Second Circuit Holds “Gifting” Plan Violates Absolute Priority Rule and Disregards Blocking Vote Cast by Competitor Attempting to Take Control of Debtor
On February 7, 2011, United States Court of Appeals for the Second Circuit issued an opinion on two consolidated appeals from the order confirming the plan of reorganization in In re DBSD North America, Inc.1 The court struck down a plan of reorganization with so-called “gifting” provisions in which a senior class shares its distribution with an out of the money junior class as violating the absolute priority rule. The Second Circuit also upheld the lower court’s “designation” (i.e., disqualification) of the blocking vote cast by a competitor of the debtor who was attempting to take control of the debtor’s valuable spectrum rights. This opinion may have profound consequences for plan formulation and confirmation, and may chill the market for post-petition loan to own strategies.
Facts in DBSD
DBSD was founded in 2004 to develop a mobile communications network that would use both satellites and land-based transmission towers. DBSD filed chapter 11 in May 2009, listing liabilities of $813 million and assets of $627 million (at book value). DBSD’s capital structure included First Lien Debt in the amount of $40 million that bore interest at 12.5%, Second Lien Debt in the amount of $740 million, unsecured claims and equity. Sprint Nextel Corporation (“Sprint”) filed a claim against each of the DBSD entities jointly and severally in the amount of $211 million. Sprint’s claim was based on a lawsuit against a DBSD subsidiary under which Sprint sought reimbursement for DBSD’s share of certain spectrum relocation expenses under an FCC order. The bankruptcy court temporarily allowed Sprint’s claim in the amount of $2 million for voting purposes.
DBSD proposed a plan of reorganization which provided that the holders of the First Lien Debt would receive new obligations with a four-year maturity date and the same 12.5% interest rate, but with interest to be paid in kind (“PIK”) for the first four years. Because the bankruptcy court valued reorganized DBSD as worth between $492 million and $692 million, the holders of the Second Lien Debt were only partially in the money, and all junior classes were out of the money. Therefore, the plan provided that the holders of the Second Lien Debt would receive the bulk of the shares of the reorganized entity, which the bankruptcy court estimated would be worth between 51% and 73% of their original claims. Despite being out of the money, junior classes shared in the distribution. Thus, the holders of unsecured claims, such as Sprint, would receive shares estimated as worth between 4% and 46% of their original claims. Moreover, existing equity would receive shares and warrants in the reorganized entity.
Sprint objected to the plan, arguing that the plan violated the absolute priority rule of Section 1129(b)(2)(B), which requires that, if a class of dissenting unsecured creditors will not receive the full value of its claims under the plan, no junior class of claims or interests may receive or retain any property under the plan on account thereof. Sprint noted that the existing shareholder, whose interest was junior to Sprint’s class of general unsecured claims, would receive substantial quantities of shares and warrants under the plan. In fact, equity would receive more value than the class of unsecured claims. The bankruptcy court disagreed because it characterized the existing shareholder’s receipt of shares and warrants as a “gift” from the holders of the Second Lien Debt, who were senior in priority to Sprint, and Sprint appealed.
A separate appeal was taken by DISH Network Corporation (“DISH”), a provider of satellite television, that also has a significant investment in TerreStar Corporation, a direct competitor of DBSD’s in the developing field of hybrid satellite/terrestrial mobile communications. DISH was not a creditor of DBSD before the bankruptcy filing, but it purchased the claims of various creditors with a view toward attaining DBSD’s valuable spectrum rights. Shortly after DBSD filed its plan and disclosure statement, DISH purchased all of the First Lien Debt at its full face value of $40 million, with an agreement that the sellers would make objections to the plan, which DISH adopted after purchasing the debt. DISH also purchased $111 million of the Second Lien Debt. Thus, DISH had a blocking position in the class of First Lien Debt, but fell far short of the amount needed to control the class of Second Lien Debt.2
DISH voted its claims against the plan, and opposed confirmation on the ground that the plan was not feasible under Section 1129(a)(11) and that the plan did not give DISH the “indubitable equivalent” of its First Lien Debt as required to cram down a dissenting class of secured creditors under Section 1129(b)(2)(A). DBSD asked the bankruptcy court to designate DISH’s rejection of the plan as not in good faith under Section 1126(e). The bankruptcy court, quoting DISH’s own internal communications, found that DISH, a competitor to DBSD, was voting against the plan “not as a traditional creditor seeking to maximize its return on the debt it holds, but . . . ‘to establish control over this strategic asset.’”
Gifting Plan Violates Absolute Priority Rule
After determining that Sprint had standing to appeal,3 the Second Circuit analyzed the criteria to cram down a plan on a dissenting class of unsecured claims. Under Section 1129(b)(2)(B), the plan must either (i) provide that each holder of a claim of such class receive or retain on account of such claim property of a value, as of the effective date of the plan, equal to the allowed amount of such claim; or (ii) the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property. The first alternate prong was clearly not satisfied because the unsecured creditors were not being paid in full, so the court analyzed the key terms under the second prong.
First, the court quickly determined that the shares and warrants to be issued to old equity were “property.” Second, the plan in DBSD expressly provided that old equity was receiving new shares and warrants “under the plan.” The court declined to decide whether the absolute priority rule would permit old equity and senior lenders to agree to transfer property outside of a plan. Third, the Second Circuit focused on the phrase “on account of” to determine whether the plan violated the absolute priority rule. In doing so, the DBSD court analyzed Supreme Court precedent on the so-called new value corollary to the absolute priority rule, which if still viable would permit a junior class to receive property not “on account of” its old out-of-the-money security, but “on account of” new value being contributed under the plan. The Second Circuit noted that, while dictum in an earlier case had suggested that contributing new value could allow prior shareholders to participate in the reorganized debtor, the Supreme Court has struck down new value of a dubious nature. For example, “future labor, experience and expertise” as well as capital contributions “without benefit of market valuation” were both found to be insufficient to escape the absolute priority rule.4 Because the Supreme Court has prevented old equity from sharing in a distribution when contributing new value of this dubious nature, the Second Circuit easily determined that DBSD’s old equity could not receive new ownership where it was not contributing any new value at all.
Relying on SPM Manufacturing Corp.,5 the seminal gifting decision, the appellees argued that the property being distributed to equity belonged to the holders of the Second Lien Debt, who could dispose of their property as they saw fit. They also argued that until the debts of the secured creditors are paid in full, the Bankruptcy Code’s distributional priority scheme is not implicated. The Second Circuit observed that the absolute priority rule applies to “any property,” not “any property not covered by a senior creditor’s lien.” The court also distinguished the SPM decision because it entailed a liquidation under chapter 7, and thus did not implicate the absolute priority rule under Section 1129(b)(2)(B). Moreover, the secured creditor in SPM had obtained relief from the automatic stay, and the collateral was no longer treated as part of the estate.
Finally, the Second Circuit addressed policy arguments in favor of gifting, including that gifting may promote efficiency and foster consensual rather than contested confirmation hearings, whereas enforcing the absolute priority rule may encourage hold-out behavior. However, the court also noted countervailing policy grounds, including that shareholders retain substantial control over the Chapter 11 process, with which comes significant opportunity for self-enrichment at the expense of creditors. In fact, under DBSD’s plan, shareholders would receive 4.99% of new equity (worth $28.5 million using the debtor’s $572 million valuation), while general unsecured creditors would receive 0.15% of new equity (worth only $850,000).
Designation of Blocking Vote Cast by Competitor Attempting to Take Control of Debtor
Section 1126(e) provides that the bankruptcy court may designate any entity whose acceptance or rejection of the plan was not in good faith, or was not solicited or procured in good faith. Merely purchasing claims in bankruptcy “for the purpose of securing the approval or rejection of a plan does not of itself amount to ‘bad faith.’”6 Instead, the Second Circuit noted that: “Section 1126(e) comes into play when voters venture beyond mere self-interested promotion of their claims. ‘[T]he section was intended to apply to those who were not attempting to protect their own proper interests, but who were, instead, attempting to obtain some benefit to which they were not entitled.’” A bankruptcy court may designate the vote of a party who votes with an “ulterior motive,” that is, with “an interest other than an interest as a creditor.”7
The DBSD court found that DISH had the requisite “ulterior motive” because it was a competitor, and it had bought a blocking position in a class of claims after a plan had been proposed, with the intention not to maximize its return on the debt but to enter a strategic transaction with DBSD. DISH bought claims to “use as levers to bend the bankruptcy process toward its own strategic objective of acquiring DBSD’s spectrum rights, not toward protecting its claim.” In fact, DISH’s motives were clear from its own admissions – the fact that DISH bought the First Lien Debt at par, its attempt to propose its own plan, and its internal communications which showed a desire to “to obtain a blocking position” and “control the bankruptcy process for this potentially strategic asset.”
The court also concluded that it was appropriate for the bankruptcy court to have disregarded the entire class of the First Lien Debt for the purpose of determining plan acceptance under Section 1129(a)(8) because DISH’s claim was the only claim in that class.
While apparently not an issue in DBSD, in many gifting cases the senior lender gives up value to a junior class in exchange for a release from potential causes of action, including allegations that the claims or liens of the senior lender are not fully enforceable or that transfers received by the senior lender can be avoided. In such a case, the author believes that any value recovered from the senior lender by asserting or threatening to assert viable causes of action that belong to the estate should be distributed in accordance with the absolute priority rule. On the other hand, if the position of the senior lender is clearly unassailable, then the senior lender should be free to part with a portion of its own recovery. For instance, lenders about to become owners of the reorganized business may want the continued support of trade creditors or management, and may find it in their interest to give such constituents a gift. Likewise, a tip may be justified to avoid a protracted valuation fight that not only would increase costs but could jeopardize the business. Thus, in the author’s view, the analysis should hinge on whether the value being distributed to junior classes was a true gift from an unassailable senior lender for legitimate business purposes or a disguised compromise of causes of action that could be asserted on behalf of the estate. However, the Second Circuit in DBSD did not make any such distinction, instead employing a per se application of the absolute priority rule, although it is not clear how the court would rule if old equity and senior lenders agree to transfer property outside of a plan. The DBSD decision may make resolution of some reorganization cases more difficult and may provide further impetus for sales of business assets as a going concern under Section 363.
The Second Circuit’s designation of DISH’s vote may chill the market for post-petition loan to own strategies. In fact, DISH argued that “future creditors looking for potential strategic transactions with chapter 11 debtors will be deterred from exploring such deals for fear of forfeiting their rights as creditors.” Nevertheless, the court expressly limited its ruling to deter only attempts to “obtain a blocking position” and thereby “control the bankruptcy process for [a] potentially strategic asset.” The DBSD court declined to address the situation in which a preexisting creditor votes with strategic intentions, and emphasized that its opinion imposed no categorical prohibition on purchasing claims with acquisitive or other strategic intentions. However, the court also noted that “[w]hether a vote has been properly designated is a fact-intensive question that must be based on the totality of the circumstances, according considerable deference to the expertise of bankruptcy judges.” This ruling may deter parties from acquiring large blocks of debt post-petition with a view to converting such debt into equity upon confirmation. On the other hand, the thrust of the court’s opinion and the decisions cited in support thereof seem to put strategic buyers, especially direct competitors, at greater risk than financial buyers such as hedge funds. This may be especially true if the claim buyer is pursuing a loan to own strategy as one way to maximize its recovery, while being open to other opportunities, whereas a competitor committed to destroying the debtor’s business will almost certainly have its vote designated.
For More Information
For more information on how these issues may affect your rights, contact Nicholas F. Kajon at 212.537.0403.
This News Alert has been prepared for informational purposes only and should not be construed as, and does not constitute, legal advice on any specific matter. For more information, please see the disclaimer.
1 __ F.3d __, 2011 WL 350480 (2d Cir. Feb. 7, 2011) (2-1) (Lynch, J.). The opinion explains the Second Circuit’s rationale for its previous two-page ruling issued on December 9, 2010.
2 A majority of creditors holding two-thirds of the debt are required for a class of claims to accept a plan. 11 U.S.C. § 1126(c). Thus, controlling a dollar more than one-third of the debt in a class gives the creditor a blocking position, meaning the plan cannot be confirmed unless it can be crammed down. If an impaired class votes to reject a plan (and provided at least one impaired class of claims has voted to accept the plan), the plan proponent can seek to have the plan “crammed down,” which requires satisfaction of additional conditions. 11 U.S.C. §§ 1129(a)(10), 1129(b).
3 The majority held Sprint had standing because it was ‘a person aggrieved’ – a person ‘directly and adversely affected pecuniarily’ by the confirmation order. Circuit Judge Pooler dissented from this portion of the opinion, noting that Sprint had an unliquidated claim that might turn out to be valueless and that such claim was in any event out of the money, and so Sprint was not directly and adversely affected by the confirmation order.
4 Citing Case v. L.A. Lumber Prods. Co., 308 U.S. 106, 121 (1939), and quoting Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 199 (1989) and Bank of Am. Nat’l Trust & Sav. Ass’n v. 203 N. LaSalle St. P’ship, 526 U.S. 434, 458 (1999).
5 In re SPM Manufacturing Corp., 984 F.2d 1305 (1st Cir. 1993).
6 Quoting In re P-R Holding Corp., 147 F.2d 895, 897 (2d Cir. 1945).
7 Quoting Revision of the Bankruptcy Act: Hearing on H.R. 6439 Before the House Comm. on the Judiciary, 75th Cong. at 180 (1937) (statement of SEC Commissioner William O. Douglas); and In re P-R Holding, 147 F.2d at 897.