The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:
A district court in Delaware has held that disparate “gifts” from senior secured creditors to two different classes of unsecured creditors does not unfairly discriminate against the least-favored class and does not violate the “absolute priority” rule in a Chapter 11 reorganization. [In re Nuverra Environmental Solutions, Inc., 2018 Westlaw 3991471 (D. Del.).]
FACTS: In the context of a prepackaged Chapter 11 plan, a group of senior secured creditors agreed to provide “gifts” to two different classes of unsecured creditors, both of which would have been “out of the money” without the gifts. The unsecured noteholders received roughly 4% of their claims in the form of gifts, and the unsecured vendors and trade creditors received 100% of their claims. The equity holders received nothing. The noteholders voted against the plan, but the separate class of trade creditors voted in favor of it, thus enabling a “cramdown” reorganization.
One of the unsecured noteholders objected to the confirmation of the plan, claiming that it unfairly discriminated against the noteholders while providing full payment to the unsecured trade creditors. The bankruptcy court ruled in favor of confirmation, holding that there was a sound reason for treating the two groups of unsecured creditors unequally.
REASONING: The District Court affirmed, first holding that under the doctrine of “equitable mootness,” the appeal of the objecting claimant could no longer be heard. The court observed that to offer relief to the objecting claimant would “fatally scramble” the plan, which had largely been consummated.
In the alternative, the court overruled the objection on its merits, holding that the gift from the senior secured parties to the two separate groups of unsecured creditors was entirely proper. The court distinguished between (1) “vertical gifting,” under which a senior creditor’s gift impermissibly skips an intermediate class of creditors in violation of the “absolute priority” rule, and (2) “horizontal gifting,” under which a gift is given by a senior creditor to a junior creditor and no distribution is made to any class junior to the donee.
Finally, the court concluded that the disparate treatment of the two different classes of unsecured creditors was not unwarranted, since the gift to the trade creditors preserved the debtor’s relationships with its vendors.
AUTHOR’S COMMENT: The practice of strategic interclass “gifting” in Chapter 11, while still controversial, is now well-established. There are several cases holding that “vertical” gifts that involve the skipping of an intermediate class are in violation of the “absolute priority” rule; but I think that the Nuverra court’s distinction between “vertical” and “horizontal” gifting is sound and will withstand appellate review. This technique enables the senior creditors to pay off a single impaired class of unsecured creditors, in order to obtain confirmation of a cramdown plan.
For discussions of cases dealing with related issues, see:
- 2011 Comm. Fin. News. 15, Gift from Senior Creditor to Equity Holders During Reorganization Violates Absolute Priority Rule, and Competitor’s Vote Is “Designated” Due to Bad Faith Because Competitor Bought Claims at Par and Sought Strategic Partnership with Debtor.
- 2007 Comm. Fin. News. 28, Plan That Provides for Transfer of Stock from Senior Creditor to Equity Holders Violates Absolute Priority Rule.
These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.