March 3‚ 2011
Second Circuit Prohibits Chapter 11 Gifts to
Junior Creditor Classes
In a recent decision, the Second Circuit Court of Appeals has
cast doubt on the continued viability of the gifting doctrine in the
context of a contested Chapter 11 plan—marking yet another carve-out from
the doctrine, which gained credence in the SPM decision from the
First Circuit Court of Appeals. Gifting is a strategy sometimes used in
Chapter 11 cases where a senior creditor diverts some of the consideration
it would otherwise receive under a plan to a junior class of creditors or
equity while bypassing an intervening class of creditors.
In DBSD, the court considered an objection to the
debtor’s proposed plan (the Plan) by Sprint Nextel Corporation (Sprint),
which held an unliquidated, unsecured litigation claim. Under the Plan, a
relatively significant distribution would be made to existing equity,
despite the fact that unsecured creditors, which have a higher payout
priority than existing equity, were to receive only a minimal distribution
and not their full claim amount.
The distribution to the equity holders was to come from the
debtor’s second lien creditors (the claims of the first lien creditors were
being satisfied in full under the Plan). Defending the Plan, DBSD argued
that the distribution to existing equity was a “gift” by the second lien
creditors, who were senior to the unsecured creditors and who were also not
paid in full.
Gifting in a Chapter 11 Plan
Rejecting the proposed distribution scheme, the court
overturned the lower courts’ decisions and held that a Chapter 11 plan
cannot override the absolute priority rule, even when a senior class is
enabling the distribution by contributing a portion of its own distribution
as a gift to a junior class. The absolute priority rule, the court
emphasized, was developed by the Supreme Court and codified in the U.S.
Bankruptcy Code in order to avoid the exact kind of class-skipping proposed
by DBSD in its plan.
The absolute priority rule states that unless the class of
claims rejecting the plan is paid-in-full on their claims, no junior class
of claims or interests can receive or retain any property under the plan on
account of their junior claims or interests. The court found that the
existing equity of DBSD would be receiving property under the Plan on
account of their equity interest in violation of the absolute priority
The ruling of the court did leave open the possibility of
gifting outside of a Chapter 11 plan, as it distinguished DBSD from In
re SPM Manufacturing Corp., 984 F.2d 1305 (1st Cir. 1993). In SPM,
the First Circuit Court of Appeals upheld a Chapter 7 arrangement that
provided an undersecured creditor would share its distribution with the
unsecured creditors, thereby bypassing priority tax claims.
Reversing a lower court’s finding that such a scheme would
have resulted in an end-run around the code’s priority scheme, the court
held that because the senior creditor would not be paid in full even absent
its giving of the gift, the priority tax claims would not have been paid at
all regardless of the arrangement between the senior creditor and the
unsecured creditors. The court’s rationale was that the estate had no right
to share in the proceeds of the secured creditor’s collateral and that
creditor could do as it pleased with its property.
The DBSD court emphasized that SPM involved
Chapter 7, which “does not include the rigid absolute priority rule” found
in Chapter 11. Additionally, the property in question in SPM was treated
by the court as no longer belonging to the estate once relief from the
automatic stay was granted to the secured creditor. By contrast, the
property in question in DBSD was never removed from the estate, and
therefore it was not up to the secured creditor to decide how it would be
distributed under the Plan.
Impact of the Ruling
Courts have split on whether the SPM holding applies
in the context of a Chapter 11 plan. The DBSD decision raises additional
doubts regarding the applicability of the gifting doctrine as a tool in
orchestrating efficient distribution arrangements in Chapter 11 cases.
Although junior creditors may have gained some negotiating
leverage from the DBSD decision, senior creditors likely will
develop creative ways to reach their ultimate goal of confirming a plan.
For example, senior creditors may come to rely more upon “death trap”
provisions in plans that give potential dissenting creditors the option to
vote in favor of the plan in exchange for a gift or vote against the plan
and receive no distribution. If all classes accept the plan, whether a
death trap is used or not, the absolute priority rule is not implicated and
the rule of law under DBSD will not be violated.
Gifting plans may now be limited, but they will not
If you have any questions about the
gifting doctrine in Chapter 11 cases or any other bankruptcy matter, please
call your Mintz Levin attorney.
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