Restructuring

Contributed by Conray C. Tseng
This is the first in a series of blog entries on the Second Circuit Court of Appeals’ recent decision In re DBSD North America, Inc. While the decision discusses many issues of law, this blog post focuses on the Second Circuit’s discussion of whether an “out-of-the-money” creditor with a disputed and unliquidated claim has standing to appeal confirmation of a plan.  Despite the protestations of secured lenders, the Second Circuit answered with a resounding “Yes!”
Background
ICO Global Communications founded DBSD in 2004 to develop a mobile communications network that would use both satellites and land-based transmission towers.  In its first five years, DBSD made progress toward this goal, successfully launching a satellite and obtaining certain spectrum licenses.  DBSD financed its development through the issuance of debt.  Because it remained in the developmental stages and was not yet operational, DBSD had little, if any, revenue to pay its debt obligations.
In May 2009, the DBSD debtors filed chapter 11 petitions with the United States Bankruptcy Court for the Southern District of New York.  DBSD’s debt obligations included, among others, $40 million in original principal amount of secured first lien debt and $650 million in original principal amount of secured second lien debt.  Sprint Nextel Corporation also asserted a general unsecured claim arising from litigation between Sprint and DBSD in the amount of at least $211 million, a claim that DBSD disputed.
DBSD proposed a plan of reorganization that would provide a holder of the first lien debt new secured notes equal to the amount of its debt and convert the second lien debt into equity in reorganized DBSD.  Although, under DBSD’s valuation, second lien creditors would not be paid in full, DBSD’s plan “gifted” a nominal recovery to general unsecured creditors and equity interest holders.  Pursuant to the terms of the plan, general unsecured creditors would obtain approximately 0.15% of the new equity in the reorganized DBSD, while old equity would receive approximately 4.99% of the new equity.
After DBSD proposed its plan, DISH Network Corporation, a competitor of DBSD, purchased significant portions of DBSD’s first and second lien debt in an attempt to block confirmation of DBSD’s plan and force DBSD to engage in a strategic transaction whereby DISH would obtain control of DBSD or acquire its assets.
Confirmation of DBSD’s Plan
DISH voted its claims to reject DBSD’s plan.  DBSD responded by moving, pursuant to section 1126(e) of the Bankruptcy Code, to designate DISH’s votes as not having been cast “in good faith.”  The Bankruptcy Court granted DBSD’s motion.  DISH appealed.  The United States District Court for the Southern District of New York affirmed the Bankruptcy Court’s decision.  DISH then appealed to the Second Circuit.
Sprint joined DISH in voting to reject the plan.  Sprint also objected to the plan on the basis that it violated the absolute priority rule in section 1129(b)(2)(B) of the Bankruptcy Code by allowing old equity to receive new DBSD equity under the plan when a class of unsecured creditors, which was not being paid in full, rejected the plan.  The Bankruptcy Court overruled Sprint’s objection and confirmed the plan.  On appeal, the District Court affirmed the Bankruptcy Court’s decision, and Sprint joined DISH in its appeal to the Second Circuit.
A threshold issue on appeal to the Second Circuit was whether Sprint, as an “out-of-the-money” general unsecured creditor with a disputed and unliquidated claim, had standing to appeal from confirmation of DBSD’s plan.  DBSD asserted that Sprint lacked standing to appeal because the plan did not adversely affect Sprint’s interest as any interest that Sprint may have had was worthless under the valuation of DBSD.  Under such valuation, neither Sprint nor any other unsecured creditor was entitled to receive any distribution absent the “gift” from the second lien lenders.  Accordingly, DBSD argued, Sprint had no vested financial interest in the plan.  DBSD reasoned that, if the court permitted Sprint to have standing, Sprint and other similarly situated “out-of-the-money” creditors could attempt to extract hold-up value by threatening debtors with litigation and appeals.
The Second Circuit rejected DBSD’s arguments and held that Sprint had standing.  If a creditor has a valid and impaired claim, the Second Circuit opined, the creditor has standing to object to confirmation.  The Second Circuit refused to look beyond the face value of a claim to the actual underlying economic interest even though such interest could actually be zero. The Second Circuit reasoned that such a rule could bar many (if not the vast majority) of creditors from their right to appeal because most creditors are, technically, “out-of-the-money.”  Such a harsh rule would permit many erroneous decisions to stand and be a disservice to development of the law.  Although DBSD suggested a creditor could appeal the issue of valuation and, in turn, obtain standing, the Second Circuit rejected such a paradigm as an invitation for frivolous valuation disputes to be brought before the appellate courts.  While the Second Circuit acknowledged that Sprint’s recovery is based upon the grace of the second lien lenders, the Second Circuit found that to deny standing would be to deny Sprint and other similarly situated creditors leverage to improve their position (despite the limited nature of any such leverage).
In her dissent, Judge Pooler questioned whether a creditor should have standing if its claim may be invalid on its merits and, accordingly, valueless.  Judge Pooler found that under no reasonable understanding of Sprint’s claim could confirmation of DBSD’s plan have affected Sprint’s pecuniary interests.  As a result, Judge Pooler believed that Sprint did not have standing.  The implication of Judge Pooler’s dissent is that creditors with a claim of no value or questionable value should not be permitted to extract hold-up value by pursuing endless appeals.  In response, the majority stated standing cannot depend upon the merits of the underlying claim because such a requirement would place courts of appeals in the untenable position of conducting mini trials on the merits of a claim before proceeding to evaluate standing to appeal.
Despite its broad ruling, the Second Circuit did cite two examples where a creditor might be denied standing to appeal.  In the first instance, if a creditor is not objecting to improve its position as a creditor and is instead acting in a separate capacity (e.g., as a defendant in an action commenced by the debtor), such a creditor may lack standing to appeal.  The other instance is where a creditor’s claim is finally disallowed by the bankruptcy court.  The Second Circuit did not opine as to whether out of the money equity interest holders have standing to appeal.
On the one hand, the Second Circuit’s decision leaves open the door for distressed debt traders to buy “out-of-the-money” debt at cents on the dollar and to attempt to extract hold-up value by appealing confirmation of a plan and other key rulings (e.g., approval of a sale of substantially all the debtor’s assets pursuant to section 363 of the Bankruptcy Code).  On the other hand, the impact of the Second Circuit’s decision may be limited because an appellant still typically must post a bond if a stay pending appeal is granted.  Moreover, the appellants in DBSD benefited from the delay caused by the need to obtain FCC approval for DBSD’s change of control.  Because the debtors could not proceed to consummate their plan, the appellants were able to pursue their appeal in the District Court (which had denied a stay pending appeal) and then request a stay from the Second Circuit, which issued a stay “to preserve the status quo pending the outcome of the appeal.”  Appellants in other chapter 11 cases may not have such time to pursue their appeal as debtors seek to moot out their appeals by consummating their plans.
Postscript
Following the Second Circuit’s reversal, DBSD submitted a modified plan that eliminated the distribution of new common stock to DBSD’s old equity and also settled Sprint’s claim for, among other things, an allowed unsecured claim of $104 million.  Last week, DBSD announced that it had accepted, subject to Bankruptcy Court approval and a new plan, an offer from DISH to purchase DBSD for approximately $1.1 billion in cash and other consideration.  Under the proposed deal, the second lien debt holders would be paid in full and general unsecured creditors, such as Sprint, would receive a recovery (assuming Sprint is successful in the defense of its claim).  The settlement of Sprint’s claim does not appear to be part of DISH’s bid.
At a status conference before the Bankruptcy Court on Monday, Sprint and the ad hoc committee of second lien debt holders expressed concerns with DISH’s bid and the risk of not meeting a March 28 deadline for emergence in the FCC’s approval of the change of control under the Plan.  The Bankruptcy Court has set a hearing for February 15 to consider the DBSD debtors’ request to enter into the proposed investment with DISH.