United States: U.S. Second Circuit Curtails "Gifting" In Plans Of Reorganization

An important Second Circuit Court decision that secured lenders and strategic investors should take note of has rejected the commonly used insolvency tactic of "gifting" – the transferring of rights or interests by a senior creditor to a junior creditor to gain support for a proposed reorganization plan. The United States Court of Appeals for the Second Circuit in In re DBSD N.A., Inc.¹ ruled that gifting improperly circumvents the absolute priority rule in bankruptcy, which provides that a plan is not "fair and equitable" with respect to a dissenting class of creditors unless the creditors in the class are paid in full or no junior creditors or equity holders receive a distribution under the plan. In holding that the senior creditors could not gift recoveries to shareholders over the objection of unsecured creditors, the Second Circuit aligned itself with the Court of Appeals for the Third Circuit. Thus, gifting is severely curtailed in reorganization cases filed in New York and Delaware. The Court also addressed critical issues relating to voting and appeals in the plan context.

In the Chapter 11 case of the satellite communications company DBSD North America, Inc., two creditors, DISH Network Corporation and Sprint Nextel Corporation appealed confirmation of the plan of reorganization of DBSD. DISH held no prepetition claims against DBSD but is a substantial investor in a direct competitor of DBSD. The bankruptcy court prevented DISH from voting on the plan because in a "loan to own" strategy, DISH purchased all of DBSD's first lien debt and a blocking portion of DBSD's second lien debt and thus its opposition to the plan was not in good faith. Sprint, a litigation creditor holding an unliquidated and disputed general unsecured claim, argued that DBSD's plan violated the absolute priority rule. Under the plan, the first lien creditors were being paid in full whereas second lien creditors were not paid in full and received new equity, and some stock and warrants were gifted to prepetition equity holders.

The major issues on appeal were (i) whether a Chapter 11 plan may involve the "gift" of recoveries from a senior creditor to junior creditors and interest holders over the objection of impaired unsecured creditors despite the absolute priority rule; (ii) whether an "out-of-the money" creditor with an unliquidated and disputed claim has standing to appeal confirmation of a plan; and (iii) whether purchasing a blocking position of claims to further strategic objectives constitutes a basis for a court "designating" and, thus, not counting, a plan vote as "not in good faith."

First, the Second Circuit upheld the appeal of Sprint that DBSD's plan violated the absolute priority rule. In adopting a strict constructionist view of the absolute priority rule, the Court held that a senior creditor could not gift recoveries to junior holders over the objection of impaired unsecured creditors. The Second Circuit disagreed with the bankruptcy court's conclusion that the plan did not violate the absolute priority rule under the "gifting" exception to the absolute priority rule, as formulated by the First Circuit in Official Unsecured Creditors Comm. v. Stern (In re SPM Mfg. Corp.) ² and rejected by the Third Circuit in In re Armstrong World Industries, Inc.³ This decision will undoubtedly affect restructuring plans in the Southern District of New York as it has done in Delaware. Perhaps senior creditors with postconfirmation ownership interests will disclose their intent to give distributions to junior parties after the reorganization plan is confirmed to maximize the value of their investment as the Court did not rule on gifting outside a plan. However, this approach has drawbacks in that a court might view it as against public policy, certain bankruptcy code securities law exemptions would be inapplicable and there are practical difficulties in binding the shareholders to a private arrangement.

Second, the Second Circuit held that Sprint, an "out-of-the money" creditor with an unliquidated and disputed claim, has standing to appeal an order confirming a plan of reorganization. In dissent, one appellate judge believed that a creditor with an unliquidated claim should not have standing to appeal a confirmation order in the absence of demonstrating pecuniary loss.

Third, the Second Circuit upheld the bankruptcy court's designation of DISH's rejecting vote against DBSD's plan under section 1126(e) of the Bankruptcy Code as being "not in good faith." The Court stated that although having ulterior motives in voting on a plan is not per se improper, certain motives rise to the level of not being in good faith. The Court found that the designation was warranted when DBSD purchased claims after DISH's plan was proposed in an attempt to "bend the bankruptcy process" to control the company and the spectrum rights, and not "towards protecting its claim." The Court noted, however, that preexisting creditors may not be subject to the same designation. It appears that vote designation is a very fact-specific issue for courts.

Footnotes

1 __ F.3d __ (2d Cir. Feb. 7, 2011) (Nos. 10-1175, 10-1201, 10-1352).

2 984 F.2d 1305, 1313-14 (1st Cir. 1993).

3 432 F.3d 507, 514 (3d Cir. 2005).

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