So what do railroad barons, second lien lenders and satellites have in common? Strangely, the derailment of the gifting doctrine for cram-down plans, at least, in the Second Circuit. In an Opinion filed on February 7, 2011, the Second Circuit issued what amounted to a teaser for bankruptcy professionals. It started with a decision by Bankruptcy Judge Gerber of the Southern District of New York to confirm a Chapter 11 plan that included a “gift” from the second lien lenders to equity, even though unsecured creditors were not being paid in full. Judge Gerber’s thinking, which was consistent with the general line of cases on the subject, was that a secured creditor who is not being paid in full is permitted to turn over part of the distribution the secured creditor would otherwise have received to a more junior creditor, even if an intermediate class is not paid in full. The theory is that the intervening class was not entitled to the extra distribution to begin with, so basically “no harm, no foul.” The District Court affirmed.
For the objecting unsecured creditor, however, revenge proved to be a dish best served cold as the Second Circuit found plenty of harm and called foul, resulting in a reversal of the lower court decisions and rejection of the gifting plan. In re DBSD N.A., Inc. (DISH Network Corp. v. DBSD North America), __ F.3d __, 2011 WL 350480 (2d Cir. Feb. 7, 2011). Reaching back 143 years in time to the logic used by the Supreme Court to prevent railroad barons and mortgagees from cutting deals that squeezed out intermediate creditors (Chi., Rock Island & Pac. R.R. v. Howard, 74 U.S. (7 Wall) 392 (1868)), the Court basically said that the “absolute priority rule” is absolute.
For at least 30 years, the majority of bankruptcy courts have confirmed plans of reorganization under which secured creditors have “gifted” a portion of their distributions to junior classes over the heads and objections of intermediate classes. These were originally called “Drexel plans” and, more recently, “SPM plans” in honor of the leading cases in which “gifts” were approved. However, the Second Circuit made short shrift of three decades of case law, beginning with the First Circuit’s decision in SPM.
Ironically, but important to the DBSD Court, SPM did not actually involve a plan at all; it was a Chapter 7 case. Per the Second Circuit, the absolute priority rule set forth in Bankruptcy Code § 1129(b) does not apply in Chapter 7 cases, so the First Circuit’s SPM decision was not relevant to resolving the Chapter 11 issue. And reading section 1129(b) as written, the Second Circuit found no wiggle room for including in a Chapter 11 plan a distribution to a junior class, whether out of estate resources or via a gift from a secured creditor, unless more senior classes are first paid in full. If you want to do that, the Court said, do it outside of a plan in a side transaction. Left unsaid, however, is the possibility that providing consideration in a side transaction could be viewed as vote buying, a potential loss of the securities registration exemption in Bankruptcy Code § 1145 and, if undisclosed, potentially even a criminal act under 18 U.S.C. § 152(6).
So what’s a charitable secured creditor and a complicit debtor to do?
First, there is nothing in the DBSD decision to suggest that the parties cannot consensually agree to a gifting plan, given that section 1129(b) only applies to classes who do not consent to a plan. An individual creditor could still object, but the only test in that case should be the “best interests” proviso set forth in section 1129(a)(7)(A)(ii), which is as easy to satisfy as falling off a (gift) horse. One could also imagine a challenge on grounds of bad faith, but we are skeptical that such a challenge would make it out of the gate if all of the facts and circumstances of the gift are timely and fully disclosed.
Second, they could bypass the Second Circuit hurdle and gallop over to the Third Circuit or the Fifth Circuit, where there remains (at least for now) favorable case law on gifting plans.