The Bankruptcy Code sets forth the relative priority of claims against a debtor and the waterfall in which such claims are typically paid. In order for a court to confirm a plan over a dissenting class of creditors – what is commonly called a “cram-down” – the Bankruptcy Code demands that either (i) the dissenting class receives the full value of its claim, or (ii) no classes junior to that class receive any property under the plan on account of their junior claims or interests. This is known as the “absolute priority rule.”

Not surprisingly, rigid enforcement of the absolute priority rule can lead to some difficulties in confirming a plan. It can encourage a class of out-of-the-money creditors or equity holders to withhold their consent to the plan, which often results in time-consuming and expensive valuation fights and confirmation battles. Traditionally, a common solution to such a problem has been that a senior secured creditor gives a “gift” or “tip” – a distribution to which the senior creditor would otherwise be entitled – to an objecting junior class in order to buy peace and achieve a consensual plan. Courts generally permitted such plan provisions under the premise that such distributions are, in essence, “gifts” of the senior party’s property and not of estate property and simply do not implicate (and, thus, do not violate), the “absolute priority rule.”

The problem arises when the gift skips over a class that comes ahead of the gift-recipient class in the Bankruptcy Code priority scheme. In such cases, the “skipped” class of creditors may argue that, to satisfy the absolute priority rule, a plan must provide that its claims be paid in full before distributions are made to any junior class of creditors (or interest holders). In 2005, the Third Circuit condemned that approach in In re Armstrong World Industries as violating the absolute priority rule. And in a recently issued opinion, the Second Circuit Court of Appeals agreed with the Third Circuit, holding that the plan In re DBSD North America, Inc., which contained a gifting provision, should not have been confirmed.

DBSD was founded in 2004 by ICO Global Communications to develop a mobile communications network. By mid-2009, the network was still in the development stage, leaving DBSD with little if any revenue to offset its mounting debt obligations. Those obligations included a $40 million secured revolving credit facility with a first-priority security interest in all of DBSD’s assets (the “First Lien Debt”), and $650 million in convertible senior secured notes with a second-priority security interest in all of DBSD’s assets (the “Second Lien Debt”).

DBSD (but not its parent ICO) filed a petition under Chapter 11 on May 15, 2009, listing liabilities of $813 million against assets with a book value of $627 million. In other words, holders of the First Lien Debt were oversecured, while holders of the Second Lien Debt were undersecured.

After negotiations with various parties, DBSD proposed a plan of reorganization that provided that the holders of the First Lien Debt would be satisfied in full through issuance of new debt obligations. Holders of the Second Lien Debt would receive the bulk of the shares of the reorganized entity, worth between 51 percent and 73 percent of their original claims. Holders of general unsecured claims would receive shares, gifted by the holders of the Second Lien Debt, estimated as worth $850,000. ICO would receive shares and warrants in the reorganized entity, also gifted by the holders of the Second Lien Debt, worth an estimated $28.5 million.

Sprint, an unsecured creditor, objected to the plan, arguing among other things that the gift provision violated the absolute priority rule. Sprint noted that under the plan, the existing shareholder, whose interest was junior to Sprint’s class of general unsecured creditors, would receive substantial amounts of shares and warrants – much more than all of the unsecured creditors received together.

The bankruptcy court disagreed that the plan violated the absolute priority rule. It characterized the existing shareholder’s receipt of shares and warrants as a “gift” from the holders of the Second Lien Debt, who were senior to Sprint yet who were themselves not receiving the full value of their claims. The bankruptcy court reasoned that the holders of the Second Lien Debt could “voluntarily offer a portion of their recovered property to junior stakeholders” without violating the absolute priority rule. Indeed, the distribution to Sprint’s own class of general unsecured creditors was a gift, carved out from the value that would otherwise have accrued to the holders of the Second Lien Debt. The district court affirmed.

On appeal, the Second Circuit rejected the bankruptcy court’s view. Strictly interpreting the text of the Bankruptcy Code, the Court of Appeals stated that the absolute priority rule prohibits a class junior to a dissenting class from receiving any property, regardless of whether a senior creditor was otherwise entitled to that property. If a secured creditor, for whatever reason, chooses to receive less than the full distribution to which it is entitled, whatever is left remains in the estate and is subject to the priorities set forth in the Bankruptcy Code. In the Second Circuit’s view, the secured creditor has no right or ability under the Bankruptcy Code to direct the distribution of the value it leaves on the table.

The Second Circuit also rejected the district court’s finding that the gift to the existing shareholder was not “on account of” its junior interest. The district court had determined that there were additional reasons why ICO merited receiving the shares and warrants, including ICO’s continued cooperation and assistance in the reorganization. The Court of Appeals held that a transfer that is partly on account of factors other than the existing interest is still partly “on account of” that interest. Even the “continued cooperation” noted by the lower court was useful only because of ICO’s position as an equity shareholder and the rights emanating from that position. Thus, the court held, notwithstanding the additional economic reasons that may have contributed to the decision to give property to ICO, it was clear that ICO “could not have gained [its] new position but for [its] prior equity position.” Given that very sweeping view, it is hard to imagine any instance in which the court could find that a gift to equity was not at least partly “on account of” its prior equity position.

So does all this mean that Chapter 11 gifts are a dead letter? Not necessarily.

Note that gifts that do not skip classes – where the intermediate class is paid in full – are not problematic. Thus, the Second Circuit’s ruling has no bearing on plans where, in order to obtain a consensual plan, a secured creditor gifts priority creditors with payment in full and general unsecured creditors with enough of a distribution to win their approval.

It is also important to recall that the absolute priority rule only applies in a cram-down – that is, where the plan proponent seeks to confirm the plan over the objection of a dissenting class. If every class votes to accept the plan, the absolute priority rule isn’t implicated. Expect to see plan proponents employing the “carrot and stick” approach – if the skipped class votes in favor of the plan, it will receive a distribution; if it votes to reject the plan, it gets nothing. Although some courts frown on this kind of so-called “deathtrap,” many courts – including the Second Circuit Court of Appeals – have affirmed confirmation of plans containing such provisions. (Even with a deathtrap, however, the balance of power isn’t entirely one-sided. As the Second Circuit intimated in its opinion in DBSD, unsecured creditors can use the specter of the absolute priority rule as leverage to increase their distribution under a plan “if the ‘good business reasons’ for the gift to the [junior class] are still worth the cost” to the gift-giver.)

The Second Circuit also expressly declined to decide whether class-skipping gifts outside of a plan of reorganization would run afoul of the Bankruptcy Code. The court faced that issue in 2007 in In re Iridium Operating LLC, in which the unsecured creditors’ committee and the secured lenders sought approval of a proposed pre-plan settlement that carved out a recovery for unsecured creditors while skipping over administrative claimants. The Second Circuit held that in determining whether to approve the settlement under Bankruptcy Rule 9019, the settlement’s compliance with the absolute priority rule will often be the dispositive factor. However, the court also found that when other factors weigh heavily in favor of a settlement, the bankruptcy court has discretion to approve a settlement that deviates from the Code’s priority scheme, provided that such deviation is expressly justified. It appears that DBSD leaves this option open to plan proponents.

Nor does DBSD address the situation in which the secured creditor actually forecloses on its collateral and then carves out a distribution for a junior class of creditors – the scenario in the original gift strategy case, In re SPM Manufacturing Corp. (1st Cir. 1993). Distinguishing DBSD from SPM, the Second Circuit noted not only that SPM was a Chapter 7 case, but that “[i]n a very real sense, the property [in SPM] belonged to the secured creditor alone, and the secured creditor could do what it pleased with it.” This dictum suggests that a plan in which the secured creditor receives the entire residual value of the debtor and subsequently “does what it pleases with it” – even if “what it pleases” is a class-skipping gift – may still be viable.

There is no question that the Second Circuit’s decision represents an obstacle to the use of consensual gifting as a restructuring technique. But commentators who have suggested the Second Circuit’s decision in DBSD spells the end of class-skipping gifts in Chapter 11 bankruptcy cases may be overlooking the avenues for gifting that remain open – and may well be underestimating the creativity of restructuring professionals and plan proponents.