Restructuring

Contributed by Debra A. Dandeneau.
Some Additional Thoughts (and Even More Questions) on DBSD
By now, the bankruptcy community has posted a number of alerts on the Second Circuit’s decision in DBSD.  In this blog, we posted a series of entries addressing the three issues of standing by an out of the money creditor to appeal, designation of votes, and, of course, the Second Circuit’s rejection of gifting under a plan.  This entry explores in more detail what may be some of the practical consequences of, and many questions raised by, DBSD’s gifting holding.
What Will Happen in Delaware?
One could say that the Third Circuit, in the Armstrong decision, rejected gifting well before the Second Circuit had an opportunity to consider the doctrine in DBSD.  Much of the post-Armstrong thinking in Delaware, however, seemed to limit the decision to its particular facts – an unsecured class of asbestos claimants “gifting” part of its distribution to equityholders even though the class of general unsecured creditors rejected the plan.  Both Armstrong and DBSD presented rare opportunities for appellate review of confirmation issues that normally would have been mooted by substantial consummation of the plan – Armstrong because the need for an asbestos 524(g) injunction required the district court to review  the bankruptcy court’s conclusions and DBSD because the debtors were required to wait for FCC approval before consummating their plan.  Therefore, post-Armstrong, practitioners and Delaware bankruptcy courts could interpret Armstrong “practically” and permit, for example, gifting from a class of senior secured creditors to a class of unsecured creditors.  The issue of whether that arrangement was consistent with Armstrong would not likely be addressed by higher courts because of the practical difficulties in appealing from a bankruptcy court’s confirmation order.
Many are wondering, though, whether bankruptcy courts in Delaware – which, of course, are not bound by DBSD – nevertheless will find it more difficult to uphold a gifting plan now that they have to couple the binding precedent of Armstrong with the persuasive authority of DBSD.  At a minimum, it seems clear that a plan strategy premised on a gifting structure has become a riskier proposition in Delaware now that the Second Circuit has firmly rejected gifting under a plan.
How Broadly Will the Courts Interpret “on Account of”?
The Second Circuit went to great lengths in DBSD to stress that the prohibition against gifting was not limited to a situation in which a junior class of creditors or equityholders was receiving or retaining property solely on account of its interest.  Instead, it concluded, even if such class is receiving or retaining property partly on account of its interest, such retention violates the absolute priority rule if an impaired senior class of creditors rejects the plan.
How broadly will courts apply this prohibition?  For example, in the pre-DBSD decision in Charter Communications, it was critical to the debtors’ strategy of reinstating the prepetition debt that no change of control occur under the plan.  As a result, the debtors had to structure a plan that the court found allowed Paul Allen, the prepetition majority holder, to remain in control.  When a class of creditors argued that the plan violated the absolute priority rule, Judge Peck refused to strike down the plan, reasoning that the retention of an equity stake by Mr. Allen was on account of, his “cooperation” with respect to maintaining the voting control needed to enable the debtors to avoid a change of control, transferring equity interests in certain solvent entities, and agreeing to the compromise of certain claims.  Mr. Allen’s retention of an equity stake also permitted the reorganized debtor to retain value by preserving certain tax benefits.
In DBSD, though, the Second Circuit was quite clear that any distribution or retention of an interest on account of a junior claim or equity interest when a senior class of unsecured claims rejects the plan violates the absolute priority rule.  Parties may have a far more difficult time now justifying a deal in which existing equity continues to play a role, regardless of how much the reorganized debtor may need such existing equity to preserve value for the senior creditors.  Should the court allow equity to retain a sufficient stake in the reorganized debtor to preserve tax benefits that otherwise might be lost (a factor in Charter Communications)?  DBSD displays no sympathy for the plight of senior creditors in situations in which junior creditors want to engage in a “hold-up” strategy because senior creditors that support the plan want to allow equityholders to retain a stake in the reorganized company so as to avoid a loss of value.   Where should courts draw the line after DBSD?  Is, for example, a post-effective date services agreement with old equity a distribution or retention of an interest on account of equity?  Presumably, it is equity’s involvement with the debtor that would make such services important.  On the other hand, courts may make a distinction between an engagement that arises on account of a group’s expertise or services as opposed to its ownership of a debtor.
Of course, unless some prohibition is written into the plan, nothing prevents the reorganized debtor from entering into post-effective date agreements independent of the plan to provide for its management and operations.  If no binding agreement exists as part of the plan process though, will that affect the debtor’s ability to demonstrate that the plan is feasible and contains adequate means for its implementation?  Moreover, if the reorganized debtor enters into such an agreement immediately after the effective date without having disclosed such an arrangement as part of the plan solicitation process, does it risk having such action challenged by a rejecting class of unsecured creditors?  It would seem that not having included the agreement as part of the plan process, the reorganized debtor would be hard-pressed to argue that substantial consummation of the plan mooted any judicial review of such action.  Even if such agreements were disclosed and adopted as part of the plan, though, given some appellate courts’ apparently increasing willingness to address distinct plan issues that may not directly affect the economics of the plan instead of holding that an appeal is moot, a plan proponent would have no assurance that it could avoid appellate review of such an action.
As plan proponents attempt to structure around DBSD, though, they risk tripping up on other provisions of the Bankruptcy Code, especially if the plan proponent seeks to provide post-effective date economic benefits to some, but perhaps not all, members of the junior class.  What about, for example, a proposal to give certain additional benefits to prepetition trade creditors that continue to do business with the reorganized debtor?  What if a group of senior creditors that will end up owning the equity in the reorganized debtor reaches an agreement with certain, but not all, equityholders to allow them to participate in the equity of the reorganized debtor?  That, in fact, was one of the complaints of dissenting public shareholders in Charter, who argued that the Charter plan wiped out their equity while preserving valuable rights for Paul Allen.  At what point does a post-effective date agreement run afoul of the requirement in section 1123(a)(4) that creditors or equityholders in a class receive the same treatment?
How Hard Will It Be to Accomplish “Private” Gifting?  
Another idea that practioners have discussed in the wake of DBSD is that senior creditors can enter into “private” agreements outside the context of the plan to share their recoveries with junior creditors.  How “private” a “private” deal should be is likely to generate some controversy.  To the extent the “private agreement” involves any parties that are or that control any of the plan proponents (for example, the debtor’s management or equity owner or the senior creditors proposing or sponsoring a plan), it would seem clear that the parties should disclose such agreements.  What about parties that are not the nominal plan proponents but have an interest in the success of the plan (e.g., senior creditors that may end up owning the lion’s share of the equity in the reorganized debtor)?  Although some may argue that a creditor that is not a proponent of the plan should be entitled to have separate negotiations with other creditors, an undisclosed side deal that affects the reorganized debtor or fundamentally alters the Bankruptcy Code’s priority scheme appears to be antithetical to the full disclosure principles that form the foundation of the chapter 11 process, and creditors are well-advised to err on the side of disclosure.  Should a lender, though, be able to sell a participation in its debt to junior creditors?  Such transfers are not covered by Bankruptcy Rule 3001(e).   If individual lenders choose to allow other creditors to participate in their recovery by selling participations in their debt, nothing in the Bankruptcy Code currently requires them to disclose those arrangements.
As a practical matter, though, how easy will a private agreement be to accomplish?  If the senior debt is widely held, will it be possible to get all holders to agree?  Or, do some of the larger debtholders simply have to step up to the plate and agree to share their distribution, while others sit back and get a greater recovery than their more generous fellow senior creditors?  The “democratic” process inherent in the development of a plan and the ability to bind rejecting creditors allows parties in a chapter 11 case to avoid such a “free rider” problem.  Having a subset of senior creditors put their own money on the line to get a plan confirmed changes the chapter 11 dynamic by introducing the free rider problem to the case.  At what point does the cost of having to deal with a rejecting junior class become so prohibitive that some senior creditors are willing to make sacrifices to their own economic recovery for the benefit of the “free riders” in the same class of senior creditors?
Once a group of senior creditors privately agrees to redistribute part of the distribution the senior creditors receive under a plan, the junior creditors or equityholders benefiting from such non-plan gift then have to worry about enforcing that right.  One would assume that the junior creditors or equityholders, for example, would want to lock up the senior creditors at least to the extent that they agree not to sell their positions unless the purchaser also agrees to redistribute part of its distribution.  Will senior creditors so readily agree to be bound, particularly if some senior creditors are not bound?  It is one thing to provide for a “gift” under the plan where the redistribution applies to everyone, and the plan itself can provide the mechanisms to effectuate the redistribution of value.  The mechanics become much more complicated, though, once the redistribution has to occur among a potentially diverse (and changing) population of senior creditors, on the one hand, and another diverse (and perhaps even larger) group of junior creditors or equityholders.
The practical problems of effectuating the redistribution do not exist solely on the side of the gifting party.  Rarely does gifting seek to benefit a junior class of debtholders, to which distributions can be made through the administrative agent or indenture trustee.  More often than not, the recipients of the gift are trade creditors or equityholders.  Although the debtor might be closely held, in which case it would be more feasible to enter into a formal agreement among the senior creditors and the equityholders, the same generally cannot be said for a group of trade creditors or a publicly held company.  Perhaps the group of trade creditors with which the senior creditors have to deal is narrowed by giving many of the smaller claims convenience class treatment.  As a practical matter, though, trying to get each and every other holder of unsecured claims – and if the senior creditors need the vote of a class of unsecured claims, at least a majority in number and two-thirds in amount voting – to enter into a private agreement with the senior creditors to receive a gift has the potential to be as easy as herding cats.
Assuming that it is legally appropriate and feasible to enter into a private agreement, one must next consider what the junior class is agreeing to give the group of senior creditors in exchange.  Are the members of the junior group agreeing to vote in favor of a plan supported by the senior creditors?  If so, then the issue becomes whether the senior creditors can effectively bind the junior creditors to vote in favor of the plan with a “plan support agreement.”  In Delaware, two decisions have made entering into postpetition, pre-disclosure statement “plan support agreements” a risky strategy.  Although parties routinely enter into postpetition, pre-disclosure statement plan support agreements in the SDNY, in Quigley, Judge Bernstein designated the votes of certain asbestos personal injury claimants who had entered into prepetition settlement agreements with Quigley’s parent, Pfizer Corporation, concluding that Pfizer had, in essence, effectively (and improperly) “bought” the votes of such creditors on a Quigley chapter 11 plan.
One issue that has been overlooked when the plan has reflected gifting is how the senior creditor and the junior creditor or equityholder should account for the gifted distribution.  Effectuating the gifting through a private agreement under which the senior creditor receives and then redistributes the “gift” only highlights the issue.  Must the senior creditor account for the consideration it has agreed to “gift” as a recovery on account of its claim?  On the flip side, how does the recipient of the “gift” account for the gift if it is not receiving the redistribution as a recovery on its claim or equity interest?
Can a Debtor Favor Certain Creditors Without Gifting?
Although DBSD makes it difficult to “jump” classes and favor a more junior class over a senior class, certain provisions of the Bankruptcy Code already allow certain types of creditors to obtain better treatment than more senior or similarly situated creditors.  DBSD does not eliminate all forms of Bankruptcy Code-sanctioned “discrimination” (and, indeed, even section 1129(b) only prohibits “unfair discrimination”), and practitioners should bear in mind the other tools that in other circumstances all similarly situated creditors are not necessarily treated in the same manner.
Any time a debtor assumes an executory contract or unexpired lease and cures the prepetition default, that counterparty is potentially receiving more favorable treatment than other creditors, including perhaps even secured creditors.  Moreover, the standard for assumption (other than for relationships with insiders) under section 365(a) is simply the debtor’s business judgment, a fairly low threshold for approval.  Under a plan, a debtor may seek to assume numerous prepetition contracts and leases by listing them on a schedule.  Unless challenged as to particular contracts, debtors typically do not provide specific justification for the assumption of each and every one of these contracts and leases.
Section 1122(b) also implicitly authorizes discriminatory treatment among similarly situated creditors by allowing a plan proponent to create a convenience class.  Although the Bankruptcy Code nowhere expressly permits unsecured claims in a convenience class to receive better treatment than other unsecured claims, that is the purpose of the provision.  Whether such treatment – which is implicitly exempt from a complaint of unfair discrimination under section 1129(b) – also is exempt from the absolute priority rule in section 1129(b)(2)(B) has not been tested.
In addition to these provisions, a debtor in possession may, with court approval, sell its assets outside the ordinary course of business pursuant to section 363(b) of the Bankruptcy Code.  Section 363 allows flexibility in structuring a deal.  For example, it does not contain any requirement that the consideration provided by the purchaser be exclusively in cash.  Therefore, nothing in section 363 or elsewhere in the Bankruptcy Code restricts a purchaser from agreeing to assume certain liabilities as part of the sale transaction.  Such assumption of liabilities typically would be valued as part of the consideration running from the purchaser to the debtor’s estate in the transaction.  The assumption of liabilities in a 363 sale, though, presents the possibility of certain groups of creditors being favored over others.  While it may be common for a purchaser to assume certain liabilities associated with the continued operation of the business or preservation of goodwill, such as warranty claims. or employee liabilities, what should happen if a purchaser wanted to assume a portion of junior debt to the exclusion of other similarly situated creditors?  In the sales in both Chrysler and GM, the courts allowed favorable treatment for certain categories of creditors because a business justification existed for the purchaser assuming such liabilities.  May a sale under section 363 essentially disregard the Bankruptcy Code’s priority scheme without a legitimate business justification?  In weighing competing bids, what consideration should be given to the assumption of such liabilities when such assumption may have the effect of altering the priority scheme of the Bankruptcy Code?  How do the legitimate concerns of the purchaser in ensuring that it is acquiring a viable business affect the ability to assume certain types of prepetition liabilities and favor one class of creditors over another?  These issues may perhaps draw more scrutiny after DBSD.
Conclusion
What was immediately clear after the Second Circuit issued DBSD was that, while it purported to shut the door on plan gifting, it clearly left open windows on other possibilities.   What are your thoughts on the practical implications of DBSD?  The Weil Bankruptcy Blog would love to hear from you.  Please contact us with your thoughts.  We will summarize our readers’ responses in a subsequent blog entry.