This is the next post in Plan Proponent’s series on the confirmation-related recommendations in the ABI Commission Report (and, in particular, its Exiting the Case piece). In this post, we’ll cover the Commission’s recommendations regarding “class-skipping” and “intra-class discriminating” distributions.
Overview of Plan “Gifting” Provisions
As we have discussed in other posts, the Bankruptcy Code establishes a relative priority of claims and the order in which claims must be paid. Although the “let’s make a deal” approach is usually the path of least resistance in plan confirmation, consensus is not always possible and “cramdown” is the only option. Cramdown (i.e., confirming a plan over the objection of a class of dissenting creditors) requires 1 of 2 things: (1) paying such class in full or (2) ensuring that no junior classes receive property on account of their junior claims/interests. In a nutshell, that’s the absolute priority rule–Section 1129(b)’s requirement that a plan must be “fair and equitable.”
However, strict enforcement of the absolute priority rule (“APR“) can encourage “out of the money” creditors to hold a plan hostage by withholding their consent and, thus, drive-up confirmation costs. A common solution to the holdout problem, especially before that solution started drawing scrutiny, was for a senior creditor to provide a “gift” or a “tip” (of its own distribution) to the holdout class to achieve consensual confirmation.
Although concerns about that approach originated as far back as Northern Pacific Railway Co. v. Boyd, 228 U.S. 482 (1913) (a bedrock APR case), it gained particular attention in In re SPM Mfg. Corp, 984 F.2d 1305 (1st Cir. 1993). In SPM, an undersecured bank received support from the creditors committee in exchange for its agreement to share proceeds with the committee. The bank’s “gift” would have skipped over the IRS (which had priority over unsecureds). Ultimately, the lower courts rejected the agreement as being contrary to the priority scheme. However, the First Circuit approved the agreement, holding that (i) the IRS was not harmed since it was out of the money and (ii) the agreement was no different than a creditor selling its claim to a third party.
SPM did not arise in the plan confirmation context, but creative creditors started relying on SPM for similar arrangements under plans. Initially, their efforts were successful, with bankruptcy courts using SPM to hold that creditors can generally do whatever they want with their own bankruptcy dividends. Things changed, though, in 2005 when the Third Circuit rejected that approach on the basis of the APR in In re Armstrong World Industries, Inc., 432 F.3d 507 (3d Circ. 2005).
Specifically, the Third Circuit held that allowing “this particular type of transfer would encourage parties to impermissibly sidestep the carefully crafted strictures of the Bankruptcy Code and would undermine Congress’s intention to give unsecured creditors bargaining power in this context.” Armstrong, 432 F.3d at 514-515. The Second Circuit joined the Third Circuit in In re DBSD North America, Inc., 419 B.R. 179) (Bankr. S.D.N.Y. 2009) when it rejected a plan gifting provision on similar grounds. See also In re Iridium Operating, LLC, 478 F.3d 452 (2d Cir. 2007) (holding that such agreements should be evaluated under Rule 9019 like any other settlement agreement, with APR deviations being appropriate only if they can be justified).
Commission Recommendations on Gifting
The Commission acknowledged the hurdle often posed by the APR and the efficiencies made possible by class-skipping distributions. Indeed, the APR can frustrate junior creditor recoveries while gifting can result in distributions to more creditors. Although the Commission generally favors “lowering barriers to confirmation of feasible plans,” it is not in favor of gifting provisions that violate the APR.
Ultimately, the “Commission agreed that — in the nonconsensual (i.e., cramdown) context — the potential abuses of gifting outweighed any benefits in class-skipping, class-discriminating, and intra-class discriminating cases.”