Although 2011 saw major decisions concerning many facets of bankruptcy law, perhaps no area of bankruptcy law drew as many high-profile decisions as the standards for confirming a chapter 11 plan of reorganization. We draw your attention to three particularly important 2011 decisions that are likely to heavily influence the contours of many future chapter 11 plans.
Designating Votes Not Cast in Good Faith
On February 7, 2011, the United States Court of Appeals for the Second Circuit issued an opinion in DBSD North America, Inc. that has major implications for two aspects of chapter 11 plan confirmation: (a) the so-called “gifting” doctrine and (b) creditor vote designation. See 634 F. 3d 79. In the first part of its opinion, the Second Circuit concluded that the “gift” contained in the debtor’s proposed chapter 11 plan violated the absolute priority rule and thereby rendered the plan unconfirmable. As we explained in our May 2011 issue of the International Restructuring NewsWire, the DBSD court narrowed the scope of the gifting doctrine by holding that it could not be used to circumvent absolute priority. However, the court left open the possibility that gifting can be used to overcome “unfair discrimination” challenges to confirmation.
This issue of the NewsWire focuses on the second major issue addressed by the DBSD opinion, claim designation. The Second Circuit affirmed the bankruptcy court’s decision to designate (i.e., disallow) votes cast by DISH Network Corp. because it found that the votes were cast to further an “ulterior strategic motive” unrelated to its interests as a creditor of DBSD. Sophisticated investors in distressed debt would be well-advised to pay close attention to this ruling.
DBSD was founded in 2004 to develop and operate a mobile communications network that combined satellite and land-based broadcast technologies. To fund that development, DBSD issued senior secured notes. When it became clear that the network would be unable to launch on schedule, the company obtained a first lien revolving credit facility to meet its working capital needs. Nevertheless, as the maturity date on its senior secured notes neared, DBSD concluded that it would be unable to meet its obligations and filed for chapter 11 protection. Ultimately, DBSD proposed a plan of reorganization under which the holders of first lien debt would receive replacement debt payable in kind. The senior secured noteholders would receive 99.85% of new equity. Unsecured creditors would receive 0.15% of new equity.
Vote Designation Upheld
After the plan was proposed, DISH purchased the entirety of DBSD’s first lien revolver debt at par (as well as a portion of the senior secured notes). DISH then voted to reject the plan. In response, DBSD filed a motion seeking to “designate” (i.e., disallow) DISH’s vote with respect to its first-lien debt, arguing, among other things, that DISH’s vote was not intended merely to convey that payment to creditors must be increased, but rather that the vote was a strategic attempt to stymie the Debtors’ reorganization and ultimately seize control of the company. The Debtors relied on Section 1126(e) of the Bankruptcy Rule which states, in relevant part, that a court may designate any entity whose acceptance or rejection of a plan “was not in good faith.” Nowhere does the Bankruptcy Code define “good faith.”
In objecting to the motion to designate its votes, DISH claimed that it was a “model bankruptcy citizen.” It cited the fact that it had “not moved to terminate exclusivity . . . [or] propose[d] a competing plan” to support its assertion. However, in a textbook example of how not to win favor with a bankruptcy court, on the very day before the confirmation hearing, DISH filed a motion to terminate exclusivity and for authority to propose a competing plan. DISH also proposed a transaction with DBSD — the details of which were not made public — that (apparently) further evidenced its intent to take control of DBSD’s assets. Based on those and other factors, the bankruptcy court concluded that “DISH made its investment . . . not as a traditional creditor seeking to maximize its return on the debt it holds, but as a strategic investor, ‘to establish control over this strategic asset.’” Accordingly, the bankruptcy court concluded that DISH did not act in “good faith” and designated its vote.
On appeal, the Second Circuit established certain bright line rules for examining “good faith” under section 1126(e) of the Bankruptcy Code. First, the court concluded that merely purchasing claims in order to block a plan of reorganization does not amount to lack of good faith. The court also found that acting selfishly in purchasing and voting claims does not establish lack of good faith. Instead, lack of good faith may exist where creditors “venture beyond mere self-interested promotion of their claims” and instead act to obtain some benefit to which they are not entitled. Specifically, creditor conduct is suspect where votes are cast to obtain more than the fair value of their claims or for some other impermissible ulterior motive. The court was careful to point out that not just any ulterior motive is sufficient to warrant vote designation. Instead, 1126(e)’s good faith requirement is intended to prohibit conduct whereby a creditor is willing to sacrifice value on its claim in order to realize some outside benefit.
Based on the foregoing, the Second Circuit reached the conclusion that DISH’s vote was properly designated by the bankruptcy court. The court highlighted several facts that it believed relevant to the examination, including (i) DISH’s admission that it voted to capture a strategic asset, (ii) overpayment of claims by DISH, (iii) DISH’s attempt to propose its own plan or reorganization and (iv) internal communications within DISH that demonstrated an intent to take control of DBSD’s bankruptcy process.
The Second Circuit noted that its ruling “should deter only attempts to ‘obtain a blocking position’ and thereby control the bankruptcy process . . . .” Given that bankruptcy investing often involves building a blocking position, the Second Circuit’s “only” notation may be of little comfort to parties seeking an active role in a bankruptcy case. Although the court emphasized that its “opinion imposes no categorical prohibition on purchasing claims with acquisitive or other strategic intentions,” activist investors should now carefully consider their options before investing in bankruptcy claims.
Largest 2011 Bankruptcy Filings
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When Obtaining a Blocking Position Makes You an Insider
In the second major decision of 2011 to highlight the risks of intentionally acquiring substantial bankruptcy claims, the Bankruptcy Court for the District of Delaware in In re Washington Mutual, Inc., 461 B.R. 200, granted the equity committee standing to pursue claims for equitable disallowance against certain activist noteholders (the “Noteholders”). The claims for equitable disallowance were based upon, among other things, “colorable claims” that the Noteholders became non-statutory insiders by obtaining blocking positions in two classes of claims and then trading on material non-public information relating to plan negotiations.
Shortly after Washington Mutual, Inc. (also known as “WaMu”) filed for bankruptcy, multiparty disputes arose regarding ownership of certain assets previously held by WaMu’s subsidiary, Washington Mutual Bank. In order to participate in plan negotiations (which principally involved a settlement concerning ownership of the disputed assets), the Noteholders signed certain confidentiality agreements that obligated them to either establish ethical walls or refrain from trading in WaMu’s debt or other securities during relevant confidentiality periods. The confidentiality agreements also obligated the Debtors to publicly disclose all material, non-public information shared with the parties at the end of each confidentiality period. The disclosure, it was thought, would allow the parties to resume trading without fear of insider trading allegations.
As negotiations progressed, the Noteholders refrained from trading during confidentiality periods and the Debtors made various disclosures, including information relating to certain tax refund proceeds. The Debtors did not, however, disclose the status of negotiations (or even that negotiations were ongoing) or the stances taken by the various parties during the negotiations.
In March 2010, the Debtors submitted a plan calling for a global settlement of ownership disputes and other causes of action to the bankruptcy court for approval. In addition to the Debtors, the plan was supported by, among others, the Noteholders and the official creditors’ committee. The official equity committee, holders of “trust preferred securities” and certain other creditors objected. On January 13, 2011, the bankruptcy court found that the global settlement proposed by the plan was fair and reasonable, but denied confirmation for other reasons. The plan was then amended to address the cited deficiencies and again submitted to the court for consideration. Support for and opposition to the amended plan again divided largely along the same lines.
Equity Committee’s Arguments
In opposing the amended plan, the equity committee advanced two primary arguments. First, the equity committee contended that the plan was not proposed in good faith because the Noteholders “dominated” and “hijacked” the bankruptcy process by purchasing claims to obtain a blocking position. Judge Walrath rejected this argument, finding that the Noteholders actions enhanced recoveries to similarly situated creditors and did not unduly influence the Debtors’ behavior. (In this respect the Noteholders’ actions were markedly different than those of DISH in the DBSD case. In WaMu, the Noteholders sought greater recovery on their claims whereas in DBSD, DISH knowingly took a loss on its claims with the hope of achieving an outside strategic objective.)
Second, the equity committee argued that it should be granted standing to pursue the equitable disallowance of the Noteholders’ claims based on allegations of insider trading. In general, a party is liable for insider trading if it (i) trades securities while in possession of material, non-public information and (ii) owes a fiduciary duty to either the issuer of the securities or the party from which it received the material, non-public information. The equity committee argued that the Noteholders satisfied these criteria because the fact that negotiations were occurring (and the positions taken by parties during those negotiations) was material information that was never publicly disclosed. As a result, argued the equity committee, the Noteholders became non-statutory insiders of the Debtors.
The Court’s Opinion with Respect to Insider Trading Allegations
After reviewing the record, the bankruptcy court found “colorable” claims that the Noteholders had engaged in insider trading and that, accordingly, the equity committee should be granted standing to pursue claims for disallowance. In reaching that conclusion, Judge Walrath made a number of findings that distressed debt investors and others should consider.
Judge Walrath first concluded that the fact that settlement negotiations were occurring constituted material non-public information. Moreover, the court found that the Noteholders’ knowledge of the positions taken by parties during the negotiations, even where such positions did not result in a settlement, was material. Thus, the first element of an insider trading claim could be satisfied. In reaching its conclusions, the court specifically rejected arguments by the Noteholders that requiring disclosure of every position taken during settlement negotiations would be impractical. The court also specifically found that the Noteholders were not entitled to rely on the Debtors’ contractual obligation to disclose all material non-public information.
The court then turned to the second element of a possible trading claim, whether the Noteholders owed a fiduciary duty to some relevant party. On this point, the court concluded that, by intentionally acquiring a blocking position in certain creditor classes, the Noteholders became temporary or non-statutory insiders who owed duties to, and were required to act for the benefit of, those classes in which they held blocking positions. Based on the foregoing, the court reasoned that the Noteholders may have traded on material information that was unavailable to other members of these classes and, thus, be liable under the theory of “classical” insider trading.
As we discussed at Chadbourne & Parke’s October 20, 2011 presentation, “New Perils in Chapter 11 — Distressed Investing after Washington Mutual,” any party engaging in non-public settlement talks should be aware that post-confidentiality disclosure may now require releasing virtually all information that was conveyed during negotiations. The alternative is to require all parties to settlement negotiations to implement permanent ethical walls or, as suggested by Judge Walrath, to indefinitely refrain from trading. The latter options, of course, are difficult or unworkable for many active distressed debt investors. Accordingly, one solution – which we understand is already being implemented by some active investors – may be to require confidentiality agreements to include provisions that allow any party to negotiations to disclose, at the conclusion of the confidentiality period, any and all information that it reasonably believes might be regarded as material.
On February 17, 2012, Judge Walrath preliminarily approved a further-revised plan of reorganization. This plan appears to have the support of all major stakeholders. In addition to the settlements envisioned in previous iterations of the plan, the revised plan contains a settlement of the causes of action that the equity committee had been granted standing to pursue. Importantly, that settlement is conditioned on the court vacating key portions of its earlier opinion, including those provisions related to the alleged insider trading activities of the Noteholders. Surprising many, the court indicated a willingness to strike those provisions from its prior opinion and, in fact, partially vacated its ruling on February 24, 2012. Accordingly, the key question for active claims traders and other case parties in the future will likely be what affect Judge Walrath’s (partially) vacated opinion will have on case participation where insider trading claims could later be asserted.
Creditors’ Votes Must be Obtained for Each and Every Debtor (Unless You Plan Ahead)
In Tribune, Inc., another important decision out of the Bankruptcy Court for the District of Delaware, the court ruled that jointly administered plans of reorganization cannot be crammed down under section 1129(b) of the Bankruptcy Code without being accepted by at least one impaired class at each debtor under the jointly-administered plans. See No. 08-13141, 2011 WL 5142420 (Oct. 31, 2011). This is an important decision in “mega-cases” where there are often numerous (tens or even hundreds) of subsidiaries being jointly administered in bankruptcy. The decision is all the more important because, surprisingly, very few cases have previously addressed the issue.
In Tribune, two competing jointly-administered plans of reorganization for the more than 100 debtors were submitted for confirmation. The first plan (the “DCL Plan”) was supported by the debtors, the debtors’ secured lenders and the creditors’ committee. The second plan (the “Noteholder Plan”) was supported by certain parties holding senior unsecured debt at the parent debtor. Both plans divided creditor classes by, among other things, which Tribune entity owed the debt.
When the votes on both of the plans were tallied, the Noteholder plan had won creditor support from three creditor classes – two at the parent debtor and one class at a non-operating subsidiary. The DCL Plan, in contrast, obtained support from an impaired class at every debtor for which any votes were cast.
Arguments on the Scope of Section 1129(a)(10)
The creditors’ committee, represented by Chadbourne, argued that the Noteholder Plan was unconfirmable even under cramdown because section 1129(a)(10) of the Bankruptcy Code forbids plan confirmation where any creditor class is impaired unless at least one class of claims that is impaired under that individual debtor’s plan has accepted the plan. The committee contended that, because joint administration — unlike substantive consolidation — has no substantive impact on creditors’ rights, and because corporate separateness is intended to be strictly honored absent substantive consolidation, allowing creditors of one debtor to cram down a plan on the creditors of another debtor is impermissible. Section 1129(a)(10), should, it was argued, be treated as a debtor-by-debtor requirement.
The proponents of the Noteholder Plan responded that 1129(a)(10) simply refers to “the plan” and should therefore be tested on a “per-plan basis.” Further, the Noteholder Plan proponents contended that if the Noteholder Plan was unconfirmable under section 1129(a)(10), so too was the DCL Plan as it had not obtained an accepting impaired class at the debtors for which no creditors voted at all. In response, the DCL Plan proponents argued that there was precedent for treating classes as accepting in large, jointly-administered cases for debtors where no votes are cast.
After considering the arguments, Judge Carey determined that there was “nothing ambiguous” about section 1129(a)(10) and found that it must be satisfied on a debtor-by-debtor basis. He also ruled that, although there is precedent for treating silent or non-voting classes as accepting a plan in mega-cases where the debtor at issue is a relatively small entity, such treatment is only appropriate where creditors are warned in plain, bold text in the disclosure statement that failure to vote may result in their class being treated as accepting. Accordingly, the court denied confirmation of both plans on this basis (among others).
After the ruling in Tribune, proponents of jointly administered plans will have to be certain that they appeal to a broad base of creditors at each and every debtor. This remains true even where one debtor’s creditors are far more numerous and economically significant (for example, the parent debtor’s creditors) than the creditors of other affiliated debtors. Additionally, even where a plan has broad-based appeal, drafting parties should include language in their disclosure statements making clear that the Court may confirm the plan as to debtors whose creditors fail to vote.