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Bankruptcy gifts from senior class to junior creditor

Bankruptcy Gifts: When a Court Will Look a Gift Horse in the Mouth

Is the Jury In or Out on Chapter 11 Bankruptcy Gifts?

 

The gifting doctrine in bankruptcy is not new and often is used to obtain creditor consensus to a debtor’s proposed exit—either through a chapter 11 plan or a Section 363 sale. Bankruptcy “gifts” typically involve a structurally senior class voluntarily giving some of its property or distribution to a structurally junior class of creditors or equity holders. 

Bankruptcy courts across the nation have reached differing and, at times, seemingly inconsistent decisions regarding the gifting doctrine. Some courts view gifting as a voluntary arrangement between the senior creditors giving their property to junior creditors. Other courts have refused to approve gifting on grounds that the class-skipping transfer involves property of the debtor’s estate and achieves an end-run around the Bankruptcy Code’s distribution scheme and/or confirmation standards (e.g., the absolute priority rule). 

Bankruptcy gifts can be broken into two key categories:

  • Gifting under a chapter 11 plan
  • Gifting carve-outs in the context of Section 363 sales (which are usually followed by either a liquidating plan or a structured dismissal of the bankruptcy case).

Gifting Doctrine Under a Plan of Reorganization

Bankruptcy courts that have analyzed the gifting doctrine in the plan context have been guided in large part by several factors. 

  • Does the gift involve property of the estate? 
  • Is the gift being made “under a plan” and, if so, is the gift “on account of” a junior interest? 
  • Is any creditor being harmed by the proposed gift? 

In 2011, the U.S. Court of Appeals for the Second Circuit in DBSD North America circumscribed a debtor’s use of gifting in chapter 11 plans.1 

In DBSD, the Second Circuit denied confirmation of a chapter 11 plan that provided for a bankruptcy gift by a senior noteholder class to an existing equity class, thereby skipping an intermediate dissenting class of creditors in which an unsecured creditor—the plan objectant—was classified. The Second Circuit’s decision in DBSD was premised on the fact that the proposed gifting was to occur under a chapter 11 plan, and the recipient of the gift (i.e., existing equity) was receiving the bankruptcy gift on account of its equity interest in violation of the absolute priority rule embodied in the Bankruptcy Code.The Second Circuit in DBSD left open the possibility that the Bankruptcy Code may allow gifting outside a plan.3

Gifting Carve-Outs in 363 Sales

Until recently, one of the most frequently cited court decisions on gifting involved a 363 sale in which the senior secured lender agreed to carve-out from its lien an amount for general unsecured creditors.4 Just following the sale, the secured creditor had obtained relief from the automatic stay and obtained an order converting the case to chapter 7. The bankruptcy court in SPM refused to enforce an agreement between the secured creditor and the creditors’ committee and directed the secured creditor to carve-out from its lien and net sale proceeds an amount to be paid to the trustee for distribution to the estate creditors in accordance with bankruptcy code priority scheme. 

The First Circuit reversed and enforced the proposed gifting arrangement. In doing so, the court observed that the secured creditor had valid liens on all of the sale proceeds, and that any sharing that was to occur between the secured creditor and the unsecured creditors was to occur after distribution of estate property and therefore would have no effect on the bankruptcy distributions to other creditors of the estate. Although the First Circuit in SPM held the proceeds of sale were property of the debtor’s estate, it noted that because the bankruptcy court had lifted the automatic stay and ordered that the sale proceeds be delivered to the secured creditor in satisfaction of its lien, the sale proceeds became property of the secured creditor—not the estate.5 

Since SPM, the courts that have analyzed the gifting doctrine in the 363 sale carve-out context have largely been guided by (1) whether the gift is from property of the estate and (2) whether it is appropriate to bypass the Bankruptcy Code’s priority distribution scheme and absolute priority rule even in a non-plan context. 

In 2009, the Bankruptcy Court for the Eastern District of Virginia in On-Site Sourcing denied the debtors’ sale motion to the extent it sought approval of a collateral carve-out to fund a trust for certain general unsecured creditors of the estate who, absent the senior lender’s carve-out, would have been “out of the money.”6 The court in On-Site Sourcing considered the harm to the skipped priority class of tax claims and absence of statutory authority to support a deviation from the Bankruptcy Code’s priority distribution scheme. The creditors’ committee argued that the sale order should be approved on the basis that the monies used to fund the unsecured creditor trust were not property of the debtor’s estate. The court disagreed and held that the entire purchase price becomes property of the debtor’s estate at closing. 

In On-Site Sourcing, as in SPM, the property as to which the undersecured creditor was entitled would not have been available for distribution to creditors of the estate. Also like SPM, the debtors in On-Site Sourcing proposed a sale of substantially all of their assets pursuant to section 363 of the Bankruptcy Code, outside of a plan. In On-Site Sourcing, the committee agreed to support the sale provided that, among other things, the secured creditor would waive its $7 million deficiency claim and agree to fund a general unsecured creditors trust. The asset purchase agreement expressly provided that the creation of an unsecured creditor trust was subject to the approval of the bankruptcy court and “it is understood and agreed that Integreon will not be expected or required to provide andy further consideration for the sale and that the sale shall go forward with all the assets provided for herein being received by the On-Site Estate including, without limitation the Collateral Carve-Out.”7 In denying the carve-out and funding of a general unsecured creditors trust, the court held that “[t]he provision effectively predetermine[d], in significant part, the structure of an as yet to be drafted plan of reorganization and effectively evades the ‘carefully crafted scheme’ of the chapter 11 plan confirmation process.”8 

The court in On-Site Sourcing may have reached a different conclusion had the asset purchase agreement provided for the assumption of unsecured liabilities up to a cap equal to the Collateral Carve-Out, or (like in SPM) had the secured creditor obtained stay relief and the case converted to chapter 7 after the sale (thereby removing any doubt that the proposed bankruptcy gift was not property of the estate). 

Recently, the U.S. Court of Appeals for the Third Circuit in LCI Holding Company, upheld a 363 sale carve-out over the objection of the US government that the sale would result in significant tax liabilities that would be unpaid administrative expenses of the debtors’ estate while junior unsecured creditors were to be paid pursuant to a settlement reached in connection with the sale.9 

In LCI, the asset purchase agreement provided that purchaser would (i) assume more than $50 million of operating liabilities, (ii) fund ordinary course administrative expense, (iii) fund most costs associated with the sale, including wind-down costs. Additionally, pursuant to a settlement term sheet between the secured lenders and the committee, the lenders agreed to pay $3.5 million to holders of general unsecured claims. 

The sole objector at the sale hearing was the U.S. Department of Justice, Tax Division asserting an approximate $24 million tax claim for anticipated capital gains liability resulting from the sale. The Third Circuit, in rejecting the DOJ’s arguments, held that the funds paid pursuant to the settlement and escrowed in connection with the APA were not monies given in consideration for the assets sold and, therefore, were not property of the estate. Accordingly, the court held that the Bankruptcy Code’s priority rules were not implicated.10 

The decision in LCI is consistent with several earlier decisions in the Third Circuit with regard to approval of 363 sale carve-outs.11 LCI and On-Site Sourcing can be distinguished principally based on the manner by which the 363 carve-out was to be effectuated. The court in On-Site Sourcing was most concerned with the proposed distribution—of property of the debtor’s estate—to a junior class of creditors outside a plan and in contravention of the Bankruptcy Code priority scheme.12 

In contrast, the payment in LCI was made from non-estate monies to unsecured creditors pursuant to a settlement agreement that followed entry of the sale order. The objectionable path taken in On-Site Sourcing may have been acceptable had the senior creditor and the committee reached a separate agreement (i.e., separate from the asset purchase agreement) to resolve objections to the sale and provide for a “gift” to unsecured creditors.

Proposals for Reform of Chapter 11

In December 2014, the American Bankruptcy Institute Commission to Study the Reform of Chapter 11 proposed amendments to make it more difficult to obtain approval of 363 sale carve-out or class-skipping transfer under a plan. Specifically, the ABI Commission proposed amendments to the confirmation provisions of the Bankruptcy Code to expressly prohibit senior creditors from making class-skipping transfers to junior creditors or interest holders under a chapter 11 plan if such transfers would violate the absolute priority rule provisions of the Bankruptcy Code.13 

Additionally, the ABI Commission proposed to require that any 363 sale provide for an amount sufficient to pay all priority creditors in full, thereby guarding against a structured dismissal of an insolvent estate.14 Unfortunately, the ABI Commisson’s reforms were not passed as legislation.

How the Jevic Case Influences Bankruptcy Gifts

A recent Supreme Court case has influenced reform in this area. In the Jevic case, a class of unsecured creditors (employees of Jevic) received nothing on their claims, but lower-priority general unsecured creditors received value pursuant to a settlement agreement that called for a structured dismissal.15 The employees argued that the settlement violated the absolute priority rule, because it paid the lower-priority general unsecured claims and left the employees with nothing. The proponents of the settlement agreement argued (and the Bankruptcy Court agreed) that no good alternative existed and that the employees would be no worse off under the structured dismissal.

The Supreme Court agreed with the employees, stating that the absolute priority rule “constitutes a basic underpinning of business bankruptcy law” that has “long been considered fundamental to the Bankruptcy Code’s operation.”16 The Court further stated that, while Section 349(b) of the Bankruptcy Code allows a judge to modify the priority rules of dismissal “for cause,” nothing in the Code allows a court ordering dismissal to make distributions that violate the priority rules without the impaired creditors’ consent.

Jevic seems to strike a serious blow to the gifting practice. While the Court in Jevic did not explicitly refer to gifting, the logic of the opinion (that settlements that violate the Bankruptcy Code’s priority rules are invalid) seems to suggest that gifting violates the Bankruptcy Code. Practitioners will need to seriously consider the Jevic case before proceeding with gifting. 

Key Takeaways on Bankruptcy Gifts

Allowing senior creditors to gift their own property to junior creditors can resolve objections to a sale or confirmation, facilitate the debtor’s reorganization, and disperse value to those creditors lower down in the debtor’s capital structure. 

Despite these positive attributes, the future of bankruptcy gifts does appear to be uncertain. For the time being, however, prudent secured creditors and debtors should proceed with caution when seeking to implement an exit strategy involving a gift. The case law has left some doors open to enable creative lawyering and the continued viability of the gifting doctrine. Consider the following points when formulating an exit involving gifting either under or outside of a plan:

Do . . .

Don’t . . .

…consider pre-plan sales providing for gifting through the purchaser’s assumption of liabilities or purchase of claims. …effectuate a gift in a 363 sale order that directs how proceeds of sale are to be distributed to creditors unless such distribution complies with the Bankruptcy Code priority scheme
…consider post-sale or pre-plan settlements to effectuate a bankruptcy gift.17 …ignore the intermediary class that may be affected by the proposed gift. Attempt to gain consensus or support from any intermediary classes of creditors and consider use of deathtrap provisions in plan to incentivize consent from skipped class
…consider agreements to modify the automatic stay to allow the secured creditor to recover possession of its collateral prior to gift (thereby removing any argument that the gifted property is property of the estate) …propose a gift under a plan to a junior creditor or interest holder on account of its claim or interest unless you’re confident the intermediary or “skipped” classes will consent to plan
…consider use of broader carve-outs in cash collateral and/or DIP orders to provide for payments to certain structurally junior creditors …enter into a side-agreement to effectuate a gift post-confirmation unless there is adequate disclosure of the terms of any such agreement to the court and parties in interest in the case
…ensure that the proposed gift is not property of the debtor’s estate and would not otherwise be available to creditors of the debtor’s estate in the absence of the gift  

 

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: The Nuts and Bolts of a 363 Motion and The Nuts and Bolts of a Chapter 11 Plan. This is an updated version of an article originally published on December 7, 2015.]

 

1. See Dish Network Corp. v. DBSD North America, Inc. (In re DBSD), 634 F.3d 79 (2d Cir. 2011). 

2. See 11 U.S.C. § 1129(b)(2)(B). The absolute priority rule was “designed to prevent a senior class from giving up consideration to a junior class unless every intermediate class consents, is paid in full, or is unimpaired.” H.R. Rep. 95-595, 1978 U.S.C.C.A.N. 5963, 6372 (1977). 

3. DBSD, 634 F.3d 79, 95 (“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 received these shares and warrants “under the plan.”). 

4. See In re SPM Mfg. Corp., 984 F.2d 1305 (1st Cir. 1993). 

5. See also In re Journal Register Co., Case No. 09-10769, 407 B.R. 520 (Bankr. S.D.N.Y. 2009) (confirming plan providing for a gift from a senior lien creditor to an unsecured class of creditors through the funding of certain plan escrows as to which the Court noted that “the funds in the Trade Account are not property of the estate. The plan provides that the Trade Account is property of the Secured Lenders, with any undistributed portion to revert to the Secured Lenders”). 

6. See In re On-Site Sourcing, Inc. et al., Chap. 11 Case No. 09-10816 (Bankr. E.D. Va. 2009). 

7. On-Site Sourcing, 412 B.R. 817, 825. 

8. See id., 412 B.R. 817, 826 (citations omitted). 

9. See In re LCI Holding Company, No. 14-2709, 2015 U.S. App. LEXIS 16306 (3d Cir. Sept. 14, 2015). 

10. See id. at *26, FN 6 (distinguishing DBSD by noting that “the [Second Circuit in DBSD] said nothing about whether a lender can distribute non estate property to a lower ranked creditor.”). 

11. See In re World Health Alternatives Inc., 344 B.R. 291 (Bankr. D. Del. 2006); In re TSIC Inc., 393 B.R. 71 (Bankr. D. Del. 2008). 

12. See On-Site Sourcing, 412 B.R. 817, 818 (The issue framed by the bankruptcy court in On-Site Sourcing was “the extent to which a chapter 11 debtor may substitute a §363 sale for a chapter 11 plan.”). 

13. See American Bankruptcy Institute Commission to Study the Reform of Chapter 11: Final Report and Recommendations, 2012-2014 (“ABI Commission Report”) at pp. 237-240. 

14. See ABI Commission Report, at 201. 

15. Czyzewski v. Jevic Holding Corp., 137 S. Ct. 973 (2017).

16. Id. at 983-84.

17. See In re Iridium Operating LLC, 478 F.3d 452, 464 (2d Cir. 2007) (holding that a “rigid, per se rule” as to the applicability of the absolute priority rule to carve-outs for unsecured creditors did not apply to pre-plan settlements).

©All Rights Reserved. May, 2020.  DailyDACTM, LLC

About Theresa A. Driscoll

Theresa A. Driscoll concentrates her practice in the representation of corporate debtors, lenders, trustees and unsecured creditors in all aspects of financial restructuring including workouts, chapter 11 cases and bankruptcy litigation.

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