On February 8, 2011, the Second Circuit Court of Appeals issued an opinion that will have a major impact on Chapter 11 plan confirmation. In consolidated appeals stemming from the In re DBSD North America, Inc. bankruptcy case, the Second Circuit held that (1) the “gifting” aspect of the debtors’ plan of reorganization violated the absolute priority rule, and (2) the bankruptcy court did not err in designating a secured creditor’s vote as lacking “good faith” and disregarding that vote for purposes of confirmation.
The DBSD Plan
Under the plan proposed by DBSD, commonly referred to in Chapter 11 cases as a “gift plan,” the first lien debt was to be satisfied in full with new debt obligations issued by the reorganized entity, and the second lien debt was to receive a majority of the stock in the new entity. The plan then proposed to issue a small amount of stock, roughly 0.15 percent, to unsecured claimants, including Sprint, with a value estimated at between 4 percent and 46 percent of their original claims, and to “gift” approximately 5 percent of the shares and warrants in the reorganized entity to the existing shareholder. In a contested confirmation, the bankruptcy court confirmed the “gift” plan over the objections of both Sprint and DISH Network, the holder of the first lien debt, finding that the plan did not violate the absolute priority rule and that the plan was feasible. The bankruptcy court designated and disregarded DISH Network’s vote as cast in “bad faith” for purposes of confirmation.
The Sprint Appeal
On appeal, Sprint argued that the plan violated the absolute priority rule set forth in 11 U.S.C. § 1129(b)(2)(B) by awarding shares and warrants in the reorganized entity to a junior class (the existing shareholder) while a more senior class (the unsecured creditors’ class including Sprint) did not receive the full value of their claims and did not approve the plan. In response, the plan proponents argued that Sprint was “out of the money” and that the holders of the second lien debt, who were senior to Sprint and undersecured, were entitled to the full residual value of the debtors and were therefore free to “gift” some of that value to the existing shareholder if they so chose. The plan proponents essentially argued that the shares and warrants in the reorganized entity created by the plan were property of the secured creditors, who were entitled to do what they wished with them.
In a 2-1 decision, the Second Circuit ruled in favor of Sprint and explained that since Sprint did not receive property of a value equal to the allowed amount of its claim, any plan in which a junior creditor received or retained property under the plan on account of its interest violated the absolute priority rule. Applying a plain reading of 11 U.S.C. § 1129(b)(2)(B), the Court found that the existing shareholder clearly received “property,” “under the plan,” “on account of its interest.” The Court had little trouble in finding that the shares and warrants at issue constituted property within the meaning of Section 1129. The Court further elaborated that the warrants and shares at issue were property of the bankruptcy estate, not of the secured creditors. The secured creditors had every right to demand a plan in which they received 100 percent of the reorganized entity, but by choosing not to, they waived ownership and the right to exercise control over the property. As explained by the Court, the Code extends the absolute priority rule to “any property” of the estate, not just “any property not covered by a secured creditor’s lien.”
Likewise, the Court had no trouble finding that the existing shareholder received the property “under the plan.” The debtors’ disclosure statement contained language clearly explaining that the existing shareholder would receive shares and warrants in the reorganized entity pursuant to the proposed plan. The Court was quick to point out that this “under the plan” prong of the analysis was central to its ruling, and left for another day whether the Code would allow an existing shareholder and senior debtholders to agree to transfer shares outside of the context of a plan of reorganization.
Finally, the Court determined that the existing shareholder received its shares and warrants “on account of” its interest in the debtors. While there were clearly other valid reasons to provide shares and warrants to the existing shareholder, receipt of property under a plan even partly because of a junior interest in the debtors is sufficient to meet the “on account of” tests delineated by the United States Supreme Court in Bank of Am. Nat’l Trust & Sav. Ass’n v. 203 N. LaSalle St. P’ship and its progeny. A copy of the LaSalle opinion can be found here. The Court also noted that the courts have hesitated to allow old owners to receive new ownership interests even when contributing new value; therefore, it is highly doubtful that Congress intended for the courts to allow old owners to receive new ownership when they contribute no new value whatsoever.
The Court acknowledged that gifting can be a powerful tool in leveraging a consensual resolution of a Chapter 11 case and that enforcing the absolute priority rule could encourage objecting creditors to hold out; however, gifting can lead to mischief between the secured creditors and existing, often controlling, shareholders and provide an opportunity for self-enrichment to the detriment of other legitimate creditors. The Court reasoned that protection against these evils clearly outweighed the benefits provided by allowing a “gifting” exception to the rule. More importantly, the Court pointed out that Congress was well aware of the benefits and disadvantages of the absolute priority rule and chose to codify the absolute priority rule without exceptions such as the “gifts” that were in question in this case.
The DISH Network Appeal
DISH Network, meanwhile, appealed the bankruptcy court’s finding that DISH voted against the plan in bad faith, and the bankruptcy court’s subsequent decision to disregard DISH’s vote for confirmation purposes. Shortly after DBSD filed its plan, DISH, a competitor of the debtors, purchased all of the first lien debt at face value, with an agreement that the sellers would object to the plan. DISH later adopted these objections and voted against the plan. The plan proponents asserted that DISH voted its claim in bad faith and that its vote should be designated and disregarded under 11 U.S.C. § 1126.
The Second Circuit unanimously upheld the bankruptcy court’s finding of bad faith on the part of DISH. The Court found sufficient evidence in the record to support the bankruptcy court’s conclusion that DISH’s motive in purchasing and voting the claim was to “obtain a blocking position,” and to “control the bankruptcy process for this potentially strategic asset,” the exact sort of behavior that 11 U.S.C. § 1126(e) was enacted to prevent. The Court noted that while not just any ulterior motive rises to the level of “bad faith,” DISH’s motive of blocking the plan and “acting with an interest other than an interest as a creditor” was the type of ulterior motive that Section 1126(e) was designed to protect against. The Court found that DISH was “less interested in maximizing the return on its claim than in diverting the progress of the proceedings to achieve an outside benefit,” namely blocking the plan and procuring the debtors’ spectrum rights.
The Court was careful to point out that its decision was not intended to “shut the door on strategic transactions,” it “simply limits the methods by which parties may pursue them.” According to the Second Circuit, the bankruptcy court did not prevent DISH from pursing the strategic assets, it simply prevented DISH from using its votes to secure an advantage over other creditors in such pursuit. Additionally, the Court pointed out that its ruling was limited to creditors that obtain blocking positions – the Court refused to expand its ruling to the situation in which a preexisting creditor votes with ulterior motives and strategic intentions.
The Second Circuit’s ruling will have a major impact in Chapter 11 cases going forward. First, it significantly curtails the use of non-consensual gift plans. It is still up in the air, however, whether or not a secured creditor and existing shareholder could agree to a gift outside of the confines of a plan of reorganization. Additionally, the Court’s ruling as to DISH Network could adversely affect creditors that buy claims with the eye toward using those claims, and the votes associated with such claims, for strategic benefit. Though the Court was careful to point out that it was not seeking to put an end to such practice, the opinion does provide some ammunition for a plan proponent seeking to have an adversary’s claim designated and disregarded for confirmation purposes. However, a bankruptcy court’s decision to designate a vote remains a fact-intensive inquiry on a case-by-case basis and creditors must assess the risk that their votes may be designated and disregarded.