On February 7, 2011, in In re DBSD North America, Inc.,1 the Court of Appeals for the Second Circuit released its opinion joining the Third Circuit in condemning socalled “gifting plans,” thus deepening the perceived circuit split with the First Circuit which has been interpreted as approving of gifting plans. In so doing, the Second Circuit relied on the U.S. Supreme Court cases of Bank of Am. Nat’l Trust & Sav. Ass’n v. 203 N. LaSalle St. P’ship2 and Norwest Bank Worthington v. Ahlers3 as support for a strict interpretation of the absolute priority rule whereby no “existing shareholder [may] receive ‘property’. . .‘under the plan’. . .‘on account of’ its prior, junior interest.”4
DBSD’s plan of reorganization provided for existing shareholders, whose interests were junior to DBSD’s class of general unsecured creditors, to receive substantial quantities of shares and warrants in the reorganized debtor. Sprint Nextel Corporation (“Sprint”) asserted that, based on the estimated value of the reorganized debtor, those shares and warrants could turn out to be worth anywhere between $28.5 million and $270 million5, while unsecured creditors, like Sprint, were likely to receive a de minimis distribution on account of their claims.6 The bankruptcy court confirmed the plan on the basis that DBSD’s secured creditors were woefully undersecured and, as such, were the only parties entitled to any distribution under the plan.7 The bankruptcy court further reasoned that, once DBSD’s secured creditors received their distribution, they were free to do whatever they wanted with it, including provide a “gift” to the existing shareholders. Thereafter, the bankruptcy court decision was affirmed by the district court.8
Sprint, an unsecured creditor, objected to DBSD’s plan citing the absolute priority rule as its basis. The absolute priority rule, codified at 11 U.S.C. § 1129(b)(2)(B),9 provides that absent the consent of all impaired classes of unsecured claimants, a confirmable plan must ensure either (i) that the dissenting class receives the full value of its claims, or (ii) that no classes junior to that class receive any property under the plan on account of their junior claims or interests. Thus, Sprint argued, because the DBSD plan provided a recovery to the existing shareholders while not paying general unsecured creditors (who are senior in priority to equity holders) in full, the plain meaning of the absolute priority rule expressly prohibits DBSD’s gifting plan. As support for its argument, Sprint relied upon the 2005 Third Circuit decision of In re Armstrong World Indus., Inc.10 In Armstrong World, the Third Circuit held that not only did the absolute priority rule disallow gifting plans where a senior class provided a gift to a junior class when a dissenting intervening class was present, but it also applied in cases where general unsecured creditors provided a gift to shareholders, a case in which no intervening dissenting creditor is present.
The Second Circuit sided with Sprint and the Third Circuit holding that because of the gifting provisions in DBSD’s plan, the same should not have been confirmed11 First, the Second Circuit found there to be no doubt that the warrants and shares in question constituted “property” under § 1129(b)(2)(B). Second, the Court found that the shares and warrants were granted “under the plan” because the plan itself provided for the distribution. Finally, the shares and warrants were granted “on account of” the shareholder’s junior interest. The property need not be provided “solely” on account of the junior interest as long as it is provided at least partly because of that interest.
The debtor’s argument under the “gifting doctrine” was that the shares and warrants rightfully belonged to the secured creditors, who were entitled to share them with the existing shareholders as they saw fit. The fatal flaw with this argument, according to the Second Circuit, is that the Bankruptcy Code extends the absolute priority rule to “any property,” not “any property not covered by a senior creditor’s lien.” The Bankruptcy Code focuses entirely on who “receive[s]” or “retain[s]” the property “under the plan,” not on who would receive it under a liquidation plan.
The Second Circuit left open the issue of whether the Bankruptcy Code would allow existing shareholders and senior noteholders to agree to a transfer of shares outside of a plan. It also left open the possibility that a contribution of new value might permit a junior interest holder to receive property, but the “continued cooperation” provided by the existing shareholder in this case was not sufficient. The Second Circuit found further support for its strict interpretation of the absolute priority rule in the U.S. Supreme Court cases of 203 N. LaSalle and Ahlers whereby the Supreme Court “hesitated to allow old owners to receive new ownership interests even when contributing new value.”12 Thus, the Second Circuit reasoned, the Supreme Court would be unlikely to “allow old owners to receive new ownership without contributing any new value[.]”13
While the Second Circuit’s decision may be in line with the jurisprudence of the Third Circuit, the Second Circuit’s decision can be interpreted as being at odds with the First Circuit decision of In re SPM Manufacturing Corp.,14 which, despite being a case under Chapter 7, is often cited by other courts as permitting gifting plans.15 In SPM Manufacturing, the First Circuit approved of a gift from secured creditors to unsecured creditors, skipping over the dissenting holders of priority tax claims, by means of a support agreement outside of the plan construct. In so holding, the First Circuit famously stated that, while the debtor is “not allowed to pay nonpriority creditors ahead of priority creditors, creditors are generally free to do whatever they wish with the bankruptcy dividends they receive, including to share them with others.”16
The Second Circuit however distinguished the First Circuit’s holding on the basis that SPM Manufacturing addressed “gifting” in the context of a Chapter 7 liquidation. In this regard, the Second Circuit notes, citing Armstrong World, that “Chapter 7 does not include the rigid absolute priority rule of § 1129(b)(2)(B).”17 The Second Circuit further distinguished SPM Manufacturing on the basis that the bankruptcy court had granted the secured creditor relief from the stay and thus the property in question was not part of the estate, noting that “the property belonged to the secured creditor alone, and the secured creditor could do what it pleased with it.”18 The Second Circuit did not address whether a senior creditor could gift property after receiving its distribution.
It bears noting that the absolute priority rule owes its genesis to the United States Supreme Court which originated the absolute priority doctrine in the context of railroad reorganizations (which were often tainted with collusion). In re Wabash Valley Power Assn., Inc., 72 F.3d 1305, 1314 (7th Cir. 1995) (“In its origins, the absolute priority rule was a judicial invention designed to preclude the practice in railroad reorganizations of ‘squeezing out’ intermediate unsecured creditors through collusion between secured creditors and stockholders (who were often the same people)”). As early as 1899, in Louisville Trust Co. v. Louisville, N.A. & C.R. Co., the Supreme Court unequivocally rejected an attempt by mortgage holders to end-run the absolute priority rule and provide a recovery to equity holders when intervening creditors were not paid, stating:
It is no answer to these objections to say that a bondholder may foreclose in his own separate interest, and, after acquiring title to the mortgaged property, may give what interest he pleases to any one, whether stockholder holder or not; and so these several mortgagees foreclosing their mortgages, if proceeding in their own interest, if acquiring title for themselves alone, may donate what interest in the property acquired by foreclosure they desire. But human nature is something whose action can never be ignored in the courts, and parties who have acquired full and absolute title to property are not, as a rule, donating any interest therein to strangers. It is one thing for a bondholder who has acquired absolute title by foreclosure to mortgaged property to thereafter give of his interest to others, and an entirely different thing whether such bondholder, to destroy the interest of all unsecured creditors, to secure a waiver of all objections on the part of the stockholder, and consummate speedily the foreclosure, may proffer to him an interest in the property after the foreclosure. The former may be beyond the power of the courts to inquire into or condemn. The latter is something which on the face of it deserves the condemnation of every court, and should never be aided by any decree or order thereof. It involves an offer, a temptation, to the mortgagor, the purchase price thereof to be paid, not by the mortgagee, but in fact by the unsecured creditor.19
The DBSD decision has serious practice implications that will affect the Second Circuit and reach outward. The most important implication is that the DBSD decision signals the death of gifting plans in the Second Circuit, thus taking away a potentially valuable tool that can be used by debtors and senior creditors to garner consensus among creditors in order to push a plan to confirmation. Thus, instead of promoting plan confirmation, the DBSD decision gives additional leverage to hold-out junior creditors in the complex “multilateral” Chapter 11 negotiation process.20 Similarly, instead of promoting debtor sponsored reorganizations, the end of “gifting plans” could result in either more Section 363 sales and the potential inefficiencies of a change of control following therefrom, or worse yet, could result in liquidations. On the other hand, as the Second Circuit noted, robust application of the absolute priority rule should curtail the serious mischief that arises when existing shareholders attempt to enrich themselves at the expense of creditors.
Further, because the DBSD decision highlights a potential circuit split between the First Circuit on the one hand and the Second and Third Circuits on the other, where a debtor contemplates that gifting may be a necessary component of a plan’s structure, whether pre-packaged, pre-negotiated, or otherwise, debtor’s counsel may need to consider venues options outside of the Second and Third Circuits. However, now that two prominent Courts of Appeal are in agreement in the only reported appellate decisions directly on point, courts in other circuits may well follow suit.