In chapter 11 bankruptcies, the absolute priority rule states that a plan of reorganization may not be confirmed if it provides for a distribution to any class that is junior in priority to a rejecting impaired class, if such distribution is made under the plan and on account of the junior class’s claims or interests. However, the gifting doctrine, holds that a creditor may nevertheless reallocate its bankruptcy recoveries as it pleases, including by transferring a portion of those recoveries to favored junior creditors. Courts in various jurisdictions have approved this premise by confirming chapter 11 plans that incorporate gifts that reorder distributions in apparent contravention of the absolute priority rule or the prohibition against unfair discrimination.
Plans of reorganization based on gifting take three main forms. First, a senior creditor could gift a distribution to junior creditors or old equity over creditors of intervening priority.
Second, a senior creditor could make a gift to a favored subset of junior creditors, without skipping over an intervening class of creditors. Finally, a gift could be made to a subset of junior creditors, while also skipping over intervening creditors. While plans containing gifts designed to leap-frog intervening creditors have been analyzed under an absolute priority rubric, plans based on gifts to a subset of equal-priority creditors are more likely to face an unfair discrimination analysis.
On February 7, 2011 the Second Circuit Court of Appeals in Dish Network Corp. v. DBSD N. Am. Inc. (In re DBSD N. Am. Inc.) held that a bankruptcy court could not confirm a chapter 11 plan that provided for a gift from a secured lender in the form of equity in the reorganized debtor to old equity over the objections of unsecured creditors.1 According to the Second Circuit, such “gifts” from senior creditors over intervening creditor classes violate the absolute priority rule. The DBSD decision has drawn significant commentary, much of which suggests that the gifting doctrine is now a dead-letter in the Second Circuit jurisdictions. To the contrary, a close reading of DBSD reveals that only the subset of gifting plans that implicate the absolute priority rule have been disapproved.
DBSD was founded in 2004 to develop and operate a mobile communications network that combined satellite and land-based broadcast technologies. In 2005, DBSD issued $650 million in convertible senior secured notes due in August 2009. In early 2009, when it became clear that the network would be unable to launch on schedule, the company obtained a $40 million first lien revolving credit facility. Nevertheless, as the maturity date on its senior secured notes neared, DBSD concluded that it would be unable to meet its obligations. On May 15, 2009, DBSD filed chapter 11 petitions with the Bankruptcy Court for the Southern District of New York. As of the petition date, the company’s schedules listed $627 million in assets and $813 million in liabilities, leaving the second lien noteholders substantially undersecured.
Rather than providing equity in the reorganized company to holders of first lien debt, DBSD proposed a plan of reorganization pursuant to which the revolver lenders would receive new four-year PIK debt. The equity in reorganized DBSD would be allocated between the (second lien) noteholders, who would receive 99.85% of new equity, and unsecured creditors. The plan further provided that, following these distributions, the noteholders would automatically “gift” five percent of their recovery to old equity.
Sprint Nextel Corp., an unsecured creditor, argued that the plan violated the absolute priority rule. Despite Sprint’s objection, the bankruptcy court, and subsequently the district court, concluded that the distribution to old equity constituted a valid gift and therefore did not violate the absolute priority rule.
DBSD: The Second Circuit’s Holding
On appeal, the Second Circuit noted that the Bankruptcy Code prohibits cramdown of a chapter 11 plan unless the plan can be shown to be “fair and equitable” with respect to impaired classes of claims that vote to reject the plan. While the Bankruptcy Code does not fully define what it means for a plan to be “fair and equitable,” it makes clear that a plan cannot be fair and equitable if it violates the absolute priority rule. Specifically, a plan may not provide for a distribution to any class that is junior in priority to a rejecting impaired class, if such distribution is made (i) under the plan and (ii) on account of the junior class’s claims or interests. Accordingly, the Second Circuit found that “[a]bsent the consent of all impaired classes of unsecured claimants, therefore, a confirmable plan must ensure either (i) that the dissenting class receives the full value of its claim, or (ii) that no classes junior to that class receive any property under the plan on account of their junior claims or interests.”2 Second, the court observed that it was undisputed that Sprint, an unsecured creditor, would receive less than the full value of it claims.
Given that Sprint would receive less than the full value of its claims under the plan, the court considered whether (i) the gifted distribution to old equity constituted “property,” (ii) those distributions were made “under the plan” and (iii) those distributions were made on account of old equity interests. The court found little difficulty in answering all three questions in the affirmative. First, as the Supreme Court held in Ahlers, the term property, as used in section 1129 of the Bankruptcy Code, should be construed broadly, and would, in any case, include shares of equity and warrants.3 Second, the plan’s disclosure statement stated that holders of old equity “shall receive the Existing Stockholder Shares and the Warrants.” Given that the disclosure statement unambiguously stated that the gift would be made as a result of the plan, the Second Circuit concluded that the gift was “clearly” made “under the plan.” Finally, the disclosure statement stated that the gift would be made “[i]n full any final satisfaction, settlement, release and discharge of each Existing Stockholder Interest.” In the face of explicit language stating that the gift would serve to discharge old equity interests, the Second Circuit concluded that, even under the test most favorable to holders of old equity, the gift constituted a distribution “on account of” old equity.
Conversely, the debtors and noteholders argued that creditors are free to reallocate their distributions at their discretion without running afoul of the absolute priority rule. The Second Circuit was unconvinced and concluded that where a plan allows old equity to (i) receive property, (ii) under the plan, (iii) on account of its prior interest, and (iv) over the objection of an objecting impaired creditor class, it violates the absolute priority rule, regardless of whether such recovery theoretically flows from the reallocation of a senior creditor’s recovery. Although the court acknowledged the existence of policy arguments in favor of a broad interpretation of the gifting doctrine, it also recognized countervailing arguments in favor of a robust absolute priority rule. The court reasoned that Congress had considered policy arguments both for and against robust absolute priority and made a conscious decision to adopt it when drafting the Bankruptcy Code. Thus, the court concluded that allowing a “gift” to circumvent absolute priority would “not square with the text of the Bankruptcy Code” as the absolute priority rule protects all property of the estate, rather than merely any estate property not covered by a lien.
DBSD: What was Not Said
DBSD can properly be characterized, as many commentators have observed, as a staunch defense of the absolute priority rule in chapter 11 cases. It is not, however, a deathblow to the gifting doctrine in its entirety. While the court rejected the proposed application of the gifting doctrine to the facts of the case, it did not reject the gifting doctrine in full. Instead, the court distinguished prior case law on factual grounds. As an initial matter, the court noted that the gifting doctrine originated in Official Unsecured Creditors’ Committee v. Stern (In re SPM Manufacturing Corp.),4 which was decided in the context of chapter 7, and thus did not face “the rigid absolute priority rule of §1129(b)(2)(B).”44 Second, the undersecured creditor making the gift in SPM had obtained relief from the automatic stay to foreclose on its collateral. In contrast, the noteholders in DBSD had not obtained such relief. The DBSD court therefore concluded that the undersecured creditor in SPM had a strong claim that the property at issue belonged to it, rather than the bankruptcy estate, whereas the noteholders in DBSD had no basis for such a claim. At the very least, the DBSD court’s analysis makes clear that the gifting doctrine has not been eliminated under the right facts and in the context of chapter 7.
Perhaps more important, however, the DBSD court’s analysis focused entirely on the absolute priority rule and did not address unfair discrimination. Accordingly, gifting may remain viable where a proposed gift distribution does not skip intervening creditor classes. Post-SPM, the gifting doctrine evolved along several distinct, if at times intertwined, branches. On the one hand, “traditional” gifting plans, such as those in DBSD, involve gifts that skip over intervening creditors to provide junior creditors (or old equity) with a recovery. These plans are analyzed under an absolute priority rubric. In the wake of DBSD, it may be fair to say that this sort of gift plan — subject to certain caveats — is a thing of the past in the Second Circuit. On the other hand, a second branch of the gifting doctrine involves plans that contain “selective gifts” that provide a recovery to a subset of equal-priority creditors. These plans have generally been analyzed under an unfair discrimination — rather than absolute priority — framework. As DBSD’s analysis was confined to absolute priority and did not speak to unfair discrimination, there may be reason to believe that “selective gifting” remains a valid tool in the Second Circuit.
Finally, it is unclear that DBSD foreclosed even the functional equivalent of a “traditional gifting” plan. One key to the Second Circuit’s ruling was that the distributions provided to old equity occurred “under the plan.” Indeed, the court stated that it “need not decide whether the Code would allow the existing shareholder and Senior Noteholders to agree to transfer shares outside of the plan . . . .”5 In In re Journal Register Co., however, the court found that distributions made from an account funded with senior lender property, even if established by a chapter 11 plan, did not occur “under the plan.”6 Applying the logic of Journal Register to the holdings of DBSD, it is not difficult to envision a plan that accomplishes the functional equivalent of a traditional gifting plan while strictly adhering to the text of the absolute priority rule.
Conclusion: “Selective Gifting” Lives
DBSD is a rejection of the idea that creditors are free to end-run the absolute priority rule through “gifts.” It does not, however, necessarily follow that the Second Circuit intended to overturn the entire doctrinal edifice. Until a circuit court says otherwise, cases approving “selective gifting” remain good law and should be kept in mind as an option to maximize estate value and otherwise resolve a challenging reorganization.