Restructuring

Contributed by Lee Jason Goldberg
This is the third in a series of blog entries on the Second Circuit’s recent decision in In re DBSD North America, Inc.  The previous blog entries in this series discussed the background facts regarding the DBSD case, the appeals to the Second Circuit, and the Second Circuit’s decision on standing of an “out of the money” creditor to appeal, as well as the Second Circuit’s affirmance of the Bankruptcy Court’s designation of DISH’s votes to reject the DBSD plan.  This post addresses the Second Circuit’s consideration of Sprint’s objection to confirmation of DBSD’s plan on the ground that the plan gave property to DBSD’s existing shareholder without fully satisfying Sprint’s disputed unsecured claim, in violation of the absolute priority rule codified in section 1129(b)(2)(B) of the Bankruptcy Code.  The Bankruptcy Court overruled Sprint’s objection and confirmed the plan, and the District Court affirmed.  The Second Circuit, however, concluded that DBSD’s plan violated the absolute priority rule.
Under DBSD’s plan, holders of second lien debt, who were senior to Sprint and other unsecured creditors, agreed to transfer part of their distribution under the plan to DBSD’s existing shareholder.  Such transfers are generally called “gifting” and often used to obtain the support of a stakeholder considered important to confirmation and consummation of the plan.  The so-called “gifting doctrine” is a controversial aspect of corporate reorganizations because it typically comes into play when a class of creditors senior to the class of creditors or equity interest holders receiving the “gift” is not being paid in full.  Accordingly, as outlined by the Second Circuit, the “gifting doctrine” implicates competing policy interests.
In emphatically rejecting gifting under a chapter 11 plan, the Second Circuit recounted the historical evolution of the absolute priority rule.  Harkening back to early railroad reorganizations of the mid-19th century, the Court noted that, even then, the U.S. Supreme Court observed that it was “well settled that stockholders are not entitled to any share of the capital stock nor to any dividend of the profits until all the debts of the corporation are paid.”  Chi., Rock Island & Pac. R.R. v. Howard.  The concern identified by the Supreme Court even then was that senior creditors often would cooperate with the debtor’s original shareholders to control the reorganization, either to ensure that the process ran smoothly or because they were in fact the same parties.  The original shareholders would then receive or retain a stake in the reorganized company while junior creditors, who were senior to the original shareholders, would receive little or nothing.  In response, the Supreme Court developed a “fixed principle” for reorganizations whereby all creditors were entitled to be paid before shareholders could retain shares.  In time, this principle came to be called the “absolute priority rule” and ultimately was codified in section 1129(b)(2)(B) of the Bankruptcy Code.
Under section 1129(b)(2)(B), if an impaired class of unsecured claims rejects a chapter 11 plan, the plan is only confirmable if either (i) the rejecting class receives the full value of its claims or (ii) no classes junior to that class receive or retain any property under the plan on account of their junior claims or interests.  Because unsecured creditors such as Sprint were not paid in full under DBSD’s plan, the plan could only be confirmed if the existing shareholder, which was junior to Sprint, did “not receive or retain” “any property” “under the plan on account of such junior . . . interest.”  Under cases where the gifting doctrine has been accepted, courts, including the Bankruptcy Court in DBSD, have generally concluded that the senior creditors were voluntarily offering a portion of their recovered property to the junior stakeholders; in other words, the junior stakeholders were not receiving property on account of their claims or interests but, rather, merely a portion of the senior creditors’ own property, which such creditors were distributing as they saw fit.  The Second Circuit held, however, that DBSD’s existing shareholder did receive property under the plan on account of its interest, rendering the plan unconfirmable.
The Second Circuit broke down a gift to a junior creditor or interest holder into three elements:  (1) “property,” (2) “under the plan,” and (3) “on account of” the junior claim or interest.  DBSD’s existing shareholder received shares and warrants in the reorganized debtor, which are undeniably “property.”  The existing shareholder also received these shares and warrants “under the plan,” as set forth in the disclosure statement for the second amended plan.
As to the third element, the Second Circuit concluded that under any of the interpretations of the phrase “on account of” addressed by the Supreme Court, the existing shareholder received the new shares and warrants “on account of” its prior junior interest.  If “on account of” were read as “in exchange for,” which interpretation the Supreme Court viewed unfavorably, DBSD’s description of the shareholder’s treatment in its disclosure statement showed that the existing shareholder received the new shares and warrants at least partially “in exchange for” its old interests.  If “on account of” were read as “because of,” which interpretation the Supreme Court viewed more favorably, the same result would obtain.
The Second Circuit rejected the argument that reasons other than the shareholder’s status as a shareholder justified the existing shareholder’s receipt of the new shares and warrants.  The Bankruptcy Court had found that the gift was aimed at ensuring the existing shareholder’s “continued cooperation and assistance.”  The Second Circuit noted that, even if property were only received partly “on account of” prior interests, the statutory phase is not modified by “only,” “solely,” or “primarily,” and, therefore, such property is still received “on account of” the prior interests.  Moreover, the other reasons given for awarding shares and warrants to the existing shareholder were likewise “on account of” its prior interest.  The shareholder’s “continued cooperation,” the Second Circuit found, was useful only because of the rights the existing shareholder enjoyed as an equity holder.  Moreover, “assistance” was similar to “future labor, management, or expertise,” which the Supreme Court has determined to be insufficient to avoid falling under the prohibition of the absolute priority rule.  Notwithstanding the economic reasons contributing to the award of shares and warrants to the existing shareholder, the existing shareholder would not have received this property but for its prior equity interest.
After noting that the Supreme Court was reluctant to allow equity interest holders to receive distributions even when such interest holders contributed new value to the reorganized entity, the Second Circuit surmised that it was doubtful the Supreme Court would allow prior shareholders to receive property without contributing any new value, which was the case here.
The Second Circuit also disagreed with the Bankruptcy Court’s determination that the secured creditors were merely giving up part of their recovery to the existing shareholder, returning again to the statutory language to hold that the absolute priority rule applied to “any property” not “any property not covered by a senior creditor’s lien.”  The statute focuses “entirely” on who “receive[s]” or “retain[s]” property “under the plan” not on who would receive such property under a liquidation plan.  Further, the statute applies to any distribution of property “under the plan on account of” a junior interest, “regardless of whether the distribution could have been made outside the plan, and regardless of whether other reasons might support the distribution in addition to the junior interest.”  While the secured creditors in this case could have demanded a plan in which they received all of the equity in the reorganized debtor (because the Bankruptcy Court had determined they were undersecured), they did not.  Therefore, whatever they did not take remained in the estate for the benefit of other claimholders, not property of the secured creditors that they could “surrender” to the shareholder as a “gift.”
This part of the Second Circuit’s analysis suggests that the determinative factor in a transfer of property from seniors to juniors may be whether such property is “property of the estate.”  The distribution scheme of chapter 11 ordinarily distributes all property of the estate, including property subject to security interests.  Specifically, the Second Circuit distinguished a First Circuit case, In re SPM Manufacturing Corp., on the basis that not only was SPM a chapter 7 case (which neither includes the absolute priority rule of section 1129(b)(2)(B) nor implicates the chapter 7 distribution scheme until all valid liens are satisfied) but the court in that case also had lifted the automatic stay and treated the property as no longer part of the estate.  The property, therefore, belonged to the secured creditor outright, unlike the property in DBSD, which had remained in the estate.
The most intriguing aspect of the Second Circuit’s decision, however, is what the Second Circuit did not decide:  whether the Bankruptcy Code would allow the existing shareholder and secured creditors to enter into an agreement to transfer shares outside of the plan.  The Court seems to have left the door open for such an arrangement by noting that the absolute priority rule applies to any distribution of property under the plan on account of a junior interest, “regardless of whether the distribution could have been made outside the plan.”  An out-of-court arrangement, though, raises other issues, including whether the parties should be required to disclose such an arrangement and how the senior creditor must account for the consideration it receives and then turns over to another stakeholder.
As the Second Circuit noted, it avoided deciding the viability of the “gifting doctrine” in the pre-plan settlement context in In re Iridium Operating LLC,  but in that case, the Second Circuit rejected a per se rule prohibiting pre-plan settlements that do not comply with the absolute priority rule.  The Court held that whether a particular settlement’s distribution scheme complies with the Bankruptcy Code’s priority scheme “must be the most important factor for the bankruptcy court to consider when determining whether a settlement is ‘fair and equitable’ under [Bankruptcy] Rule 9019.  The court must be certain that parties to a settlement have not employed a settlement as a means to avoid the priority strictures of the Bankruptcy Code.”
In Iridium, though, the Second Circuit held that where the remaining factors used by courts to evaluate settlements “weigh heavily in favor of approving a settlement, the bankruptcy court, in its discretion, could endorse a settlement that does not comply in some minor respects with the priority rule if the parties to the settlement justify, and the reviewing court clearly articulates the reasons for approving, a settlement that deviates from the priority rule.”  The Court remanded the case to the Bankruptcy Court because no reason was offered to explain why, under the pre-plan settlement, the remaining funds in a litigation trust could not or should not be distributed pursuant to the rule of priorities.  The Court noted that the settlement had the overwhelming approval of almost all the parties involved and that the remand was not a repudiation of that support but merely the seeking of “clarification of why the settlement need require a possible deviation from the rule in one regard.”
Reading DBSD and Iridium together, the Second Circuit has severely restricted the “gifting doctrine.”  DBSD sets forth a per se rule prohibiting class-skipping gifting under a plan, and Iridium, although refusing to set forth a per se rule prohibiting gifting under a pre-plan settlement, establishes a high bar for allowing gifting in that context, seemingly limiting it to deviations from the absolute priority rule in “some minor respects” and only where the settlement is not being used to avoid the Bankruptcy Code’s priority scheme.  Now that gifts have been prohibited under chapter 11 plans, debtors, creditors, and equity interest holders will undoubtedly test the limits of how much they may deviate from the absolute priority rule in pre-plan settlements and private agreements entered into in contemplation of a plan.