Reports of the Demise of Gifting Chapter 11 Plans Are an Exaggeration
In Hargreaves v. Nuverra Environmental Solutions Inc. (In re Nuverra Environmental Solutions Inc.), 590 B.R. 75 (D. Del. 2018), the U.S. District Court for the District of Delaware affirmed a bankruptcy court order confirming a nonconsensual chapter 11 plan that included "gifted" consideration from a senior secured creditor to fund unequal distributions to two separate classes of unsecured creditors. The court also ruled that, even though the appeal was equitably moot, the plan's separate classification and differing treatment of unsecured noteholders and trade creditors: (i) did not unfairly discriminate between, or improperly classify, the two unsecured classes because there was a rational basis for the classification scheme; and (ii) were "fair and equitable" because they did not constitute "vertical gifting" that violated applicable precedent and they promoted the debtor's reorganization.
In so ruling, the district court dispelled speculation that the U.S. Supreme Court's 2017 decision in Czyzewski v. Jevic Holding Corp. concerning "structured dismissals" might presage an end to all kinds of gifting chapter 11 plans. Because the district court's Nuverra ruling has been appealed, the U.S. Court of Appeals for the Third Circuit may soon have yet another opportunity to weigh in on gifting chapter 11 plans.
Classification of Claims and Interests Under a Chapter 11 Plan
Section 1122 of the Bankruptcy Code provides that, except with respect to a class of "administrative convenience" claims (i.e., relatively small unsecured claims, such as trade claims below a certain dollar amount), a plan may place a claim or interest in a particular class "only if such claim or interest is substantially similar to the claims or interests of such class." The statute, however, does not define "substantially similar."
This task was left to the courts. They have relied largely upon past practice under the former Bankruptcy Act and lawmakers' statements in connection with the enactment of the Bankruptcy Code that indicate that the term should be construed to mean similar in legal character or effect as a claim against the debtor's assets or as an interest in the debtor. See Collier on Bankruptcy ¶ 1122.03 (16th ed. 2018) (citing cases). Thus, for example, interests, such as stock, may not be classified together with claims, such as trade or bond debt, because the relationship between the debtor and its creditors, who assume credit risk but not enterprise risk, is fundamentally different from the relationship between the debtor and its stockholders, who undertake enterprise risk as investors. In addition, secured claims cannot be placed in the same class as unsecured claims, because a secured creditor has recourse to collateral to satisfy its debt in the event of nonpayment.
Cramdown Confirmation of a Chapter 11 Plan
Section 1129(a) of the Bankruptcy Code requires, among other things, that for a plan to be confirmable, each class of claims or interests must either accept the plan or not be "impaired." However, "cramdown" confirmation is possible in the absence of acceptance by impaired classes under section 1129(b) if all of the other plan requirements are satisfied and the plan: (i) "does not discriminate unfairly"; and (ii) is "fair and equitable" with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.
The Bankruptcy Code provides no definition of "unfair discrimination." As noted by a leading commentator, "Courts have struggled to give the unfair discrimination test an objective standard." Collier on Bankruptcy ¶ 1129.03 (16th ed. 2018). Nevertheless, most courts agree that the purpose underlying the requirement is to "ensure[ ] that a dissenting class will receive value equal to the value given to all other similarly situated classes." In re Johns-Manville Corp., 68 B.R. 618, 636 (Bankr. S.D.N.Y. 1986), aff'd, 78 B.R. 407 (S.D.N.Y. 1987), aff'd, 843 F.2d 636 (2d Cir. 1988); accord In re SunEdison, Inc., 575 B.R. 220 (Bankr. S.D.N.Y. 2017); In re 20 Bayard Views, LLC, 445 B.R. 83 (Bankr. E.D.N.Y. 2011).
Several courts have adopted some form of the unfair discrimination test (the "Markell test") articulated by Bruce A. Markell in his article A New Perspective on Unfair Discrimination in Chapter 11, 72 Am. Bankr. L.J. 227, 249 (1998). See, e.g., Law Debenture Trust Co. of New York v. Tribune Media Co. (In re Tribune Media Co.), 587 B.R. 606, 618 (D. Del. 2018); In re Armstrong World Indus., Inc., 348 B.R. 111 (D. Del. 2006); In re Quay Corp., Inc., 372 B.R. 378 (Bankr. N.D. Ill. 2007); In re Exide Techs., 303 B.R. 48 (Bankr. D. Del. 2003). The Markell test was first applied by a bankruptcy court in In re Dow Corning Corp., 244 B.R. 705 (Bankr. E.D. Mich. 1999), aff'd in relevant part, 255 B.R. 445 (E.D. Mich. 2000), aff'd in part and remanded, 280 F.3d 648 (6th Cir. 2002).
Under the Markell test, a rebuttable presumption that a plan unfairly discriminates will arise when the following elements exist:
(1) a dissenting class; (2) another class of the same priority; and (3) a difference in the plan's treatment of the two classes that results in either (a) a materially lower percentage recovery for the dissenting class (measured in terms of the net present value of all payments), or (b) regardless of percentage recovery, an allocation under the plan of materially greater risk to the dissenting class in connection with its proposed distribution.
Id. at 702. The burden then lies with the plan proponent to rebut the presumption by demonstrating that "outside of bankruptcy, the dissenting class would similarly receive less than the class receiving a greater recovery, or that the alleged preferred class had infused new value into the reorganization which offset its gain." Id.
Fair and Equitable
Section 1129(b)(2) of the Bankruptcy Code specifies what is necessary for a plan to be "fair and equitable" with respect to secured claims, unsecured claims, and interests. With respect to a class of unsecured creditors, the plan must provide that either: (i) holders of claims in the rejecting class will receive value, as of the effective date, equal to the allowed amount of their claims; or (ii) holders of claims or interests in a more junior class will not receive or retain any property under the plan on account of their claims or interests. The "fair and equitable" requirement as to unsecured creditors thus includes a form of the "absolute priority rule," which implicates the Bankruptcy Code's priority-of-distribution scheme.
The Bankruptcy Code's Distribution Scheme
The Bankruptcy Code recognizes a secured creditor's interest in estate property only to the extent that the value of the underlying collateral is equal to, or greater than, the face amount of the indebtedness. If this is not the case, the creditor will hold a secured claim in the amount of the collateral value and an unsecured claim for the deficiency. Applicable nonbankruptcy law and any agreements between the debtor and its secured creditors (or among such creditors) generally determine the relative priority of secured claims. However, if certain requirements are met, the Bankruptcy Code provides for the creation of priming liens superior to pre-existing liens in connection with financing extended to a debtor during a bankruptcy case.
The priority treatment of certain types of unsecured claims is specified in section 507(a) of the Bankruptcy Code. Priorities are afforded to a wide variety of unsecured claims, including specified categories and (in some cases) amounts of domestic support obligations, administrative expenses, employee wages, and taxes.
In a chapter 7 case, the order of distribution of unencumbered bankruptcy estate assets is determined by section 726 of the Bankruptcy Code. This order ranges from payments on claims in the order of priority specified in section 507(a), which have the highest ranking, to payment of any residual assets to the debtor, which has the lowest. Distributions are to be made pro rata to claimants of equal ranking within each of the six categories of claims specified in section 726. If claimants in a higher category of distribution receive less than full payment of their claims, lower-category claimants are to receive no distributions.
In a chapter 11 case, the plan determines the treatment of secured and unsecured claims (as well as equity interests) in accordance with the provisions of the Bankruptcy Code. As noted, if a creditor does not consent to impairment of its claim under a plan and votes to reject the plan, the bankruptcy court may confirm the plan only under certain specified conditions. Among these conditions are the following: (i) the creditor must receive at least as much under the plan as it would receive in a chapter 7 case (section 1129(a)(7)), a requirement that incorporates the priority and distribution schemes delineated in sections 507(a) and 726; and (ii) the plan must be "fair and equitable" (i.e., the plan satisfies the absolute priority rule).
Class "Gifting" Under Chapter 11 Plans
A matter of considerable debate concerning section 1129(b)'s "fair and equitable" mandate is whether the provision allows a class of senior creditors voluntarily to "gift" a portion of its recovery under a chapter 11 plan to a junior class of creditors or equity holders, while an intermediate class does not receive payment in full. This is sometimes referred to as "vertical gifting" or "class skipping."
In approving senior-class gifting, some courts rely on the First Circuit's ruling in Official Unsecured Creditors' Comm. v. Stern (In re SPM Manufacturing Corp.), 984 F.2d 1305 (1st Cir. 1993). In SPM, the First Circuit upheld the validity of a "sharing agreement" under which a substantially undersecured first-priority secured creditor in an administratively insolvent, converted chapter 7 case agreed to gift a portion of the proceeds of the sale of its collateral to general unsecured creditors even though priority tax claims were not paid. Reasoning that the lender was otherwise entitled to the entire amount of any proceeds of the sale of the debtor's assets, the court wrote that "[w]hile 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."
Even though SPM was a chapter 7 case, some courts have cited the ruling as authority for confirming a nonconsensual chapter 11 plan 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) and the Bankruptcy Code's priority scheme. See, e.g., In re MCorp. Financial, Inc., 160 B.R. 941 (S.D. Tex. 1993); In re Journal Register Co., 407 B.R. 520 (Bankr. S.D.N.Y. 2009); In re World Health Alternatives, Inc., 344 B.R. 291 (Bankr. D. Del. 2006); In re Union Fin. Servs. Grp., 303 B.R. 390 (Bankr. E.D. Mo. 2003); In re Genesis Health Ventures, Inc., 266 B.R. 591 (Bankr. D. Del. 2001).
Other courts have rejected SPM and the gifting doctrine as being contrary to both the Bankruptcy Code and notions of fairness. See, e.g., DISH Network Corp. v. DBSD N. Am., Inc. (In re DBSD N. Am., Inc.), 634 F.3d 79 (2d Cir. 2011) (ruling that a class-skipping gift made by an undersecured creditor to old equity under a plan violated the absolute priority rule, but declining to determine whether the creditor, after receiving a distribution under the plan, could in turn distribute a portion of that recovery to old equity "outside the plan").
In In re Armstrong World Indus., Inc., 432 F.3d 507 (3d Cir. 2005), the Third Circuit affirmed an order denying confirmation of a chapter 11 plan under which equity holders would receive warrants waived by one class of unsecured creditors even though another class of unsecured creditors received less than full payment. According to the Third Circuit, if the distribution scheme proposed in the debtor's plan were permitted, it "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 court in World Health Alternatives, 344 B.R. at 299, "Armstrong distinguished, but did not disapprove of," the gifting doctrine because it left open the possibility that gifts by a senior class under a plan might pass muster under other circumstances.
Settlements, Structured Dismissals, and Jevic
Most rulings construing the "fair and equitable" requirement in section 1129(b) involve proposals under a chapter 11 plan providing for the distribution of value to junior creditors without paying more 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), 478 F.3d 452 (2d Cir. 2007), the Second Circuit ruled that the most important consideration in determining whether the court should approve a pre-chapter 11 plan settlement of disputed claims as being "fair and equitable" is whether the terms of the settlement comply with the Bankruptcy Code's distribution scheme. In remanding a proposed "gifting" settlement to the bankruptcy court for further factual findings, the Second Circuit reserved the question of whether the gifting doctrine "could ever apply to Chapter 11 settlements." The Second Circuit, however, rejected a per se rule invalidating the practice, such as that adopted by the Fifth Circuit in United States v. AWECO, Inc. (In re AWECO, Inc.), 725 F.2d 293 (5th Cir. 1984).
Because of the significant time and costs associated with confirming a liquidating chapter 11 plan or converting the case to chapter 7 following the sale of substantially all of a debtor's assets under section 363(b) of the Bankruptcy Code, "structured dismissals" of chapter 11 cases have become a popular mechanism for concluding liquidating chapter 11 cases. A structured dismissal is conditioned upon certain elements agreed to in advance by stakeholders and then approved by the court, as distinguished from an unconditional dismissal of the chapter 11 case ordered by the court under section 1112(b). One such structured dismissal reached the U.S. Supreme Court on appeal from the Jevic bankruptcy case.
In In re Jevic Holding Corp., 787 F.3d 173 (3d Cir. 2015), the Third Circuit ruled that "absent a showing that a structured dismissal has been contrived to evade the procedural protections and safeguards of the plan confirmation or conversion processes, a bankruptcy court has discretion to order such a disposition." The court also held that "bankruptcy courts may approve settlements that deviate from the priority scheme of [the Bankruptcy Code]," but only if the court has "specific and credible grounds" to justify the deviation. The Third Circuit affirmed approval of a structured dismissal of a chapter 11 case that incorporated a settlement under which unsecured creditors would receive a distribution from secured creditors' collateral, but certain holders of priority wage claims would receive nothing. According to the court, "dire circumstances" justified the remedy—the debtor had no prospect of confirming a plan, and conversion of the case to chapter 7 would mean that only secured creditors would recover anything.
The U.S. Supreme Court reversed in Czyzewski v. Jevic Holding Corp., 137 S. Ct. 973 (2017). By a vote of 6-2, the Court held that, without the consent of affected creditors, bankruptcy courts may not approve "structured dismissals" providing for distributions that "deviate from the basic priority rules that apply under the primary mechanisms the [Bankruptcy] Code establishes for final distributions of estate value in business bankruptcies."
The Court distinguished cases where courts have approved interim settlements that distributed estate assets in violation of the priority rules, such as Iridium, from Jevic, which involved final distributions pursuant to a structured dismissal. The Court found that Iridium "does not state or suggest that the Code authorizes nonconsensual departures from ordinary priority rules in the context of a dismissal—which is the final distribution of estate value—and in the absence of any further unresolved bankruptcy issues." In this sense, the Court explained, the situation in Iridium is similar to certain "first-day" orders, where courts have allowed for, among other things, payments ahead of secured and priority creditors to employees for prepetition wages or to "critical vendors" on account of their prepetition invoices. However, the Court noted that "in such instances one can generally find significant Code-related objectives that the priority-violating distributions serve." By contrast, the Court explained, the structured dismissal in Jevic served no such objectives—it did not benefit disfavored creditors by preserving the debtor as a going concern in order for the debtor to possibly emerge under a confirmable plan of reorganization.
Nevertheless, the Court wrote, "We express no view about the legality of structured dismissals in general."
At least one court has invoked Jevic in refusing to approve a settlement involving distributions in violation of the Bankruptcy Code's priority scheme. See In re Fryar, 570 B.R. 602 (Bankr. E.D. Tenn. 2017). Until Nuverra, however, no court had addressed whether a gifting chapter 11 plan is categorically prohibited by the Supreme Court's ruling in Jevic.
Nuverra Environmental Solutions, Inc., and certain affiliates (collectively, "NES") filed a prepackaged chapter 11 case on May 1, 2017, in the District of Delaware with $500 million in secured debt and a value of approximately $300 million. NES's chapter 11 plan proposed a secured debt-for-equity swap as well as distributions to unsecured creditors consisting of: (i) a combination of new stock and cash to unsecured noteholders amounting to a 4 to 6 percent recovery; and (ii) reinstatement and payment in full of trade and certain other business-related unsecured claims (collectively, "trade claims"). Senior secured creditors agreed to fund all payments to unsecured creditors, which otherwise would receive nothing under the plan.
The unsecured noteholder class voted to reject the plan. An unsecured noteholder ("Hargreaves") objected to confirmation, arguing that: (i) the plan's proposed treatment of the dissenting unsecured noteholder class was not "fair and equitable," because the plan distributed less value to that class than to the trade claim class; and (ii) the plan's classification scheme was improper.
The bankruptcy court overruled the objection and confirmed the plan. The court determined that separate classification of the noteholder claims and the trade claims was reasonable, because trade creditors were critical to the success of reorganized NES. In addition, the court ruled that, although the disparate treatment of the classes gave rise to a rebuttable presumption of unfair discrimination, that presumption had been rebutted because the noteholder class was "indisputably out of the money and not, otherwise, entitled to any distribution under the [B]ankruptcy [C]ode's priority scheme[,] and . . . the proposed classification and treatment of the unsecured creditors fosters a reorganization of these debtors." The court also held that the plan satisfied the absolute priority rule, because the secured creditors' "gift" was not from estate property.
Hargreaves appealed the confirmation order to the district court. The bankruptcy court denied his request to stay the confirmation order beyond the 10-day period specified in the order, finding that he was unlikely to succeed on the merits and would not suffer irreparable harm absent a stay.
The District Court's Ruling
The district court affirmed. As an initial matter, the court ruled that the appeal was equitably moot. The judge-fashioned remedy of "equitable mootness" bars adjudication of an appeal when a comprehensive change of circumstances has occurred such that it would be inequitable for a reviewing court to address the merits of the appeal. In bankruptcy cases, appellees often invoke equitable mootness as a basis for precluding appellate review of an order confirming a chapter 11 plan. See, e.g., In re LCI Holding Company, Inc., 802 F.3d 547, 554 (3d Cir. 2015) (stating that the doctrine "comes into play in bankruptcy (so far as we know, its only playground) after a plan of reorganization is approved" and ruling that equitable mootness would not cut off the authority to hear an appeal outside the plan context).
In Nuverra, the district court concluded that NES had "substantially consummated" its chapter 11 plan and that the relief sought by Hargreaves—equal distributions to noteholders and trade creditors—would "require undoing the [p]lan" and necessarily result in harm to third parties. Specifically, the court noted, "disgorgement would require the clawback, not only of cash payments made to hundreds of individual creditors, but also the clawback of stock that is trading on the national stock exchange, and may now be held by third parties who purchased these securities in the ordinary course."
In addition, the district court addressed the merits of the appeal. It ruled that NES's chapter 11 plan did not unfairly discriminate between the trade creditor and noteholder classes and that the plan's classification scheme was permissible.
Considering the Markell test for unfair discrimination, the court noted that: (i) the Third Circuit has not mandated that the test be applied in determining whether a plan discriminates unfairly; and (ii) the test does not address a situation in which the disparately treated classes are to receive distributions provided solely by means of a senior-class gift.
Even so, the district court concluded that the bankruptcy court did not err in applying the test. Specifically, the district court found no fault in the bankruptcy court's holdings that: (i) the presumption of unfair discrimination had been rebutted because the noteholder class was not otherwise entitled to any distribution under the Bankruptcy Code's priority scheme; and (ii) the plan's treatment of the trade creditor class fostered NES's reorganization. Because Hargreaves and his class were not entitled to any distribution in the first place, the court wrote, "providing a greater distribution to a different class of unsecured creditors does not alter the distribution" to which the noteholder class was entitled.
In so ruling, the district court distinguished between vertical and horizontal gifting. It explained that gifting in a manner that skips over an intermediate junior class of dissenting creditors—vertical gifting—violates the absolute priority rule. By contrast, horizontal gifting "concerns unequal gifts by a secured creditor to two classes of junior creditors." Only the former, the district court emphasized, is foreclosed by Third Circuit precedent, whereas horizontal gifting was expressly sanctioned by the bankruptcy courts in General Health Ventures and World Health Alternatives and is not foreclosed by the Third Circuit's ruling in Armstrong.
According to the court, nearly all of the cases cited by Hargreaves involved vertical gifting, and the only decision finding horizontal gifting invalid—In re Sentry Operating Co. of Texas, 264 B.R. 850 (Bankr. S.D. Tex. 2001)—was both nonbinding and distinguishable. In Sentry, the Nuverra district court explained, the court held that a plan under which a secured creditor gifted funds to pay trade creditor claims, but provided only a de minimis distribution to other unsecured creditors, unfairly discriminated because of conflicts of interest—the debtors' competitor controlled the secured creditor, and the secured creditor's corporate parent conducted substantial business with the trade creditors.
Finally, the district court ruled that separate classification of the trade and noteholder claims in NES's chapter 11 plan was permissible, because there was a rational basis for the classification. The court noted that numerous courts permit the practice "on the grounds that such claims have different legal attributes" (citing In re Coram Healthcare Corp., 315 B.R. 321 (Bankr. D. Del. 2004)). According to the district court, the evidentiary record supported the bankruptcy court's conclusion that separate classification: (i) fostered NES's reorganization; (ii) was not arbitrary or fraudulent; and (iii) was necessary to preserve what little trade credit NES still had, because NES's businesses typically operated in smaller towns with limited vendors and because failing to pay any vendor accordingly would likely tarnish NES's reputation and harm relationships with other current or potential vendors.
Senior-class gifting is an important tool for building consensus on the terms of a confirmable chapter 11 plan. Nuverra indicates that horizontal gifting is still alive and well, at least under the facts involved, because it offends neither Third Circuit precedent nor the Supreme Court's prohibition of final distributions that violate the Bankruptcy Code's priority scheme. The harder question—i.e., the validity of vertical gifting or other distributions (interim or final) that run afoul of the Bankruptcy Code's priority scheme but serve a valid reorganizational purpose or another "Code-related objective"—remains for another day. Hargreaves appealed the district court's ruling on September 19, 2018. Thus, the Third Circuit may have yet another opportunity to weigh in on gifting chapter 11 plans.
Another key takeaway from Nuverra is the principle that separate classification and treatment of different groups of general unsecured creditors, even where separate classification of such creditors creates an accepting impaired class needed for cramdown confirmation, violates neither section 1122 nor 1129(b)(2) so long as the plan proponent can articulate a rational basis for separate classification and show that it promotes reorganization.
A version of this article was previously published in The Bankruptcy Strategist. It has been reprinted here with permission.
Jones Day publications should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general information purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at our discretion. To request reprint permission for any of our publications, please use our "Contact Us" form, which can be found on our website at www.jonesday.com. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the Firm.