Reports of the Demise of Senior-Class Gifting in Chapter 11 an Exaggeration
“Give-ups” by senior classes of creditors to achieve confirmation of a plan have become an increasingly common feature of the chapter 11 process, as stakeholders strive to avoid disputes that can prolong the bankruptcy case and drain estate assets by driving up administrative costs. Under certain circumstances, however, senior-class “gifting” or “carve-outs” from senior-class recoveries may violate a well-established bankruptcy principle commonly referred to as the “absolute priority rule,” a maxim predating the enactment of the Bankruptcy Code that established a strict hierarchy of payment among claims of differing priorities. The rule’s continued application under the current statutory scheme has been a magnet for controversy. Even so, a ruling recently handed down by a New York bankruptcy court in In re Journal Register Co. indicates that senior-class gifting continues to be an important catalyst toward achieving confirmation of a chapter 11 plan.
Cram-Down and the “Fair and Equitable” RequirementIf a class of creditors or shareholders votes to reject a chapter 11 plan, it can be confirmed only if the plan satisfies the requirements of section 1129(b) of the Bankruptcy Code. Among these is the mandate that a plan be “fair and equitable” with respect to dissenting classes of creditors and shareholders.
Section 1129(b)(2) of the Bankruptcy Code provides that a plan is “fair and equitable” with respect to a dissenting impaired class of unsecured claims if the creditors in the class receive or retain property of a value equal to the allowed amount of their claims or, failing that, if no creditor of lesser priority, or no equity holder, receives any distribution under the plan. This requirement is sometimes referred to as the “absolute priority rule.”
Section 1129(b)(2) has been the focus of considerable debate in the courts. One of the most significant disputes concerns the propriety of an increasingly common, albeit controversial, practice in large chapter 11 cases—whether section 1129(b)(2) allows a class of senior creditors voluntarily to cede a portion of its recovery under a plan to a junior class of creditors or equity holders, while an intermediate class is not receiving payment in full.
Legitimacy of Senior-Class “Give-Ups” Under the Absolute Priority Rule
Notwithstanding section 1129(b)(2)’s preclusion of distributions to junior classes of claims or equity interests in cases where it applies, some courts have ruled that a plan does not violate the “fair and equitable” requirement if a class of senior creditors agrees that some of the property that would otherwise be distributed to it under the plan can be given to a junior class of creditors or shareholders. In doing so, many courts rely on a 1993 decision involving a chapter 7 case issued by the First Circuit Court of Appeals in In re SPM Manufacturing Corp.
In SPM, a secured lender holding a first-priority security interest in substantially all of a chapter 11 debtor’s assets entered into a “sharing agreement” with general unsecured creditors to divide the proceeds that would result from the reorganization, presumably as a way to obtain their cooperation in the case. After the case was converted to a chapter 7 liquidation, the secured lender and the unsecured creditors tried to force the chapter 7 trustee to distribute the proceeds from the sale of the debtor’s assets in accordance with the sharing agreement. The agreement, however, contravened the Bankruptcy Code’s distribution scheme because it provided for distributions to general unsecured creditors before payment of priority tax claims. The bankruptcy court ordered the trustee to ignore the sharing agreement and to distribute the proceeds of the sale in accordance with the statutory distribution scheme. The district court upheld that determination on appeal.
The First Circuit reversed, reasoning that, as a first-priority secured lien holder, the lender was entitled to the entire amount of any proceeds of the sale of the debtor’s assets, whether or not there was a sharing agreement. According to the Court, “While the debtor and the trustee are not allowed to pay nonpriority creditors ahead of priority creditors . . . , creditors are generally free to do whatever they wish with the bankruptcy dividends they receive, including to share them with other creditors.”
Other courts have cited SPM as authority for confirming a nonconsensual chapter 11 plan (or approving a settlement) in which a senior secured creditor assigns a portion of its recovery to creditors (or shareholders) who would otherwise receive nothing by operation of section 1129(b)(2). Still, the concept of allowing a senior creditor or class of creditors to assign part of its recovery under a chapter 11 plan to junior creditors or equity holders who would otherwise receive nothing by operation of section 1129(b)(2) is controversial. Some courts have rejected the gifting doctrine altogether as being contrary to both the Bankruptcy Code and notions of fairness. Others, such as the Third Circuit Court of Appeals in its 2005 ruling in In re Armstrong World Indus., Inc., have invalidated certain applications of the doctrine without rejecting it out of hand.
Armstrong World Industries, Inc. (“Armstrong”), proposed a chapter 11 plan under which unsecured creditors (other than asbestos claimants) would recover approximately 59.5 percent of their claims and asbestos personal-injury creditors would recover approximately 20 percent of an estimated $3.1 billion in claims. In addition, the plan provided that Armstrong’s equity holders would receive warrants to purchase new common stock in the reorganized company valued at $35 million to $40 million. A key provision of the plan was the consent of the class of asbestos claimants to share a portion of its proposed distribution with equity. The plan provided that, if Armstrong’s class of unsecured creditors (other than asbestos claimants) voted to reject the plan, asbestos claimants would receive new warrants but would automatically waive their distribution, causing equity holders to obtain the warrants that otherwise would have been distributed to the asbestos claimants.
Armstrong’s general unsecured creditors voted against the plan. The Delaware district court, upon review of the bankruptcy court’s proposed findings of fact and conclusions of law, denied confirmation, ruling that distribution of new warrants to the class of equity holders over the objection of the general unsecured creditor class violated the “fair and equitable” requirement of section 1129(b)(2)(B)(ii). In doing so, it distinguished, or characterized as “wrongly decided,” cases in which the courts have not strictly applied section 1129(b)(2). It found SPM to be inapposite because the distribution in SPM occurred in a chapter 7 case, “where the sweep of 11 U.S.C. § 1129(b)(2)(B)(ii) does not reach,” and SPM’s unsecured creditors, rather than being deprived of a distribution, were receiving a distribution ahead of priority, such that “the teachings of the absolute priority rule—which prevents a junior class from receiving a distribution ahead of the unsecured creditor class—are not applicable.” The court also found that the sharing agreement in SPM might be more properly construed as an ordinary “carve-out,” whereby a secured party allows a portion of its lien proceeds to be paid to others as part of a cash collateral agreement.
The Third Circuit affirmed on appeal, adopting substantially all of the lower court’s reasoning regarding the strictures of the absolute priority rule. According to the court of appeals, allowing the distribution scheme proposed in Armstrong’s plan “would encourage parties to impermissibly sidestep the carefully crafted strictures of the Bankruptcy Code, and would undermine Congress’s intention to give unsecured creditors bargaining power in this context.” However, the Third Circuit did not categorically reject the gifting doctrine. Rather, as noted by the bankruptcy court in In re World Health Alternatives, Inc. in its 2006 ruling, “Armstrong distinguished, but did not disapprove” the gifting doctrine because it left open the possibility that give-ups by a senior class under a plan might pass muster under other circumstances.
Finally, some courts have refused to condone gifting when the practice is used for an ulterior, improper purpose. For example, in In re Scott Cable Communications, Inc., a debtor proposed a liquidating chapter 11 plan that provided for payment of administrative, priority, and unsecured claims from recoveries that were otherwise payable to secured creditors but did not provide for payment of capital gains taxes arising from the sale of its assets. The bankruptcy court refused to confirm the plan, ruling that its principal purpose was to avoid taxes, contrary to section 1129(d), and that reliance on SPM as authority for the proposed gifting was misplaced, given the different circumstances involved (e.g., the inapplicability of section 1129 in SPM).
Most rulings construing the “fair and equitable” requirement in section 1129(b) involve proposed distribution schemes under a chapter 11 plan providing for the distribution of value to junior creditors without paying senior creditors in full. Even so, the dictates of the absolute priority rule must be considered in other related contexts as well. For example, in Motorola, Inc. v. Official Comm. of Unsecured Creditors (In re Iridium Operating LLC), the Second Circuit ruled that the most important consideration in determining whether a pre-plan settlement of disputed claims should be approved as being “fair and equitable” is whether the terms of the settlement comply with the Bankruptcy Code’s distribution scheme. In remanding a proposed settlement based upon the gifting doctrine to the bankruptcy court for further factual findings, the Second Circuit reserved the question whether the doctrine “could ever apply to Chapter 11 settlements,” but it rejected a per se rule adopted by a sister circuit invalidating the practice.
A New York bankruptcy court recently had an opportunity to examine the gifting doctrine in Journal Register.
Journal Register Company and 26 affiliates (collectively “JRC”), a national media company established in 1997 that owns and operates daily newspapers, nondaily publications, news and employment web sites, and commercial printing facilities, filed for chapter 11 protection in February 2009 in New York. At the time it filed for bankruptcy, substantially all of JRC’s assets were encumbered by perfected first-priority liens securing nearly $700 million in debt. JRC proposed a chapter 11 plan in May that provided for, among other things: (i) conversion of a portion of the senior secured debt to 100 percent of the equity in the reorganized debtor and the issuance of two new tranches of debt with first and third priority in exchange for the remainder of the senior secured debt; (ii) payment in full of priority tax, administrative, and other secured claims; (iii) pro rata distribution of $2 million to unsecured creditors, representing an approximate 9 percent recovery; (iv) no distribution to creditors asserting securities-law claims against JRC; and (v) cancellation of existing stockholder interests. The midrange of the bankruptcy valuations conducted by JRC’s advisor placed the company’s worth at approximately $300 million, meaning that the senior lenders were significantly undersecured.
In addition, the senior secured lenders agreed to fund a “trade account distribution” in the amount of nearly $7 million, which was to be distributed pro rata to unsecured trade creditors who did not object to confirmation of the plan and consented to the release of any claims against JRC and the lenders arising during the chapter 11 case or from confirmation of the plan. This “gift” was to be placed in a “trade account” that “shall not constitute property of the Debtors or the Reorganized Debtors,” and any undistributed portion of the funds “shall become the sole and exclusive property” of the lenders. The details of the distribution were expressly incorporated into the “means of implementation” section of the plan. The plan also designated an “unsecured claim distribution agent” and a “plan distribution agent” to administer plan distributions to all unsecured creditors, including creditors qualifying for distributions from the trade account. At the confirmation hearing, JRC’s chief restructuring officer testified that the trade account distribution “was critically important to the future of the Reorganized Debtors and their ability to fulfill their business plan, in that it would ensure the goodwill and survival of certain trade creditors that were under severe financial stress themselves and were essential to the Debtors’ daily operations and long-term survival.”
All classes of creditors entitled to vote (including the sole unsecured class, in which trade and other unsecured creditor claims were classified together) voted overwhelmingly in favor of the plan. Because the securities claimant and equity classes were deemed to reject the plan, JRC sought confirmation of the plan under the “cram-down” provisions in section 1129(b) of the Bankruptcy Code. Among the objections to confirmation interposed by creditors and shareholders was an objection filed by Central States Pension Fund (“Central States”), an employee pension plan asserting unsecured claims against JRC in the amount of $4.3 million on behalf of 46 of JRC’s employees. According to Central States, the secured lenders’ gift under the plan violated sections 1122 and 1129(b) of the Bankruptcy Code.
The bankruptcy court overruled the objection. Initially, the court determined that Central States’ reliance on section 1122, which provides that “a plan may place a claim or an interest in a particular class only if such claim or interest is substantially similar to the other claims or interests of such class,” was misplaced. Because all nonpriority unsecured claims were classified in a single class, the court explained, “compliance with § 1122 is not an issue.” The court similarly rejected Central States’ assertion that the plan discriminated unfairly in violation of section 1129(b)(1), ruling that the provision did not bar confirmation because it “is concerned with plan treatment between classes, not within classes” and “there is no charge of unfair discrimination between classes of creditors.”
The court then addressed that portion of the objection implicating the absolute priority rule:
Section 1129(b) of the Bankruptcy Code also requires that a cramdown plan satisfy the fair and equitable or absolute priority rule. This was the rule at issue in Armstrong, and the fact that the so-called gift had the effect of undermining the priority principles of the Code was the principal factor that the Circuit Court relied on in reversing. Here, there is no forced distribution from one class to a junior class over the objection of an intervening dissenting or objecting class. The “gift” by a small group of Secured Lenders is wholly consensual on their part, and there is no contention that they are making the “gift” to another class over the dissent of an intervening class.
According to the court, the only objection to confirmation that could be raised by Central States under the circumstances would be under section 1123(a)(4) of the Bankruptcy Code, which provides that a chapter 11 plan must “provide the same treatment for each claim or interest of a particular class, unless the holder of a particular claim or interest agrees to a less favorable treatment of such particular claim or interest.” Because trade creditors in the unsecured class qualifying for the trade distribution would be entitled to a greater recovery following confirmation than other unsecured creditors, the court explained, the plan could violate section 1123(a)(4) if the “gift” creating the difference were provided “under the plan.”
The bankruptcy court concluded that it was not. Members of an unsecured class, the court noted, may have rights to payment from third parties, such as joint obligors, sureties, and guarantors, that may entitle them to a greater recovery than other creditors in the same class. The existence of such rights, the court remarked, “does not create a classification problem under § 1123(a),” nor does the debtor’s right under section 524(f) to repay a creditor in full voluntarily, notwithstanding discharge of the underlying debt. According to the court, neither these rights, nor the secured lenders’ “gift” in the form of a trade distribution, runs afoul of section 1123(a)(4) because they do not involve distributions “under” a chapter 11 plan:
Since there is no principle that would preclude the Secured Lenders from making the “gift” totally outside the Plan and the chapter 11 process, the further question is whether the fact that certain provisions of the Plan facilitate the “gift” and provide that it is one of the “means of execution of the Plan” should cause the Court to invalidate it. Under the circumstances, the provisions of the Plan relating to the Trade Account Distribution are immaterial and do not cause it to be an inappropriate distribution “under the Plan.” The fact that the Plan provides for an administrator to make the distribution and for the Court to resolve any disputes does not implicate the classification scheme under the Plan. Indeed, if the Court excised the gift provision from the Plan, the recoveries of the “disfavored” Class 4 creditors would not be increased. This would only put the “gift” at risk by providing the Secured Lenders with an opportunity to withdraw their offer. It would also make it much more difficult to resolve disputes as to who is a trade creditor, since the Court would have no jurisdiction over the issue, and the process would be carried out by the Secured Lenders alone or be subject to an expensive and extended proceeding under State law. This would not benefit any party.
A “more negative result would take place,” the court explained, were it to deny confirmation altogether on the basis of unequal treatment, as JRC and the secured lenders could propose another plan that provided no recovery for unsecured creditors, or the secured lenders could seek dismissal of the bankruptcy case to foreclose on their collateral. Finally, the bankruptcy court determined that the secured lenders’ gift was not being used for an “ulterior purpose” because, among other things: (i) JRC adequately demonstrated that the gift was necessary to ensure the goodwill of trade creditors essential to JRC’s post-confirmation survival; (ii) the goal of the gift was “in accordance with the overriding purpose of chapter 11 that going concern value be preserved and enhanced”; and (iii) both the favored and disfavored members of the unsecured class voted overwhelmingly to accept it.
Journal Register confirms that senior-class gifting continues to be an important yet controversial catalyst in the chapter 11 process. The “gift or graft” debate is likely to endure, given the prominence of the practice in high-profile chapter 11 cases such as the bankruptcies of Journal Register, casino and slot machine operator Herbst Gaming Inc., and former telecom giant WorldCom Inc. According to some commentators, it should be neither controversial nor illegal if a senior creditor wishes to give up a portion of its recovery to other creditors, particularly if it serves the legitimate and laudable goal of allowing a debtor to reorganize successfully in chapter 11. Even so, there is a fine line between facilitating the reorganization process and buying votes in favor of a plan, and courts will continue to struggle in an effort to strike the proper balance between complying with the dictates of the Bankruptcy Code and enabling rehabilitation of a chapter 11 debtor by means of intercreditor dealmaking.
The bankruptcy court in Journal Register was able to skirt the classic gifting problem due to the absence of an intervening dissenting class of creditors. Even so, its conclusion that disparate recoveries to creditors in the same class did not offend section 1123(a)(4) because the payments to trade creditors were not “under the plan” is not without controversy. As noted, the trade distributions were expressly incorporated into JRC’s chapter 11 plan as a “means of implementation.” Moreover, in light of the court’s conclusion that no additional distributions were being made under the plan, we are left to speculate whether it would have confirmed the plan even if there had been an intervening dissenting class.
In re Journal Register Co., 407 B.R. 520 (Bankr. S.D.N.Y. 2009).
Official Unsecured Creditors’ Committee v. Stern (In re SPM Manufacturing Corp.), 984 F.2d 1305 (1st Cir. 1993).
In re Union Fin. Servs. Group, 303 B.R. 390 (Bankr. E.D. Mo. 2003).
In re Genesis Health Ventures, Inc., 266 B.R. 591 (Bankr. D. Del. 2001).
In re Parke Imperial Canton, Ltd., 1994 WL 842777 (Bankr. N.D. Ohio).
In re MCorp. Financial, Inc., 160 B.R. 941 (S.D. Tex. 1993).
In re World Health Alternatives, Inc., 344 B.R. 291 (Bankr. D. Del. 2006).
In re Armstrong World Indus., Inc., 432 F.3d 507 (3d Cir. 2005).
In re Snyders Drug Stores, Inc., 307 B.R. 889 (Bankr. N.D. Ohio 2004).
In re Scott Cable Communications, Inc., 227 B.R. 596 (Bankr. D. Conn. 1998).
Motorola, Inc. v. Official Comm. of Unsecured Creditors (In re Iridium Operating LLC), 478 F.3d 452 (2d Cir. 2007).