History of the Absolute Priority Rule, Contributed by Joseph J. DiPasquale and Jennifer D. Talley of Trenk, DiPasquale, Webster, Della Fera & Sodono, P.C.
By Joseph J. DiPasquale and Jennifer D. Talley of Trenk, DiPasquale, Webster, Della Fera & Sodono, P.C.
It is well settled for over a century that a shareholder or equity holder must not receive any payment or other form of profits until a business’s debts are paid.1 This theory came in response to the actions taken by senior creditors and shareholders looking to reorganize a failed business.2 Senior creditors would entice shareholders to supply new capital to a floundering business by providing the shareholders with a stake in the newly formed business.3 However, subordinated debt holders would often be left with nothing, despite the fact that their debt was clearly superior to any equity position held by the shareholders.4
Almost one hundred years ago, the Supreme Court quashed this practice by holding that creditors must be paid before any stockholder should be compensated monetarily in a reorganization of a failed business.5
Eventually, the Bankruptcy Code codified this theory as the absolute priority rule, which is a perquisite to confirmation of a chapter 11 plan of reorganization.6 In its most basic form, the absolute priority rule mandates that a contested chapter 11 plan must not be confirmed over the objection of a dissenting class unless the dissenting class receives the full value of its claim, or a junior creditor to the dissenting class receives no property under the plan on account of its interest.7
History of Gifting
The effect of the absolute priority rule has significant implications for a debtor attempting to reorganize pursuant to chapter 11. Practitioners and professionals working in a chapter 11 reorganization must contend with the strict confines of the absolute priority rule while also remaining true to the goal of a chapter 11 reorganization: restoring the debtor’s business and maximizing the value of the estate for all stakeholders.8 In order to craft efficient ways to adhere to the Code while maximizing the value of the debtor’s estate, professionals have evaded the absolute priority rule by “gifting” property to a class of unsecured creditors or equity holders over a senior lien holder under the premise that the property is not part of the debtor’s estate and is being provided by the secured creditor consensually.9
In 2005, the Third Circuit held in In re Armstrong World Industries, Inc. that “gifting” to shareholders pursuant to a chapter 11 plan violated the absolute priority rule when other debt holders objected and were not paid in full.10 The Armstrong court also relied upon the precise language of the Bankruptcy Code, stating, “The plain language of the statute makes it clear that a plan cannot give property to junior claimants over the objection of a more senior class that is impaired.”11
Recently, in In re DBSD North American, the Second Circuit joined the Third Circuit’s stance on the absolute priority rule. Despite this holding, the DBSD decision seems to indicate that there may be other ways to “gift” property to unsecured classes and equity holders.
In re DBSD North America Decision
The holding of DBSD is unequivocal: gifting to equity shareholders when subordinated debt holders have not been paid in full and object to the plan, as written in a chapter 11 plan, violates the absolute priority rule.12 However, a variety of other issues remain unclear despite the court’s clear holding.
In DBSD, Sprint, who held a claim based on a lawsuit against one of DBSD’s subsidiaries, objected to the plan, arguing that the majority shareholder should not receive any of the debtor’s property because junior subordinated debt holders would not receive the full value of their claim pursuant to the plan.13 Sprint relied on 11 U.S.C. § 1129(b)(2)(B), stating that “if a class of senior claim-holders will not receive the full value of their claims under the plan and the class does not accept the plan, no junior claim or interest-holder may receive ‘any property’ ‘under the plan on account of such junior claim or interest.’”14
The DBSD court agreed with Sprint’s position and simply concluded, “We hold that the existing shareholder did receive property under the plan on account of its interest, and that the bankruptcy court therefore should not have confirmed the plan.”15 The DBSD court found so for three reasons: (1) the shareholder received “property” pursuant to § 1129(b)(2)(B) because it received shares and warrants; (2) the shareholder received property “under the plan” because the plan clearly stated that the shareholder would receive such shares and warrants; and (3) the shareholder received the property “on account of” its subordinated interest.16
The decision went on to elucidate point three, delineating the test to determine if property is received “on account of” a junior interest. The court first supplied the framework for this analysis expounded in Bank of Am. Nat’l Trust & Sav. Ass’n v. 203 N. LaSalle St. P’ship.17
The first test explains that so long as a subordinate debt holder obtained new property “in exchange for” old property, the property was obtained “on account of” its junior interest.18 The second test states that “on account of” means “because of.”19 In sum, the LaSalle decision essentially held that previous equity owners could not be “gifted” property pursuant to a plan even if the equity holders provided new value in exchange for such property, unless all other parties had an equal opportunity to obtain such value as well.20
Importantly, the DBSD court noted that the LaSalle decision was not factually identical to the situation at bar. In essence, LaSalle stands for the proposition that a shareholder cannot attempt to evade the absolute priority rule by arguing that “gifted” property is received in exchange for new value contributed by the shareholder.21 In the case at bar, the shareholder did not even contribute any new value. Thus, in holding that the existing shareholder’s receipt of property pursuant to the plan violated the absolute priority rule, the DBSD court relied on the inference that the Supreme Court would certainly not allow gifting in return for no value, if it would not allow gifting in exchange for new value.22
The shareholders attempted to argue that the secured creditors could share their property with any entities they saw fit because they were the true owners of the shares and warrants.23 However, the DBSD court found that the type of property to be conveyed to a subordinated class was irrelevant; the plain text of the Bankruptcy Code applies the absolute priority rule to all property, even if the property “gifted” to a subordinated class was not subsumed in a senior debt holder’s lien.24 The focus of the inquiry, as the plain language of the Code dictates, must solely be who receives and retains the property under the plan.25
Gifting Shares Outside of the Plan
However, despite the plain language of the Code, certain courts have held that “gifting” is permissible in other contexts.26 In particular, the First Circuit in In re SPM Manufacturing Corp. held that secured creditors could gift property to undersecured creditors, even if superior lien holders did not receive any value.27 Specifically, the secured creditor agreed “to share whatever proceeds they received as a result of the reorganization or liquidation of the Debtor” with the general unsecured creditors.28 The SPM court reasoned that the secured creditors were merely giving away their own assets, which did not violate the absolute priority rule.29 The heart of the court’s reasoning centered on the premise that “creditors are generally free to do whatever they wish with the bankruptcy dividends they receive, including to share them with other creditors.”30
Significantly, SPM was a chapter 7 liquidation and did not take place in the context of a reorganization. Therefore, while setting the framework for asset redistribution and reallocation, SPM is not instructive as to the confines of “gifting” to subordinate classes or undersecured creditors in a chapter 11 plan confirmation, or in a pre-plan chapter 11 settlement.
In a similar case, the Second Circuit in In re Iridium Operating, LLC again declined to decide whether “gifting” could occur outside the context of a chapter 11 plan, for instance in a chapter 11 settlement.31 While the question was presented, the Second Circuit never addressed whether a secured senior debt holder of a debtor’s assets could “gift” a portion of those assets to a subordinate debt holder if a priority debt holder remained unpaid outside of the plan.32 Instead, the Iridium Court determined that the senior debt holder did not in fact have a perfected interest in the debtor’s assets.33 Therefore, the court could not and would not decide such an issue, declaring that “we need not decide if SPM could ever apply to chapter 11 settlements, because it is clear that the [secured creditor] did not actually have a perfected interest in the cash on hand.”34
The Iridium court did hold that “gifting” to junior lien holders could occur outside of a chapter 11 plan of reorganization if the settlement was fair and equitable.35 Additionally, the Iridium court went further and stated that settlement should be approved if factors weighed in favor of approving a settlement, even if the settlement does not completely comply with the absolute priority rule.36 Such factors included but were not limited to: “(1) the balance between the litigation’s possibility of success and the settlement’s future benefits; (2) the likelihood of complex and protracted litigation…and (3) the paramount interests of the creditors…”37
While DBSD’s ultimate holding is straight-forward and leaves no room for ambiguity, notably, the DBSD court did not comment on whether subordinate classes could receive property outside of the plan in a chapter 11 case, as was mentioned but not decided in Iridium. The DBSD court even went so far as to state, “We need not decide whether the Code would allow the existing shareholder and Senior Noteholders to agree to transfer shares outside of the plan, for, on the present record, the existing shareholder clearly receives these shares and warrants ‘under the plan.’”38
Interestingly, the decision explicitly recognized the strong arguments in favor of less strict compliance with the absolute priority rule.39 For example, in general, “gifting” to subordinate classes expeditiously and non-contentiously resolves chapter 11 proceedings.40 Moreover, the DBSD court described the history of objection and protest to the absolute priority rule.41
The court’s unwillingness to extend its holding to gifting outside of the plan can also be gleaned by interpreting the court’s distinct reliance on the precise interpretation of the meaning of the words in the Code. For instance, the court notes, “[u]nder the plan in this case, Sprint does not receive ‘property of a value…equal to the allowed amount’ of its claim…The plan may be confirmed, therefore, only if the existing shareholder [ ] does ‘not receive or retain’ ‘any property’ ‘under the plan on account of such junior…interest.”42
Therefore, it is seemingly permissible to gift assets to subordinate classes outside of a chapter 11 plan, as the question remains unanswered. Additionally, the dictum in the Second Circuit’s most recent ruling explicitly touts the benefits of “gifting” in order to expeditiously confirm chapter 11 cases.
Furthermore, the DBSD decision did not address the factual situation originally brought before the First Circuit in SPM. In SPM, the property that was later gifted to a general unsecured creditor and not given to a priority, administrative claimant was the property of the secured creditor, and the secured creditor alone.43 The secured creditor in SPM foreclosed on the property in question, and thus, the secured creditor was within its rights to gift or utilize the property in whichever way it saw fit.44
However, the DBSD court specifically stated that the factual situation before the court was distinguishable.45 The property in question was certainly part of the estate and had never belonged to the secured creditor “outright.”46 The DBSD court specifically declined to address whether the SPM reasoning would be appropriate in a chapter 11 case if the property had been foreclosed on by the secured creditor.47 “[A]ssuming without deciding that the First Circuit’s approach was correct in the context of a Chapter 7 – a question not before us – we do not find it relevant to this case.”48
Thus, the DBSD decision leaves open the possibility that a secured creditor may gift to subordinate classes in a chapter 11 reorganization if it has foreclosed on the property in question.
The DBSD court’s precision in explicitly stating that it would not comment on the above issues, as well as the court’s discussion of the policy implications in favor of “gifting” as an efficient tool for confirming chapter 11 plans, suggests that “gifting” may not be dead. Instead, those looking to utilize the gifting doctrine may have to read between the lines of the Second Circuit’s ruling and find other means of accomplishing their goals of quickly and non-contentiously confirming chapter 11 cases.
Mr. DiPasquale is a partner of the law firm of Trenk, DiPasquale, Webster, Della Fera & Sodono, P.C. Mr. DiPasquale concentrates his practice in the areas of bankruptcy, corporate restructuring, debtor/creditor rights, and commercial litigation. In 2008, 2009, 2010, and 2011, Mr. DiPasquale was named a “New Jersey Super Lawyer” by New Jersey Monthly magazine. The firm has offices in West Orange and Red Bank, New Jersey, as well as New York.
Ms. Talley is an associate at the law firm of Trenk, DiPasquale, Webster, Della Fera & Sodono, P.C. Ms. Talley concentrates her practice in the areas of bankruptcy, commercial litigation, and debtor/creditor rights. During her third year of law school, Ms. Talley worked in the Civil Litigation Clinic, where she handled cases primarily focused on predatory lending and foreclosure defense. At graduation, Ms. Talley was awarded with the Most Significant Contribution to the Civil Litigation Clinic Award for her work during the Spring of 2010.
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