THE EVOLUTION OF THE GIFTING DOCTRINE AND IMPLICATIONS OF RECENT CASE LAW 1

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1 THE EVOLUTION OF THE GIFTING DOCTRINE AND IMPLICATIONS OF RECENT CASE LAW 1 Regina Stango Kelbon 2 Rocco A. Cavaliere 3 BLANK ROME LLP 4 One Logan Square 130 North 18 th Street Philadelphia, PA Tel: (215) Fax: (302) The Chrysler Building 405 Lexington Avenue New York, NY Tel: (212) Fax: (212) Prepared: August 4, 2011 Ms. Kelbon is the Chair of the Business Restructuring and Bankruptcy Group of Blank Rome LLP. Her practice focuses on bankruptcy, reorganizations, workouts and other strategic restructuring options. Ms. Kelbon represents creditors committees, debtors, institutional lenders, lender groups, plan administrators, plan of reorganization proponents, executory contract parties and asset purchasers. She frequently lectures on bankruptcy, insolvency and related issues. Ms. Kelbon presently serves as the Co-Chair of the Subcommittee on Corporate Governance of the Business Bankruptcy Section of the American Bar Association. She is a former Vice Chair of the Subcommittee on Bankruptcy Crimes, Fraud and Abuse of the Bankruptcy Process of the Business Bankruptcy Section of the American Bar Association; Mass Torts and Environmental Law Subcommittee of the Business Bankruptcy Section of the American Bar Association; and Unconventional Bankruptcy Problems Subcommittee of the Business Bankruptcy Section of the American Bar Association. Ms. Kelbon is also former President and Chairman of the Board of the Consumer Bankruptcy Assistance Project for the Eastern District of Pennsylvania. She currently serves as a Mediator for the United States Bankruptcy Court for the Eastern District of Pennsylvania. Chambers USA ranks Ms. Kelbon as one of the leaders in the fields of bankruptcy and restructuring. Mr. Cavaliere is a senior associate in the Business Restructuring and Bankruptcy Group of Blank Rome LLP. Mr. Cavaliere represents debtors in possession, creditors committees, chapter 7 trustees, secured and unsecured creditors and other constituents in all facets of bankruptcy and insolvency matters. Mr. Cavaliere is on the Advisory Board for the American Bankruptcy Institute s Section 363 Asset Sales Databank. The opinions expressed are those of the authors.

2 This paper addresses the evolution and decisional development of the Gifting Doctrine and the viability of this doctrine in light of recent Circuit Court authority and other reported decisions. A. Tension between The Gifting Doctrine, The Absolute Priority Rule and The Unfair Discrimination Principle While bankruptcy policy contemplates providing a debtor with a fresh start, it also envisions a fair distribution between and among various classes of creditors and equity holders. Section 726 of the Bankruptcy Code, applicable in chapter 7 liquidation cases, sets forth a hierarchical scheme for distributing proceeds obtained through liquidating the assets of a debtor. The scheme contemplates, among other things, that secured creditors are to be paid from their collateral, that administrative and priority creditors are to be paid in full before unsecured creditors and that unsecured creditors are to be paid in full before a distribution to existing equity holders. Similarly, in order to confirm a chapter 11 plan of reorganization, section 1129 of the Bankruptcy Code requires that the plan must be fair and equitable and that creditors receive at least what they would otherwise have received in a chapter 7 liquidation. Hence the hierarchical scheme comes into play again. Because the pie is often not large enough to pay all senior classes of creditors in full before reaching junior classes of creditors, the gifting concept reflected a creative attempt to circumvent the strict statutory requirements of sections 726 and In effect, the gifting concept allows a senior class to share its distributions with a junior class without regard to the hierarchical scheme established in the Bankruptcy Code. In re SPM Manufacturing Corporation, 984 F.2d 1305 (1 st Cir. 1993) was an early decision implicating the gifting concept. In SPM, the First Circuit upheld a settlement between the official committee of unsecured creditors and the debtor s secured creditor whereby the secured creditor agreed to gift a portion of its recoveries from the liquidation of its collateral directly to the unsecured creditors, in an effort to avoid litigation with the committee. The debtor and its shareholders objected to the proposed settlement arguing that the priority tax claim of the Internal Revenue Service (of which the shareholders were personally liable) must be paid before unsecured creditors received a distribution because priority claims are higher in the pecking order in the Bankruptcy Code s statutory scheme for distribution. 5 The First Circuit disagreed with the debtor s contention, finding that while the debtor and the trustee are not allowed to pay non-priority 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. 6 This quoted language has come to be known as the Gifting Doctrine. While SPM did not involve equity holders receiving a distribution before unsecured creditors were paid in full, it did involve a class of non-priority unsecured creditors being paid before priority unsecured tax creditors were paid. Parties have argued that for the same reason that SPM authorized the skipping of the priority tax creditors in favor of non-priority unsecured creditors, unsecured creditors can similarly be skipped in favor of equity where there is a direct 5 6 See 11 U.S.C See SPM, 984 F.2d at

3 arrangement with the secured creditor. The main argument against this arrangement is that it violates the absolute priority rule codified in 1129(b)(2). Section 1129(b)(2) only comes into play when a class of claim votes to reject a plan. Consequently, if a plan is consensual and all classes vote in favor of the plan, Section 1129(b)(2) is not implicated. As it pertains to unsecured creditor classes, 1129(b)(2)(B) provides, in relevant part, as follows: 7 (2) For the purposes of this subsection, the condition that a plan be fair and equitable with respect to a class includes the following requirements: (B) With respect to a class of unsecured claims- (i) the plan provides 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 7 Most of the cases discussed herein address the absolute priority rule as it relates to unsecured creditors. The absolute priority rule at 1129(b)(2) also includes subsections relating to secured creditors and equity holders. For classes of secured creditors, 1129(b)(2)(A) provides as follows: (2) For the purpose of this subsection, the condition that a plan be fair and equitable with respect to a class includes the following requirements: (A) With respect to a class of secured claims, the plan provides - (i)(i) that the holders of such claims retain the liens securing such claims, whether the property subject to such liens is retained by the debtor or transferred to another entity, to the extent of the allowed amount of such claims; and (II) that each holder of a claim of such class receive on account of such claim deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder s interest in the estate s interest in such property; (ii) for the sale, subject to section 363(k) of this title, of any property that is subject to the liens securing such claims, free and clear of such liens, with such liens to attach to the proceeds of such sale, and the treatment of such liens on proceeds under clause (i) or (iii) of this subparagraph; or (iii) for the realization by such holders of the indubitable equivalent of such claims. Also, for classes of equity interests, 1129(b)(2)(C) provides as follows: (C) With respect to a class of interests (i) the plan provides that each holder of an interest of such class receive or retain on account of such interest property of a value, as of the effective date of the plan, equal to the greatest of the allowed amount of any fixed liquidation preference to which such holder is entitled, any fixed redemption price to which such holder is entitled, or the value of such interest; or (ii) the holder of any interest that is junior to the interests of such class will not receive or retain under the plan on account of such junior interest any property. 3

4 (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 In other words, the absolute priority rule provides that if a class of senior claimholders will not receive the full value of their claims under the plan and the class does not accept the plan, no junior claimholder or interestholder may receive "any property" "under the plan on account of such junior claim or interest. In addition, courts are also often faced with situations in which gifts to certain classes may be inappropriate where the class receiving the gift is similarly situated to another class that did not receive the gift. In such circumstances, the deprived class may argue that the proposed plan constitutes unfair discrimination and runs afoul of section 1129(b)(1) of the Bankruptcy Code ( the court shall confirm the plan if the plan does not discriminate unfairly ). Since SPM was decided, courts have been split as to its propriety and limitations. See In re DBSD North America, Inc., 634 F.3d 79 (2d Cir. 2011) (finding that a gift from a senior class to a junior class over the rejection of an intermediate class violates the absolute priority rule); see also In re Armstrong World Industries, Inc., 432 F.3d 507 (3d Cir. 2005) (same). In the next section, we will highlight the key facts, holdings and implications of each of the important cases discussing the Gifting Doctrine. Finally, in the last section, we will outline possible permitted uses of the Gifting Doctrine in certain circumstances. B. Analysis Of Cases Addressing the Gifting Doctrine Below is a summary of several important Circuit Court decisions as well as numerous reported decisions from bankruptcy and district courts addressing the applicability of the Gifting Doctrine. 1. In re SPM Manufacturing Corporation, 984 F.2d 1305 (1 st Cir. 1993) Facts: After it became apparent that SPM Manufacturing could not successfully reorganize, the bankruptcy court granted a motion by Citizens Bank, the debtor s secured creditor, to appoint a receiver with the power to negotiate a sale of SPM s assets pursuant to 363(b) of the Bankruptcy Code. Thereafter, SPM s assets were sold for $5 million in the chapter 11 case, Citizens obtained relief from the automatic stay, and SPM s case was converted to chapter 7. The official committee of unsecured creditors and Citizens then filed a joint motion seeking approval of a settlement which would allow the sale proceeds to be delivered to Citizens, and then distributed in accordance with an earlier agreement between the parties. The debtor and the shareholders objected to the motion, arguing that the agreement between the Committee and Citizens allowed for a distribution of proceeds of collateral distributed to general unsecured 4

5 creditors ahead of priority tax claims in violation of the statutory scheme for distribution. 8 The bankruptcy court agreed with the debtor and shareholders and ordered that the consideration that would otherwise be paid to general unsecured creditors under the agreement be paid instead to the chapter 7 trustee for distribution in accordance with the priority scheme of the Bankruptcy Code. The district court affirmed and the Committee appealed to the First Circuit, which reversed the district court s order. Holding and Rationale: The First Circuit determined that since Citizens secured claim and lien absorbed all of the debtor s assets, there was nothing left for any other creditor in the case. Once the bankruptcy court lifted the automatic stay and ordered those proceeds distributed to Citizens in proper satisfaction of its lien that money became the property of Citizens, not of the estate. The Court stated that nothing in the Bankruptcy Code barred Citizens from voluntarily paying part of these monies to some or all of the general unsecured creditors after the bankruptcy case concluded. The Court stated that the distribution scheme under 726 does not come into play to govern the rights of creditors to transfer or receive non-estate property. Further, the court opined that while 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 In re Armstrong World Industries, Inc., 432 F.3d 507 (3d Cir. 2005) Facts: Armstrong World Industries, Inc. and certain of its subsidiaries ( Armstrong ) filed for chapter 11 due to significant asbestos litigation liability. The United States Trustee appointed a committee of unsecured creditors and a committee of asbestos personal injury claimants. Further, a future claimants representative was appointed. After negotiations between Armstrong, the asbestos committee, the creditors committee, and the future claims representative, Armstrong filed a plan in which creditors were divided into eleven classes and equity was placed into Class 12. Relevant to the case, Class 6 consisted of general unsecured creditors, Class 7 consisted of present and future asbestos-related personal injury claimants, and Class 12 consisted of Armstrong s common stock, which was held by the Debtor s direct parent, Armstrong Worldwide, Inc. ( AWWD ), which itself was owned by Armstrong Holdings, Inc. ( Holdings ). The plan provided that $1.8 billion in assets would be put in trust for Class 7 and members in such Class would receive an initial 20% distribution. Meanwhile, Class 6 would recover about 59.5% of their allowed claims. The plan also provided for the issuance of new warrants to Armstrong s current equity owner, AWWD, or its parent, Holdings, to purchase Armstrong s common stock. However, if Class 6 rejected the plan, the warrants would be provided to Class 7 which would automatically waive receipt of the warrants such that they would be issued to AWWD or Holdings. After plan voting, Class 6 rejected the plan and thus, under the terms of the plan, Class 7 received the warrants and relinquished them to Class 12. The bankruptcy court recommended confirmation of the plan to the district court, 8 9 See 11 U.S.C See SPM, 984 F.2d at

6 finding that the absolute priority rule under 1129(b)(2) was satisfied because the warrants were distributed to the holder of equity interests through Class 7. The creditors committee representing the interests of unsecured creditors in Class 6 appealed to the district court. The district court denied confirmation, finding that the distribution of warrants to equity interest holders over the objection of a class of unsecured creditors violated the absolute priority rule of 11 U.S.C. 1129(b)(2)(B). The Debtors appealed the District Court s decision to the Third Circuit. Holding and Rationale: On appeal, the Third Circuit began its analysis by looking at the statute and noting that if the meaning is plain, we will make no further inquiry unless the literal application of the statute will end in a result that conflicts with Congress s intentions. 10 The Third Circuit then stated that the plain language of the statute made it clear that a plan cannot give property to junior claimants over the objection of a more senior class that is impaired. Id. Next, the Third Circuit dismissed Armstrong s arguments on appeal that Class 7 may distribute property it receives under the Plan to Class 12 without violating the absolute priority rule. The Third Circuit adopted the district court s criticism of cases like MCorp and Genesis (each discussed below) which had previously worked around the absolute priority rule. Specifically, the Third Circuit stated the following: We adopt the district court's reading of these cases, and agree that they do not stand for the unconditional proposition that creditors are generally free to do whatever they wish with the bankruptcy proceeds they receive. Creditors must also be guided by the statutory prohibitions of the absolute priority rule, as codified in 11 U.S.C. 1129(b)(2)(B). Under the plan at issue here, an unsecured creditor class would receive and automatically transfer warrants to the holder of equity interests in the event that its coequal class rejects the reorganization plan. We conclude that the absolute priority rule applies and is violated by this distribution scheme. 11 Lastly, the Third Circuit determined that the warrants that were to be distributed to Class 12 were on account of their equity interests, in direct contravention of the plain language of the Code. 3. In re DBSD North America, Inc., 634 F.3d 79 (2d Cir. 2011) Facts: DBSD was formed to develop a mobile communications network that would use both satellites and land-based transmission towers. In its first five years, DBSD made progress toward this goal, successfully launching a satellite and obtaining certain spectrum licenses from the FCC, but it also accumulated a large amount of debt. Because its network remained in the developmental stage and had not become operational, DBSD had little if any revenue to offset its mounting obligations Armstrong, 432 F.3d at 513. Id. at

7 There were three major groups of claims relevant to the decision: (1) the First Lien Debt, consisting of a $40 million revolving credit facility; (2) the Second Lien Debt consisting of $650 million in 7.5% convertible senior secured notes with a second priority security interest in substantially all of DBSD's assets, which, as of the Petition Date, had grown to approximately $740 million; and (3) Sprint's Claim: an unliquidated, unsecured claim in the asserted amount of $211 million based on a lawsuit against a DBSD subsidiary. The plan 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, meaning that for the first four years the owners of the new obligations would receive as interest more debt from DBSD rather than cash. 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. The holders of unsecured claims, such as Sprint, would receive shares estimated to be worth between 4% and 46% of their original claims. Finally, the existing shareholder (effectively just ICO Global Communications, which owned 99.8% of DBSD) would receive shares and warrants in the reorganized entity. Sprint objected to the plan, arguing that the plan violated the absolute priority rule of 11 U.S.C. 1129(b)(2)(B). In making its objection, Sprint noted that the plan provided for the existing shareholder, whose interest is junior to Sprint's class of general unsecured claims, to receive substantial quantities of shares and warrants under the plan -- in fact, much more than all the unsecured creditors received together. The bankruptcy court disagreed with Sprint s arguments. The bankruptcy court characterized the existing shareholder's receipt of shares and warrants as a "gift" from the holders of the Second Lien Debt, who are senior to Sprint in priority yet who were themselves not receiving the full value of their claims, and who may therefore "voluntarily offer a portion of their recovered property to junior stakeholders" without violating the absolute priority rule. 12 The district court affirmed and Sprint appealed to the Second Circuit. Holding and Rationale: The Second Circuit started its analysis by analyzing the evolution of the absolute priority rule under the bankruptcy laws. The Second Circuit stated that even before the Bankruptcy Code was enacted, it was already "well settled that stockholders are not entitled to any share of the capital stock nor to any dividend of the profits until all the debts of the corporation are paid." 13 When Congress enacted the Bankruptcy Code, section 1129(b)(2) codified the absolute priority rule that had been developed by the courts. Under the plan in this case, the Second Circuit determined that Sprint did not receive "property of a value... equal to the allowed amount" of its claim. 14 Rather, Sprint received less than half the value of its claim. The plan could be confirmed, therefore, only if the existing shareholder, whose interest is junior to Sprint's, does "not receive or retain" "any property" "under the plan on account of such junior... interest." 15 The Second Circuit held that the DBSD, 634 F.3d at 87. Id. at 94. Id. at 95. Id. 7

8 existing shareholder received property under the plan on account of its interest, and that the bankruptcy court therefore should not have confirmed the plan. The Second Circuit took comfort in its position with a review of the Supreme Court's interpretations of 1129(b)(2)(B) in Bank of America Nat l Trust & Sav. Ass n. v. 203 N. LaSalle St. P ship, 526 U.S. 434 (1999) and Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1987). In both cases, the prior shareholders tried to avoid the absolute priority rule by arguing that they received distributions not on account of their prior interests but rather on account of the new value that they would contribute to the reorganized entity. 16 In both cases, the Supreme Court rejected the shareholders arguments. Although dictum in an earlier Supreme Court case 17 had suggested that contributing new value could allow prior shareholders to participate in the reorganized entity, the Supreme Court refused to decide whether 1129(b)(2)(B) permitted such new-value exchanges. Instead, the Supreme Court held that neither "future labor, experience and expertise," 18 nor capital contributions "without benefit of market valuation", 19 could suffice to escape the absolute priority rule. Finally, the Second Circuit distinguished SPM finding that a Chapter 7 liquidation scenario (as was the case in SPM) is different from a Chapter 11 reorganization which includes the absolute priority rule under 1129(b)(2)(B) as part of the plan process. The Second Circuit s reasoning is now aligned with the Third Circuit in Armstrong. 4. In re Iridium Operating LLC, 478 F.3d 452 (2d Cir. 2007) Facts: Iridium Operating LLC ( Iridium ) filed for Chapter 11 relief. Various lenders led by JP Morgan Chase Bank (the Lenders ) asserted liens over much of what was left in Iridium. The Official Committee of Unsecured Creditors (the Iridium Committee ) challenged the validity of the liens and determined that it retained meritorious causes of action against the Lenders. In addition, the Iridium Committee determined there were meritorious claims against Motorola, Inc. for breach of contract, breach of fiduciary duty and avoidance of fraudulent conveyances. The Iridium Committee was prepared to pursue litigation on two fronts but the estate had limited resources. Thus, the Iridium Committee decided to enter into a settlement with the Lenders which (i) determined that the Lenders liens were valid, (ii) divided estate s cash into various funds, including a distribution of $37.5 million into a newly created entity See 203 N. LaSalle, 526 U.S. at 437; Ahlers, 485 U.S. at 199. Marine Harbor Props., Inc. v. Mfrs. Trust Co., 317 U.S. 78 (1942). Ahlers, 485 U.S. at 199 (quotation marks omitted). 203 N. LaSalle, 526 U.S. at 456, but see J.P. Morgan Chase Bank N.A. v. Charter Communications Operating, LLC (In re Charter Communications), 419 B.R. 221, 269 (Bankr. S.D.N.Y. 2009) (plan confirmed over noteholders absolute priority rule objection where debtor demonstrated that existing equity holder s distribution in connection with a plan settlement was on account of his cooperation with respect to maintaining requisite voting power within [Debtor], his transferring of valuable interests in solvent Debtor CC VIII, LLC, and his compromising of certain contract claims ); see also In re Allegheny International, Inc., 118 B.R. 282, 307 (Bankr. W.D. Pa. 1990) (distribution of warrants to junior equity class over objection of senior class was appropriate to resolve junior equity s litigation claims). 8

9 called Iridium Litigation LLC (the Litigation Trust ), and (iii) divided any recovery between the Lenders and estate from litigation against Motorola, leaving any money remaining in the Litigation Trust payable to unsecured creditors. The Litigation Trust was controlled by Iridium Committee members and represented by the Iridium Committee counsel. Motorola objected to the settlement. The bankruptcy court approved the settlement over Motorola s objection. Motorola appealed to the district court which affirmed the bankruptcy court s order. Motorola then appealed to the Second Circuit. Holding and Rationale: The Lenders and the Iridium Committee, citing SPM, argued that the monies belonged to the Lenders who held blanket liens and therefore the distribution of $37.5 million into the Litigation Trust to pursue Motorola was appropriate. However, the Second Circuit found that the Lenders liens were not yet determined to be properly perfected because the settlement was the subject of the appeal. This fact distinguished Iridium from SPM where the bankruptcy court entered an order recognizing the properly perfected liens of the Lenders. The Court thus analyzed the settlement under Rule 9019 and applied various judicially created factors in its analysis. Motorola claimed that the settlement was not fair and equitable if junior creditors claims are satisfied before those of senior creditors. The Second Circuit noted that settlements presented outside a plan, as was the case in Iridium, do not generally implicate the absolute priority rule of 1129(b)(2). The Second Circuit noted that the Fifth Circuit in United States v. Aweco, Inc. (In re Aweco, Inc.), 725 F.2d 293, 298 (5 th Cir. 1984) held that the absolute priority rule should also apply to pre-plan settlements, concluding that a bankruptcy court abuses its discretion in approving a [pre-plan] settlement with a junior creditor unless the court concludes that priority of payment will be respected as to objectioning senior creditors. The Second Circuit found the Aweco test to be too rigid. However, the Second Circuit opined that whether a particular settlement s distribution scheme complies with the Code s priority scheme is the most important factor for the bankruptcy court to consider when determining whether a settlement is fair and equitable under Rule The Court further stated that in the Chapter 11 context, whether a settlement s distribution plan complies with the Bankruptcy Code s priority scheme will often be the dispositive factor However, the Court also opined that where the remaining factors weigh heavily in favor of approving a settlement, a bankruptcy court, in its discretion, could endorse a settlement that does not comply in some minor respects with the priority rule. 22 With this guidance, the Second Circuit noted that the settlement appeared to satisfy many of the key factors for approval; however, there was no adequate record established to deviate from the priority scheme, thereby requiring a remand to the bankruptcy court to assess the justification for providing a distribution of the Litigation Trust funds to junior creditors at the conclusion of the Motorola litigation Iridium, 478 F.2d at 464. Id. Id. at

10 5. In re MCorp Financial Inc., 160 B.R. 941 (S.D. Tex. 1993) Facts: MCorp was involved in significant litigation with the FDIC for a number of years. MCorp, the committee, and the senior secured bondholders proposed plans for each of the three debtors which proposed to settle the litigation with the FDIC. The crux of the settlement provided that the senior secured bondholders would reduce their claim by a certain amount based on the present value of MCorp s assets which would allow the FDIC to receive a distribution of roughly $33 million. Junior bondholders argued that a resolution with the FDIC was inappropriate because the estate has given up valuable claims against the FDIC, in addition to providing the FDIC with an affirmative recovery of $30 million, while the junior bondholders would receive only 5% of their claims. The junior bondholders argued that their interests are not subordinate to the FDIC. Holding and Rationale: After withdrawing the reference to decide confirmation issues, the District Court evaluated the merits of the settlement proposed under the plan and found that the plans for ending the litigation, liquidating the assets and distributing funds were reasonable solutions to the longstanding litigation. In doing so, the Court dismissed the junior bondholders argument of unfair discrimination stating that Even if you assume the FDIC is inferior to the juniors, the FDIC is paid by the seniors out of their highest priority share. The seniors [m]ay share therein proceeds with creditors junior to the juniors, as long as the juniors continue to receive at least as much as what they would without the sharing. 23 The Court cited SPM with approval for the general proposition that secured creditors can share their distributions with junior creditors. 6. In re Genesis Health Ventures, Inc., 266 B.R. 591 (Bankr. D. Del. 2001) Facts: Genesis Health Ventures, and Multicare AMC, Inc. (collectively Genesis ), each proposed a plan by which general unsecured claimants in the Genesis cases (Classes G4 and M4) would receive New Common Stock, estimated in Genesis' Disclosure Statement to provide a dividend of 7.34%. In each case, however, Genesis punitive damages claimants would receive no distribution under the plan. The recovery by the general unsecured classes of a dividend in the form of New Common Stock was based on an agreement of the senior lenders to allocate a portion of the value it would otherwise have received to such classes. Dozens of personal injury and wrongful death claimants objected to the classification and treatment of the punitive damages claims. Holding and Rationale: The Court dismissed the arguments of the punitive damages claimants, finding that the senior lenders agreed to share the distribution that they would 23 McCorp., 160 B.R. at

11 otherwise be entitled with only certain classes of unsecured creditors and had chosen to omit punitive damages claimants from the agreement. Notwithstanding the resulting difference in the treatment of punitive damages claimants from the treatment of unsecured claimants, the Court determined that there is no impediment to the agreement. In reaching this conclusion, the Court cited to the MCorp and SPM decisions discussed above as examples of instances in which senior creditors may share their distributions with junior constituents. Note, however, that this decision predates the Third Circuit s decision in Armstrong. 7. In re TSIC, Inc., 393 B.R. 71 (Bankr. D. Del. 2008) Facts: Following an auction and sale hearing, TSIC entered into a liquidation agreement with the successful bidder, comprised of Hilco Merchant Resources LLC and Gordon Brothers Retail Partners LLC (the Joint Venture ), to conduct the store closing sales for 96 of TSIC's 184 stores. Thereafter, TSIC proposed a sale of all of its inventory and intellectual property through an auction to be held on May 28, As part of that process, TSIC negotiated a "stalking horse" agreement with the Joint Venture, with an opening bid of $51.25 million. However, one day before the scheduled auction, a document was discovered that challenged TSIC's rights to use and transfer certain intellectual property, resulting in the Joint Venture reducing its opening bid to $42.5 million. During the negotiations of the revised bid and following its execution, the official committee of unsecured creditors (the TSIC Committee ) advised TSIC and the Joint Venture that it was prepared to file an objection to the revised agreement because a sale at the lower price would yield no benefit to the estate insofar as it would substantially reduce, or quite possibly altogether eliminate, any distribution to unsecured creditors. At the conclusion of the auction, the Joint Venture's final bid of $49 million was the highest and best offer for the sale of TSIC's inventory and intellectual property. The TSIC Committee then began its own negotiations with the Joint Venture to resolve its objection to the auction and sale. The TSIC Committee and the Joint Venture reached an agreement in principle on May 29, 2008, memorialized in a letter agreement ("the Settlement") and subsequently filed a motion for its approval, after the sale was approved on May 30, In the Settlement, the TSCI Committee agreed to (i) refrain from impeding the consummation of the sale transaction, including, without limitation, the filing or prosecution of its objection to the sale and the filing or prosecution of an appeal or motion to reconsider the sale; and (ii) waive the right to challenge the Joint Venture's conduct during the auction process or the reduction of its bid. In return, the Joint Venture agreed to fund a trust account for the exclusive benefit of TSIC's general unsecured creditors in an amount equal to the lesser of (i) $500,000 and (ii) 10% of the gross royalties ultimately paid for the period of January 1, 2009 through December 31, 2009 in connection with the intellectual property acquired from the Debtors in the sale transaction. 11

12 The United States Trustee s office objected to the Court's approval of the Settlement on the grounds that the Settlement was improper, unfairly favored the unsecured creditors, and contradicted the absolute priority rule. Holding and Rationale: The United States Trustee argued that the absolute priority rule applied and barred a pre-plan settlement that provided consideration to general unsecured creditors directly from the purchaser when there may be other outstanding administrative and priority claims in the Debtor s estate. The Court overruled the United States Trustee s objection stating that a lengthy discussion of the Settlement's adherence to the absolute priority rule is neither necessary nor appropriate here for the simple reason that the absolute priority rule is not violated in substance or spirit. 24 The Court went to great lengths to distinguish the Third Circuit s opinion in Armstrong. Initially, the Court agreed that Armstrong is clear that the absolute priority rule is violated when a senior class' portion of its share of estate property is allocated to a junior class over the objection of an intervening creditor class. 25 However, the Court found that Armstrong did not address a payment of non-estate property by a non-creditor, such as the Joint Venture, to a junior class outside of a plan of confirmation, stating that the Joint Venture's funds are not proceeds from a secured creditor's lien, do not belong to the estate, and will not become part of the estate even if the Court does not approve the Settlement. 26 Finally, the Court distinguished Armstrong by pointing out that unlike Armstrong, there is no intervening creditor (as opposed to the United States Trustee) that objected to the Settlement. The Court then highlighted two cases in which secured creditors made distributions to unsecured claims. First, in PSA Successor Corp., Case No (Bkrtcy. D. Del. 2004), Judge Walrath, in an unreported decision, approved a settlement agreement between a secured creditor and the committee for unsecured creditors, over the objection of the United States Trustee. In the PSA case, the committee objected to the sale and the DIP facility. In return for a portion of the secured creditor's lien proceeds, the committee agreed to resolve its objections in order for the case to proceed. Judge Walrath approved the settlement in PSA, holding that a "secured creditor may give up part of its recovery to other creditors without concern for the priorities of the Bankruptcy Code." Second, the Court applied the rationale of SPM as applied in In re World Health Alternatives, Inc., 344 B.R. 291 (Bankr. D. Del. 2006), which is further described herein. In World Health, Judge Walsh approved a settlement in which the creditors committee agreed to withdraw its objection to a sale motion in exchange for $1,625,000 for the benefit of general unsecured creditors. The Court approved the settlement, holding that because the Court was not addressing a plan of confirmation, the funds at issue would otherwise not have been available to the debtor's estate and the Bankruptcy Code did not prohibit the arrangement TSIC, 393 B.R. at 75. Id. Id. at

13 It is noteworthy that the TSIC decision was rendered after the Third Circuit s decision in Armstrong. 8. In re World Health Alternatives, Inc., 344 B.R. 291 (Bankr. D. Del. 2006) Facts. The World Health Debtors proposed a sale of its assets. Prior to the hearing on the sale, the official committee of unsecured creditors (the World Health Committee ) negotiated extensively with CapSource, the secured lender, and the World Health Debtors regarding the Committee s objection. As a result, on April 19, 2006, the World Health Debtors, the World Health Committee, and CapSource entered into a letter agreement (the "Letter Agreement"), which provided for a global settlement of disputes among the parties. At the sale hearing, counsel for the World Health Committee advised the Bankruptcy Court that, as a result of extensive negotiations, the parties had reached a settlement, whereby the World Health Committee agreed to withdraw its objection to the sale motion. Counsel for the World Health Committee represented to the Bankruptcy Court that the withdrawal was made in consideration for certain concessions made by CapSource as set forth in the Letter Agreement. The principal terms of the Letter Agreement were as follows: (1) CapSource agreed to cap its secured claim at $42,500,000 (an amount less than its asserted claim), and waive any deficiency claim; (2) CapSource agreed to grant and pay to and for the exclusive benefit of the World Health Debtors' general unsecured creditors a collateral carveout from its lien in the amount of $1,625, to be (a) distributed to the holders of allowed general unsecured claims after payment of any unpaid professional fees and expenses of the World Health Committee and/or (b) used to investigate and prosecute estate causes of action against parties other than CapSource; (3) the World Health Committee and World Health Debtors agreed to release estate causes of action against CapSource; and (4) the World Health Committee agreed to withdraw its objections to the sale and CapSource s liens. The World Health Debtors' schedules listed a number of tax creditors entitled to priority under 507 of the Bankruptcy Code. The amounts of these claims are listed as "unknown," but there was testimony that the IRS asserted a tax claim in excess of $4,000,000. No priority creditor or any other party in interest, other than the United States Trustee, objected to the settlement. Holding and Rationale. The United States Trustee objected to the settlement arguing that it violated the Third Circuit s decision in Armstrong, and that the World Health Committee is not authorized to compromise estate causes of action at the expense of priority creditors in a Chapter 11 case. Although the general unsecured creditors would receive money before the priority creditors, the Bankruptcy Court determined that such money belonged to CapSource, rather than the estate. The Bankruptcy Court stated that Armstrong distinguished, but did not disapprove of, a line of authority that approved this type of agreement. 13

14 The Bankruptcy Court found that the absolute priority rule under 1129(b)(2)(B) was not implicated because the settlement did not arise in the context of a plan of reorganization. In other words, while Armstrong involved a gift under a plan of reorganization, the gift in World Health was effectuated in a pre-plan settlement. In sum, this case permitted a pre-plan settlement of sale objections in which the secured creditors were allowed to gift certain of their distributions to unsecured creditors, notwithstanding the existence of priority creditors holding claims estimated to total $4,000,000. It should be noted however that the Court emphasized that no priority creditor objected to the settlement between the Committee and CapSource. 9. In re On-Site Sourcing, Inc., 412 B.R. 817 (Bankr. E.D. Va. 2009) Facts: On the Petition Date, the debtor filed a motion seeking authority for bidding procedures and the sale of substantially all of its assets. The sale motion made it clear that the debtor was experiencing liquidity issues. As such, prior to the Petition Date, the debtor solicited potential purchasers of its business. The discussions led to an entity called Integreon purchasing the secured debt of $35 million from the secured creditors, leading to a credit bid offer in a stalking horse asset purchase agreement. In connection with the case, Integreon also proposed a loan of $40 million, most of which would be utilized to pay back Integreon s prepetition loan with the balance to be used by the debtor to sustain operations until a sale could take place. The committee of unsecured creditors (the On-Site Committee ) initially opposed the sale but then supported the sale on modified terms. The proposed modifications reached between Integreon and the On-Site Committee provided that (1) Integreon would forgive its deficiency claim, (2) certain assets would be excluded from the sale, (3) the pre-sale budget line item for the committee s professionals would increase from $115,000 to $225,000, and (4) a general unsecured creditor trust with a lump sum of $132,500 would be created. The United States Trustee objected to the creditor trust aspect of the modifications and certain other aspects of the sale proposed by the debtor. Holding and Rationale: The Bankruptcy Court approved the sale but excised certain provisions, including the general creditor trust. The On-Site Committee argued that the intended payment was a distribution of Integreon s property. The Bankruptcy Court disagreed stating that the property, while subject to an encumbrance, was still property of the estate. The Bankruptcy Court indicated that the creditor trust effectively predetermined in significant part, the structure of an as yet drafted plan and effectively evaded the carefully crafted scheme of the Chapter 11 confirmation process. The Bankruptcy Court pointed to at least two provisions that would be affected by the proposed trust for unsecured creditors. First, the creditor trust ran afoul of 1129(a)(7) known as the best interests test which requires an impaired class of creditors to accept a plan or receive as much as they would receive under a distribution under Chapter 7. Second, the creditor trust impacted 1129(a)(9) which requires that all administrative expenses be paid in full unless such creditor agrees to a different treatment. Finally, the Bankruptcy Court stated that 14

15 no sound business reason was articulated for the creditor trust. The Bankruptcy Court directed that the monies that would otherwise be paid to the trust would instead be paid into the debtor s estate. In sum, the Bankruptcy Court in On-Site significantly limited the application of the Gifting Doctrine, raising sub rosa type concerns and stating that the sale effectively evaded the Chapter 11 plan requirements. 10. In re Worldcom, Inc. et al., 2003 Bankr. Lexis 1401 (Bankr. S.D.N.Y. October 31, 2003) Facts: The Worldcom Debtors proposed a plan which requested substantive consolidation and the approval of a number of settlements related to the Plan. The Ad Hoc MCI Trade Claims Committee objected to the original version of the Worldcom Debtors plan. To settle this objection, representatives of certain other classes agreed to give up certain plan distributions and allocate them to this separate group of trade creditors. The Bankruptcy Court then essentially treated this group of creditors as a separate class. Holding and Rationale: The Bankruptcy Court determined that there was no unfair discrimination amongst the various classes of creditors. The Bankruptcy Court stated that the greater value received by the members of the Ad Hoc MCI Trade Claims Committee as a result of the contributions from other classes does not violate the Bankruptcy Code, because the contributions are the result of other creditors (holders of MCI Senior Debt Claims and MCI Subordinated Debt Claims) voluntarily sharing their recoveries under the Plan with the members of the Ad Hoc MCI Trade Claims Committee. 27 The Bankruptcy Court stated: The greater value received by the members of the Ad Hoc MCI Trade Claims Committee is not the result of the Debtors' distribution of estate property to such creditors. Creditors are generally free to do whatever they wish with the bankruptcy dividends they receive, including sharing them with other creditors, so long as recoveries received under the Plan by other creditors are not impacted. 28 Finally, the Bankruptcy Court opined that the absolute priority rule is inapplicable to contributions of Plan recoveries made by certain creditors to other creditors, citing SPM with approval in the context of a consensual plan of reorganization. The decision stands for the proposition that creditors in certain classes can provide distributions to certain classes of claims, regardless of whether other similarly situated classes receive anything at all from the gifting creditors. It is noteworthy that the Worldcom bankruptcy decision was decided before the Second Circuit s more recent pronouncements in Iridium and DBSD Worldcom, 2003 Bankr. Lexis 1401 at *178. Id. at *

16 11. In re Journal Register Company, 407 B.R. 520 (Bankr. S.D.N.Y. 2009) Facts: The Debtors were a national media company that owned newspapers and other publications, web sites, and printing facilities. The Debtors had $695 million in outstanding debt to its secured lenders (the Secured Lenders ) who maintained fully perfected liens on all of the Debtors assets. In addition, the Debtors had $27 million in unsecured debt, of which $6.6 million was owed to trade creditors. The Debtors proposed a plan that, among other things, proposed to (i) deleverage the Debtors by converting the Secured Lenders' debt into 100% of the new equity of the Reorganized Debtors and new tranche A and B secured loans; (ii) make certain distributions to the unsecured creditors class; (iii) cancel the old equity; and (iv) establish a Post-Emergence Incentive Plan. As one of the "means of execution" of the Plan, but not as a matter of Plan classification and distribution, it was also proposed that there be a further payment to certain of the unsecured trade creditors from a purported "gift" of the Secured Lenders. The gift was labeled a Trade Account Distribution in the plan. 29 Central States, a pension fund with an unsecured claim of $4.3 million, objected to the "gift" conferred on the trade creditors, arguing that the proposal constitutes unfair discrimination and that while the trade creditors and other unsecured creditors were in the same class, there were really two classes of creditors because of the disparate treatments. Holding and Rationale: The Bankruptcy Court overruled Central States objections. The Court found that since the general unsecured creditors were all part of the same class, there was no improper classification. The Court then stated that unfair discrimination under section 1129(b) is only implicated when there are separate classes of claims and since there was only one class, that the unfair discrimination argument must fail. Lastly, the Court analyzed section 1123(a)(4) to determine whether the gift from the Secured Lenders to the trade creditors violated this section of the Code. Section 1123(a)(4) requires that a plan provide the same treatment for each claim or interest in a particular class, unless the holder of a particular claim or interest agrees to less favorable treatment of such particular claim or interest. The Court determined that section 1123(a)(4) was not violated and the gift was proper. The Court stated that the distribution was property of the Secured Lenders and nothing could stop the Secured Lenders, outside of bankruptcy, from gifting their property as they so chose. The Debtors established a record demonstrating that the Trade Account Distribution was necessary to preserve the going concern of the reorganized debtors Finally, the Court noted that the alternative was that there would be no recoveries at all to any creditor if the Secured Lenders foreclosed on their collateral. The case stands for the proposition that a plan proponent may provide a gift to certain members in a class without violating the unfair discrimination principle or section 1123(a)(4). 29 See Journal Register Co., 407 B.R. at

17 This case was decided before the Second Circuit s decision in DBSD and thus its impact may be limited in the Second Circuit and elsewhere. 12. In re Snyders Drug Stores, Inc., 307 B.R. 889 (Bankr. N.D. Ohio 2004) Facts: The Debtors and Official Committee of Unsecured Creditors filed a plan that consisted 12 classes of claims. The following classes are relevant to the opinion: Class 4 comprised of reclamation claims, Class 10 comprised of various trade vendors, including those in which the reorganized debtor would continue doing business, and Class 12 consisting of landlords and lessors to rejected leases. The plan provided that McKesson, a secured creditor, would agree to allow some of the distributions it would otherwise receive on account of its secured claim to be set aside and paid to Classes 4 and 10. Class 4 was estimated to receive a 27% distribution, Class 10 was to receive about 6-7% from recoveries of preserved litigation claims, including avoidance actions, and Class 12 was to receive nothing under the Plan. Class 12 rejected the plan. Many creditors in Class 12 objected to the plan arguing that the plan proponents should not classify them separately from the other unsecured creditor classes. In addition, the creditors argued that the plan unfairly discriminates against Class 12. The plan proponents responded that the plan did not unfairly discriminate because the property that was being distributed to classes 4 and 10 was not property of the estate, and absent the contributions of the purchaser and concessions by the secured creditor, unsecured creditors would receive nothing. Holding and Rationale: The Bankruptcy Court found that the plan proponents established a sound business reason for separate classification of claims. Turning to the unfair discrimination argument, the bankruptcy court in the first instance analyzed whether the proposed distributions were property of the estate. The Bankruptcy Court answered in the affirmative because the proposed recovery included distributions from preserved litigation claims including avoidance actions. The Bankruptcy Court then distinguished the SPM case, finding that SPM did not involve property of the estate and that the agreement proposed in SPM was not part of a reorganization plan, but was instead in the nature of a partial assignment or subordination that was not subject to Chapter 11 s confirmation requirements. The Bankruptcy Court refused to confirm the plan. In essence, the Court limited the use of the Gifting Doctrine when the plan proposed to provide certain classes of unsecured creditors with distributions of property of the estate, while other classes of equal rank received nothing. The Court would not extend SPM to a Chapter 11 plan. 17