On February 7, 2011, in a highly anticipated decision, the Second Circuit Court of Appeals held that in Chapter 11 reorganizations, senior creditors may not “gift” recoveries to junior creditors and/or equity interest holders over the objection of an intervening class. In In re DBSD N.A., Inc., __ F.3d __, 2011 WL 350480 (2d Cir. 2011), the majority ruled that such “gift plans” run afoul of the “absolute priority rule,” which is codified in Section 1129(b) of Bankruptcy Code. The decision has significant implications for future bankruptcy cases in New York.
The Absolute Priority Rule and Gift Plans
The absolute priority rule is relatively straightforward: if a class of creditors objects to a Chapter 11 plan, that plan may not distribute any value to subordinate classes of creditors until the objecting class receives full value, as described in the Bankruptcy Code, for its claim. However, certain courts have permitted deviation from the absolute priority rule in certain circumstances, pursuant to “gift plans.”
Under a gift plan, a senior claimant allocates value it would otherwise receive to a junior claimant as a “gift,” even over the objection of an intermediate creditor that is being crammed-down. The rule was established by the First Circuit in In re SPM Manufacturing Corp., a case converted to Chapter 7 liquidation. Because the case was a liquidation, the absolute priority rule was not implicated. The First Circuit held, in oft-quoted language, that “creditors are generally free to do whatever they wish with the bankruptcy dividends they receive, including to share them with other creditors.”1 The holding in SPM was extended to Chapter 11 reorganizations in Texas in In re MCorp Fin. Inc.,2 and in Delaware in In re Genesis Health Ventures Inc.3
Subsequent cases, such as the Third Circuit’s decision in In re Armstrong World Industries, Inc.4 (confirmation of a gift plan denied; unsecured creditors could not gift to equity over objection of another class of unsecured creditors in a Chapter 11 reorganization), the Delaware bankruptcy court’s decision in In re World Health Alternatives, Inc.5 (distinguishing Armstrong, permitting gift plan), and the Second Circuit’s decision in In re Iridium Operating LLC6 (denying gift plan where secured creditors’ liens were not absolute) have cast doubt as to the applicability of SPM, and the permissibility of gift plans, in the Chapter 11 context. DBSD has clarified much of this remaining uncertainty, at least in the Second Circuit.
In DBSD, the debtors proposed a plan of reorganization that reinstated the first lien debt, converted the second lien debt to the bulk of equity in the reorganized company, and provided some equity for unsecured creditors as well. Under the proposed plan, holders of prepetition equity of the debtors would also receive shares and warrants in the reorganized company.
Sprint Nextel Corporation, an unsecured creditor with a litigation claim, objected to the plan. Sprint argued, among other things, that the plan violated the absolute priority rule because it provided equity to the old shareholders, even though Sprint was not receiving full value on its claim.
DBSD: Second Circuit Analysis and Holding
After determining that Sprint had standing to appeal, the Second Circuit applied the absolute priority rule to the facts in a straightforward manner. The court determined that Sprint received less than half the value of its claim and, therefore, the plan could only be confirmed if the equity, whose interest is junior to Sprint’s, did not receive or retain any property under the plan on account of such junior interest. The Second Circuit disagreed with the bankruptcy court’s determination that under the “gifting doctrine,” the shares and warrants rightfully belonged to the second lien debt, which could share them with equity in its discretion, thereby defeating Sprint’s absolute priority rule objection. Because the equity did receive property under the plan on account of its interest, the Second Circuit held that the bankruptcy court should not have confirmed the plan.
Recognizing the various policy arguments in favor of the gifting doctrine (i.e., that gifting can prevent contested bankruptcies and hold-out behavior by objecting creditors), the Second Circuit also identified policy arguments in favor of maintaining the primacy of the absolute priority rule: “Shareholders retain substantial control of the Chapter 11 process, and with that control comes significant opportunity for self-enrichment at the expense of creditors.”7 The Second Circuit continued that “[t]his case provides a nice example. Although no one alleges any untoward conduct here, it is noticeable how much larger a distribution the existing shareholder will receive under this plan (4.99% of all equity in the reorganized entity) than the general unsecured creditors put together (0.15% of all equity), despite the latter’s technical seniority.”8 In any event, the Second Circuit held that the Bankruptcy Code’s adoption of the absolute priority rule was clear and must be respected.
DBSD could have significant implications for plan negotiations in Chapter 11 cases. For example, it will be more difficult for parties to bankruptcy proceedings in New York to transfer value to junior parties via a gift plan so as to achieve a consensual result. In certain cases, that may present challenges for senior secured creditors. However, in broader terms, the Second Circuit’s respect for the sanctity of the absolute priority rule could ultimately redound to the benefit of senior secured creditors, who stand at the “head of the line” in most Chapter 11 proceedings. Of course, it is not yet clear whether this holding will be followed in other significant jurisdictions, such as the Third Circuit, which includes Delaware