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Second Circuit Decision Alters Balance in Bankruptcy Reorganizations and Limits Acquisition of Claims to Acquire DebtorFebruary 17, 2011
The United States Court of Appeals for the Second Circuit, whose jurisdiction includes New York, recently reversed a bankruptcy court's approval of a so-called "bankruptcy gifting plan," while at the same time affirming the bankruptcy court’s decision to disqualify votes relating to claims acquired to support a takeover of the debtor. The decision in DISH Network v. DBSD North America, Inc. (In re DBSD North America, Inc.), Case No. 10-1175 (2d Cir. Feb. 7. 2011), significantly limits the ability of senior creditors to obtain the support of equityholders for reorganization plans by sharing their dividends. It may also limit the viability of investors purchasing distressed debt to pursue an acquisition of the debtor.
DBSD North America, Inc. and its subsidiaries (the “Debtors”) were a development stage enterprise formed to develop an integrated mobile satellite and terrestrial services network. DISH Network Corporation (“DISH”) has made significant investments in TerreStar Corporation, a direct competitor of the Debtors. Under their plan of reorganization, the Debtors proposed to satisfy their first lien secured prepetition debt through issuance of a modified promissory note under an amended first lien facility. The Debtors’ second lien creditors would receive the bulk of the equity in the new company, estimated to be worth less than 76% of the amount of the second lien debt. Holders of general unsecured claims, including Sprint Nextel Corporation (“Sprint”), would receive shares estimated to be worth between 4% and 46% of their claims. Finally, the Debtors’ existing shareholder would receive shares and warrants in the reorganized company.
After the Debtors filed their plan, DISH purchased all of the Debtors’ outstanding first lien debt at par and, through an affiliate, purchased a substantial portion of the Debtors’ second lien debt. DISH’s own internal documents revealed that it was at least in part motivated by the possibility of consummating a strategic acquisition of the Debtors’ assets that would be useful in DISH’s business. DISH, whose first and second lien claims were in separate classes, and Sprint, who was in its own class for voting purposes, voted all of their claims against the plan. All other classes voted to accept the plan. The day before the plan confirmation hearing DISH filed a motion seeking authority to propose a competing plan centered upon a strategic transaction with the Debtors.
The bankruptcy court disregarded the votes of DISH on the basis of DISH’s motivation to engage in a strategic transaction with the Debtors and confirmed the Debtors’ plan.
Sprint argued that the Debtors’ plan violated the Bankruptcy Code’s absolute priority rule by giving shares of the reorganized company to the existing shareholder even though the general unsecured creditors neither approved the plan nor received the full value of their claims.
Because equityholders normally have the exclusive right early in a bankruptcy case to propose a plan of reorganization, obtaining their support may be critical to senior lenders. Under a “gifting” plan, senior lenders give up part of their distribution--often bypassing unsecured creditors--to pay the equityholders a dividend. A line of cases permits this “gifting” by secured creditors to more junior classes, reasoning that in cases where secured creditors are entitled to the full residual value of the debtor, they are free to give away part of their dividend to the existing shareholders as they see fit.
While the United States Supreme Court rejected gifting plans in the context of railroad reorganizations in the late 1800’s, it has not weighed in on the viability of gifting since the enactment of the Bankruptcy Code, and gifting plans have become quite common. Relying on the old railroad reorganization cases, the Second Circuit concluded that gifting plans violate the absolute priority rule, which requires that creditors be paid before equityholders unless the creditor classes consent. Even though the general unsecured creditors would not otherwise receive any distributions in light of the secured lenders’ priority, the existing shareholder did receive property under the plan on account of its interest--contravening the express language of the absolute priority rule.
The Second Circuit left open the possibility that senior creditors could make gifts from their distributions to equityholders outside of the plan, but the viability of such a side-deal is unclear and raises tax, securities law, and other issues. At bottom, the DBSD decision will significantly limit the ability of senior creditors to structure a reorganization deal without buy-in from unsecured creditors.
Acquisition of Claims with a Strategic Motive
The Bankruptcy Code permits the court to ignore votes that are not cast in “good faith.” The bankruptcy court found the fact that DISH sought to acquire the debtor evidenced an “ulterior motive” and that it acted “other than as a creditor” and in bad faith. The Second Circuit affirmed, but provides no clear guidance on what constitutes an improper ulterior motive.
While the court held that DISH’s act of purchasing claims, as a competitor of the Debtors, with the intent of voting against any plan that did not give it a strategic interest in the reorganized company was an improper motive warranting designation, the court noted that in “appropriate” cases voting claims purchased to support an acquisition may be proper. The court appears to have been heavily influenced by DISH’s status as a competitor of DBSD although it did not hold that this factor was controlling. Ultimately, the court seems to give very broad discretion to the bankruptcy judge.
Without clear guidance as to what constitutes an improper ulterior motive, the votes of a variety of creditors may be designated based on ulterior motivation--particularly where the creditor’s intent is to engage in a strategic transaction with the debtor. Future cases will give guidance as to whether DBSD will be confined to its facts on the designation issue.
O’Melveny represented the Loan Syndications and Trading Association, as amicus curiae, solely with regard to the voting issue in the appeal before the Second Circuit.
 The plan proceeded from the premise that the value of the debtor was inadequate to fully satisfy the senior claims. Thus, any dividend to the equityholders was a "gift" from the senior creditors. In the district court Sprint had challenged the valuation, but abandoned that argument in the Second Circuit. After the Second Circuit ruling, a new acquisition proposal by DISH suggests that the value was significantly higher than the courts below had found.
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