) In re DBSD N Am, Inc, 2011 WL 350480, at *2.
(8) In re DBSD N Am, Inc, 419 BR 179, 185 (Bankr SDNY 2009).
(9) In re DBSD N Am, Inc, 421 BR at 135.
(10) In re DBSD N Am, Inc, 2011 WL 350480 at *2.
(11) In re DBSD N Am, Inc, 419 BR at 211 (citing Official Unsecured Creditors Comm v Stern (In re SPM Mfg Corp), 984 F 2d 1305, 1313 (1st Cir 1993)).
(12) In re DBSD N Am, Inc, 421 BR at 135.
(17) In re DBSD N Am, Inc, 419 BR at 205.
(18) In re DBSD N Am, Inc, No 90-13061, 2010 WL 1223109, at *5 (SDNY Mar 24 2010).
(19) In re DBSD N Am, Inc, 2011 WL 350480.
(22) Id at *10 (citing N Pac Ry Co v Boyd, 228 US 482 (1913); Rock Island & Pac RR v Howard, 74 US 392 (1868)).
(25) Id at *12 (citing Bank of Am Nat'l Trust & Sav Ass'n v 203 N LaSalle St P'ship, 526 US 434, 456-58 (1999)).
(29) Id at *11. Transfer of shares outside of a bankruptcy plan could raise other issues, including whether the debtor or any transferor is an underwriter for securities law purposes.
(38) The Third Circuit, which is the only other circuit level court to consider gifting in the context of a Chapter 11 plan, also clearly ruled against the gifting doctrine in its opinion in In re Armstrong World Indus, Inc, 432 F 3d 507 (3d Cir 2005). After Armstrong, courts in the Third Circuit have approved distributions to junior classes in settlements under Bankruptcy Rule 9019 – for example, In re World Health Alternatives, Inc, 344 BR 291, 298-99 (Bankr D Del 2006) (finding that a settlement pursuant to which a secured creditor gave up a portion of its lien for the benefit of unsecured creditors did not violate the absolute priority rule). Outside the Third Circuit, there are also a small number of cases of gifting to junior classes under a plan of reorganisation – for example, In re Journal Register Co, 407 BR 520, 533 (Bankr SDNY 2009) (authorising a gift from secured creditors to unsecured creditors).
(39) 599 F 3d 298 (3d Cir 2010).
(40) The tension between bankruptcy jurisprudence and circuit-level review is not an entirely new trend. The Seventh Circuit's decision in In re Kmart Corp 359 F 3d 866 (7th Cir 2004) was an example of a circuit court imposing significant restrictions on the widespread practice of paying favoured pre-petition vendors notwithstanding the clear statutory prohibitions on favouring pre-petition creditors.