Earlier this year, the U.S. Court of Appeals for the Second Circuit held that a proposed “gifting” plan distributing value from the second lien lenders to the prepetition equity holder violated the absolute priority rule and was confirmed in error.2 This decision, by a 2-1 panel vote,3 reversed the decisions of the Bankruptcy and District Courts for the Southern District of New York. The Second Circuit also affirmed unanimously the designation of the vote of an indirect competitor of the debtor that held no claims prior to the petition date. The Second Circuit held that this entity did not vote on the plan in good faith because it purchased an entire class of claims with the goal of blocking plan confirmation in an effort to acquire DBSD’s assets.4 This opinion prohibits class-skipping gifting plans in the Second Circuit and raises a host of questions about the applicability of gifting in bankruptcy. The ruling also curtails a competitor’s ability to purchase bankruptcy claims for strategic purposes.  


On May 15, 2009, DBSD filed for Chapter 11 relief in the U.S. Bankruptcy Court for the Southern District of New York. Following negotiations, DBSD filed a “gifting” plan of reorganization, pursuant to which the unsecured creditors would receive an estimated recovery ranging from four percent to nearly 50 percent. Holders of DBSD’s second lien debt would receive the majority of the reorganized company’s equity and then “gift” portions of that equity to DBSD’s pre-bankruptcy shareholder, ICO Global Communications, and the unsecured creditors.5

Sprint Nextel Corporation objected to the plan. Sprint argued that the plan violated the absolute priority rule of section 1129(b)(2)(B) of the Bankruptcy Code by distributing equity to ICO, whose prepetition equity interest was junior in priority to Sprint’s prepetition unsecured claim, while failing to pay the unsecured creditors’ claims in full. The Bankruptcy Court overruled Sprint’s objection, holding that the undersecured second lien lenders were allowed to “gift” a portion of their recovery to ICO.6  

After DBSD filed its disclosure statement, DISH Network Corporation, a competitor of DBSD that was not a prepetition creditor, purchased all of the first lien debt at face value and a portion of the second lien debt with the intention of blocking confirmation and seizing control of certain DBSD assets. DISH voted against the plan and objected to confirmation, arguing that the plan was not feasible and that DISH did not receive the indubitable equivalent of its claims. In response, DBSD moved to designate DISH’s vote pursuant to section 1126(e) of the Bankruptcy Code as not being made in good faith. The Bankruptcy Court granted DBSD’s motion, designated DISH’s vote, disregarded the first lien lender class for voting purposes, and confirmed the plan on October 26, 2009.7 After the District Court affirmed the Bankruptcy Court’s decision, both Sprint and DISH appealed to the Second Circuit.8

Second Circuit Rejects Gifting

Sprint argued that the plan violated the absolute priority rule by distributing property to ICO on account of its prepetition equity interests although the more senior class of unsecured creditors did not receive complete satisfaction of its claims. The Second Circuit looked first to the text of the absolute priority rule in section 1129(b)(2)(B) of the Bankruptcy Code, which requires that, to be fair and equitable to unsecured creditors  

(i) the plan provides that each holder of a claim of such class receive or retain on account of such claim property of a value, as of the effective date of the plan, equal to the allowed amount of such claim; or (ii) the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property . . . .

The Second Circuit stated that the plan, which did not satisfy Sprint’s claim, would comply with the absolute priority rule “only if the existing shareholder, whose interest is junior to Sprint’s, does ‘not receive or retain’ ‘any property’ ‘under the plan on account of such junior . . . interest.’”9

Reviewing the plan, the Second Circuit concluded that ICO received “property” because the meaning of “any property” includes the equity the second lien lenders granted to ICO. ICO received this property “under the plan” because the plan expressly stated that ICO was to receive this equity. Finally, ICO received its new equity “on account of” its prepetition interest because it received the shares in exchange for its old shares pursuant to the terms of the plan. Although the disclosure statement articulated additional reasons why ICO received this gift, namely ICO’s “continued cooperation and assistance,” the Second Circuit found that ICO’s cooperation was only necessary and possible because of its prior interest. In addition, the Second Circuit found that even if ICO had made a capital contribution to the reorganized debtor, which it had not, ICO’s “receipt of property partly on account of the existing interest [would be] enough for the absolute priority rule to bar confirmation of the plan.”10  

The Second Circuit rejected DBSD’s argument that the so-called “gifting doctrine” allowed the undersecured second lien lenders to gift shares of new equity to ICO. The Second Circuit found that the text of the Bankruptcy Code, Supreme Court jurisprudence, and the distinguishing facts of the landmark gifting doctrine case, Official, Unsecured Creditors’ Committee v. Stern (In re SPM Manufacturing Corp.),11 offered ample support for its determination that any gifting exception to the absolute priority rule did not apply in this case.12  

The Second Circuit also addressed the policy arguments against a strict interpretation of the absolute priority rule, noting that “[g]ifting may be a ‘powerful tool in accelerating an efficient and nonadversarial . . . chapter 11 proceeding’ . . . and no doubt the parties intended the gift to have such an effect here.” Regardless of the policy merits of the absolute priority rule, the Second Circuit concluded that “Congress was well aware of both [the absolute priority rule’s] benefits and disadvantages when it codified the rule in the Bankruptcy Code. . . . [A]lthough Congress did soften the absolute priority rule in some ways [in the 1978 Bankruptcy Code], it did not create any exception for ‘gifts’ like the one at issue here.”13  

Second Circuit Permits Designation of Votes for Bad Faith Actions

The Second Circuit also held unanimously that the Bankruptcy Court did not err in designating DISH’s vote for not being made in good faith.14 Section 1126(e) of the Bankruptcy Code provides that “[o]n request of a party in interest, and after notice and a hearing, the court may designate any entity whose acceptance or rejection of such plan was not in good faith . . . .”  

The Second Circuit found that DISH was a competitor of DBSD that had purchased the entire class of first lien debt “not to maximize its return on the debt but to . . . use [the votes] as levers to bend the bankruptcy process toward its own strategic objective . . . .” Based on these facts, and in light of the history behind section 1126(e) of the Bankruptcy Code and its modern interpretation in bankruptcy courts, the Second Circuit ruled that DISH acted on the type of “ulterior motive” that constitutes bad faith. Accordingly, the Second Circuit held that the Bankruptcy Court correctly designated DISH’s vote as not having been made in good faith.15

The Second Circuit limited its decision, however, stating that the ruling “should deter only attempts to ‘obtain a blocking position’ and thereby ‘control the bankruptcy process for [a] potentially strategic asset,’” as opposed to when a “preexisting creditor votes with strategic intentions.”16 In addition, the Second Circuit emphasized that its decision is not a “categorical ban” on the strategic purchasing of claims, which may be appropriate in other contexts, but was instead a “fact-intensive” analysis “based on the totality of the circumstances.”17

DBSD Likely To Have Extensive Impact

In DBSD, the Second Circuit’s strict application of the absolute priority rule virtually prohibits any class-skipping gift under a plan, and the plain meaning of section 1129(b)(2) of the Bankruptcy Code clearly supports the Second Circuit’s conclusion. Under a cramdown plan, a junior class may not be paid unless a dissenting senior class is paid in full. This limitation applies even to those plans where the recipient also contributes new value to the reorganized debtor. Indeed, the Second Circuit found that “a transfer partly on account of factors other than the prior interest is still partly ‘on account of’ that interest . . . [which is] enough for the absolute priority rule to bar confirmation of the plan.”18 However, to the extent a debtor can demonstrate that a gift under a plan was not made on account of the beneficiary’s prior interest, the gift may be permitted under the Second Circuit’s analysis.  

Although this decision may be correct from a purely legal perspective, the analysis creates practical problems. First, the Second Circuit recognized explicitly that the absolute priority rule does not exist in chapter 7 and is inapplicable to gifting mechanisms akin to that employed in SPM, where a senior secured creditor agreed with unsecured creditors to seek liquidation of the debtor in chapter 7 and to share in the proceeds of the liquidation.19 Thus, the permissibility of gifting in chapter 7 could steer debtors toward chapter 7 in situations where parties cannot reach a consensual plan—contrary to the Bankruptcy Code’s general policy favoring reorganization.

Additionally, plan proponents can effectuate a gift through means outside of chapter 7 or a plan. For example, parties could implement a settlement under Federal Rule of Bankruptcy Procedure 9019 or through a private agreement subsequent to the effective date of the plan.20 It is unclear how gifting outside the chapter 11 plan, while continuing to pursue the plan process, is consistent with the absolute priority rule as interpreted by the Second Circuit’s decision in DBSD. It is also uncertain whether and to what extent parties would be required to disclose a private agreement, though greater disclosure to a bankruptcy court is generally preferred.

The vote designation ruling is also significant. The Second Circuit endorses the Bankruptcy Court’s ruling that a purchaser cannot acquire claims with a strategic, rather than financial, motivation. It is, of course, difficult to draw the line between a strategic versus a financial motivation. Can a financial player acquire claims and use them to takeover a company? Can an existing creditor use its claims to act strategically? Those questions remain unanswered and both the Bankruptcy Court and the Second Circuit clearly limit the reach of their respective holdings. Specifically, the Second Circuit held that “purchasing claims with acquisitive or other strategic intentions” may be proper in some circumstances. This leaves future courts flexibility in applying designation.21 For this reason, the designation portion of the opinion should be read narrowly.