The United States Bankruptcy Court for the Southern District of New York ruled recently on the validity of “gift plans” – plans of reorganization under which a senior creditor “gifts” assets to a junior creditor or equity holder.1 In In re Journal Register Co.,2 Bankruptcy Judge Alan L. Gropper approved a plan in which secured lenders gifted a portion of their recovery to certain trade creditors, and detailed some of the important limitations on gift plans.
Evolution of the Gift Plan Doctrine
Gift plans have attracted substantial judicial scrutiny ever since 1993 when the First Circuit Court of Appeals upheld a gift plan in In re SPM Manufacturing Corp.3 In SPM, a bank held a perfected, first priority security interest in substantially all of the debtor’s assets.4 Because the collateral was worth less than the bank’s claim, SPM’s other creditors stood to receive nothing in a liquidation, and were therefore not entitled to receive anything under a chapter 11 plan. The bank, however, agreed to share a portion of its recovery with general unsecured creditors in exchange for the creditors’ support of a reorganization plan and certain management changes.
After the case converted to a chapter 7 liquidation, the bank and the creditors’ committee still attempted to implement their agreement, drawing an objection from the debtor. The debtor, who remained liable on an Internal Revenue Service (“IRS”) priority claim, which would not receive any payment from the bankruptcy, argued that the bank’s agreement violated the Bankruptcy Code’s distribution scheme by allowing for a distribution to unsecured creditors ahead of the IRS, even though the IRS tax claim had priority ahead of all unsecured creditors’ claims. Rejecting the debtor’s argument, the First Circuit reasoned that the IRS was not receiving any less than it would receive if the bank did not make the gift, as the liquidation value of the debtor’s assets was insufficient to satisfy the bank’s first priority secured claim. The First Circuit permitted the gift, reasoning that “creditors are generally free to do whatever they wish with the bankruptcy dividends they receive, including to share them with other creditors.”5 Furthermore, the court emphasized that as soon as it lifted the automatic stay and ordered that the proceeds from the sale of SPM’s assets be distributed, the proceeds were no longer property of the estate and could therefore be gifted at the recipient’s discretion.
In 2003, the United States Bankruptcy Court for the Southern District of New York reached a similar conclusion with respect to a gift included in the chapter 11 reorganization plan approved in In re WorldCom, Inc.6 In WorldCom, members of certain creditor classes consisting of senior and subordinated bondholders agreed to share a part of their recovery under the plan with certain junior creditors. Citing SPM, the WorldCom court rejected an argument raised by trade creditors excluded from the gift, that the plan could not be confirmed because it violated the unfair discrimination and absolute priority rules codified in section 1129(b) of the Bankruptcy Code. With respect to the unfair discrimination provision, which prohibits the disparate treatment of creditors in similarly situated classes without a reasonable basis for such different treatment, the court noted that the junior creditors receiving the gift were not receiving estate property. The court added that the “greater value received by the members of the Ad Hoc MCI Trade Claims Committee as a result of the Contributions does not violate the Bankruptcy Code, because the Contributions are the result of other creditors . . . voluntarily sharing their recoveries.”7
With respect to the absolute priority rule, which generally prohibits plan distributions to a junior class unless senior claims are satisfied in full, the WorldCom court held that the rule is “inapplicable to contributions of plan recoveries made by certain creditors to other creditors.”8 The court added that gifts between creditors need not benefit an entire class of creditors in order to be permissible under section 1129(b).
Not all courts that have considered the gift plan doctrine have followed the SPM decision, and indeed some have rejected the doctrine outright. For instance, the United States Bankruptcy Court for the Southern District of Texas in In re Sentry Operating Co. of Texas, Inc. has determined that gift plans run counter to the historical purpose of the Bankruptcy Code. Specifically, the court noted that “to accept [the] argument that a secured lender can, without any reference to fairness, decide which creditors get paid and how much those creditors get paid, is to reject the historical foundation of equity receiverships and to read the § 1129(b) requirements out of the [Bankruptcy] Code.”9
Although the United States Court of Appeals for the Third Circuit has not entirely rejected the gift doctrine, in In re Armstrong World Industries, Inc., it declined to approve a creditor gift to equity holders that were junior in priority to an objecting impaired class.10 The Third Circuit reasoned that any distribution to equity holders under a plan in which any creditor was impaired was a clear violation of the absolute priority rule, regardless of whether the distribution occurred through a creditor gift.
It also should be noted that the United States Court of Appeals for the Second Circuit has not ruled upon the validity or scope of the gift doctrine in the context of chapter 11 reorganization plans.11 In In re Iridium Operating LLC, the Second Circuit considered a settlement agreement (which was not part of a plan) between the debtors’ secured lenders and the unsecured creditors’ committee, pursuant to which the creditors’ committee acknowledged the validity of the lenders’ liens in return for the lenders’ agreement to establish a litigation fund to pursue claims against Motorola, Inc., the debtors’ former parent company. Motorola objected to the settlement on the grounds that it held claims senior in priority to general unsecured creditors, and that those general unsecured creditors would be eligible for distributions from the litigation fund even though Motorola’s priority claims would not be paid in full. In responding to Motorola’s objection, the court distinguished Iridium from SPM, noting that the Iridium secured lenders’ liens were vigorously contested prior to the settlement agreement and therefore the collateral securing those liens remained property of the estate. The court declined to address whether SPM could ever be extended beyond chapter 11 plans, and confined its decision to the evaluation of the settlement agreement under the framework of Rule 9019 of the Federal Rules of Bankruptcy Procedure.
The Journal Register Decision
In Journal Register, the debtor, a newspaper conglomerate, owed approximately $695 million to a group of secured lenders. As in SPM, first priority liens on virtually all of the debtors’ assets secured the loans. During the course of the debtors’ chapter 11 cases, the secured lenders agreed to gift a portion of their recovery to fund a “Trade Account Distribution.” Through the Trade Account Distribution, the plan would provide for the distribution of funds to a particular group of unsecured trade creditors in exchange for their support of the debtors’ plan of reorganization and their agreement to a general release of claims against the secured lenders. According to the debtors’ interim chief operating officer, the gift “would ensure the goodwill and survival of certain trade creditors that were under severe financial distress themselves and were essential to the debtors’ daily operations and long-term survival.”
A pension fund asserting a $4.3 million unsecured claim objected on the ground that the proposed gift plan violated section 1129 of the Bankruptcy Code for several reasons. First, the creditor argued that the gift to trade creditors constituted unfair discrimination. The court rejected this argument, noting that the anti-discrimination provision “is concerned with plan treatment between classes – not within classes.”13 Because there was “no charge of unfair discrimination between classes of creditors,” given that the pension fund and the trade creditors occupied the same class, the plan did not violate section 1129(b) “on the ground of unfair discrimination.”14 Further, even if there were allegations of disparate treatment between classes, the court added that section 1129(b) only prohibits unfair discrimination, and in this case “the Debtors introduced substantial evidence as to why certain creditors were favored.”15 Second, the pension fund argued that the gift violated the absolute priority rule of section 1129(b) of the Bankruptcy Code. In response, the court stated that the rule was inapplicable because the gift was consensually made by the secured lenders and no “intervening class” objected to the gift.16
After finding that the proposed gift did not violate section 1129(b), the court observed that an objection premised on section 1123(a)(4) of the Bankruptcy Code, which requires that a plan “provide the same treatment for each claim or interest of a particular class, unless the holder of a particular claim or interest agrees to less favorable treatment,” would be the only viable objection a creditor such as the pension fund could raise to plan confirmation. Commenting on this provision, the court held that “this section advances the policy of equality of distribution of estate property.”17 It added that section 1123(a)(4) applied because the trade creditors eligible for distributions from the trade account were in the same class as general unsecured creditors that were ineligible for such distributions.
In applying section 1123(a)(4), the court first held that any “funds in the Trade Account are not property of the estate.”18 The court also stated that eliminating the gift at issue would not affect the recovery of the objecting creditors, and that rights to payment from third parties, including sureties and guarantors, frequently entitle certain creditors to a “disproportionate recovery compared to other creditors of the same class.”19 Finally, the court stressed that the provisions of the plan implementing the creditor gift, which included having an administrator make distributions from the Trade Account, did not cause the gift to be an “inappropriate distribution under the Plan.”20 On this point, the court observed that requiring the secured creditor to make the gift outside of a reorganization plan would subject the secured lenders to expensive and extended proceedings under state law as to who constituted a trade creditor and unnecessarily eliminate the court’s jurisdiction to resolve such disputes.
Although the court ultimately approved the debtors’ plan, it outlined an important limitation on gift plans, namely that gift plans cannot be used for an “ulterior purpose,”21 such as avoiding capital gains taxes or the chapter 11 voting requirements.22 Applying this principle, the court held that the secured lenders did not make the gift for any ulterior purpose, but rather to ensure continued goodwill with trade creditors to the reorganized company. The Journal Register court concluded that this goal “is in accordance with the overriding purpose of chapter 11 that going concern value be preserved or enhanced.”23
Analysis and Conclusion
In re Journal Register’s guidance on the application of the gift doctrine is beneficial for a number of reasons. First, the decision signals the continued acceptance of gift plans by the United States Bankruptcy Court for the Southern District of New York. Accordingly, senior lenders involved in matters in this jurisdiction should continue to view gifting as a viable option in attempting to reach a consensus with junior creditors.
In addition, Journal Register reaffirms that proceeds distributed to creditors under a plan of reorganization do not thereby become estate property, and can be gifted irrespective of the priority scheme created under the Bankruptcy Code. Moreover, while earlier gift plan decisions focused primarily on the requirements of section 1129(b), Journal Register examines a creditor gift under the framework of both section 1129(b) and section 1123 of the Bankruptcy Code, concluding that the gift plan at issue was permissible under both provisions.
Despite the favorable treatment of gift plans, to date, no decision from the United States Bankruptcy Court for the Southern District of New York has approved a plan providing for a gift to equity holders where other creditor classes are impaired. The court in Journal Register even noted the Third Circuit’s explicit rejection of such a gift in Armstrong. Additionally, the court in Journal Register stressed that creditor gifts may not be used for “ulterior” motives, such as avoiding capital gains taxes or the chapter 11 confirmation requirements. With these potential limitations in mind, Journal Register still signals that gift plan distributions can continue to be a useful tool for bankruptcy cases in the Southern District of New York.