United States: Do's & Don'ts Of Gifting In Bankruptcy: When A Court Will Look A Gift Horse In The Mouth

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 363 sale. A bankruptcy "gift" typically involves 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).

Gifting in bankruptcy approaches can be broken to key categories: (i) gifting under a chapter 11 plan; and (ii) gifting carve-outs in the context of 363 sales (which are usually followed by either a liquidating plan or a structured dismissal of the bankruptcy case).

A. Gifting 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. First, does the gift involve property of the estate? Second, is the gift being made "under a plan" and, if so, is the gift "on account of" a junior interest? Third, 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 gift by a senior noteholder class to 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 gift on account of its equity interest in violation of the absolute property rule embodied in the Bankruptcy Code.² The Second Circuit in DBSD left open the possibility that the Bankruptcy Code may allow gifting outside a plan.³

B. 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 had agreed to support the sale provided that, among other things, the secured creditor 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 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 puruant 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.

C. Proposals for Reform of Chapter 11

In December 2014, the American Bankruptcy Institute Commission to Study the Reform of Chapter 11 proposed amendments that, if enacted, will make it more difficult to obtain approval of 363 sale carve-out or class-skipping transfer under a plan. Specifically, the ABI Commission proposes 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 proposes 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 Lender reaction to the proposed reform has been less than favorable. ¹⁵

D. Key Takeaways from Caselaw on Gifting

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 gifting 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 caselaw 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:

Footnotes

[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 property 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] See First Report of the Commercial Fin. Ass'n to the ABI Comm'n to Study the Reform of Chapter 11: Field Hearing at Commercial Fin/ Ass'n Annual Meeting, at 15 (Nov. 15, 2012) ("CFA believes that Senior Creditors should be permitted to reallocate their recovery to junior classes because doing so would foster the reorganization process, even if it means skipping out-of-the-money junior classes. The law should favor efficient ventures between managers and senior lenders and encourage reorganizations that share in the growth in the value of the debtor. Accordingly, CFA encourages the Commission to reexamine the prohibition against "gift' plans"); see also The Trouble with Unneeded Bankruptcy Reform: The LSTA's Response to the ABI Chapter 11 Commission Report, October 2015.

[16] 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).

Originally published by Commercial Bankruptcy Litigation Online Newsletter.

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