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Game Changer: Second Circuit Finds Gifting By Secured Creditor to Old Equity Pursuant to Chapter 11 Plan Violates Absolute Priority Rule

The concept of gifting in the chapter 11 plan context has been discussed for years. It often arises when secured creditors who have a lien on all, or substantially all, of a borrowers assets seek to take control of the borrower. The enterprise value of the borrower is less than the amount of the secured debt, so unsecured creditors and old equity are out-of-the-money. Nonetheless, to ensure a peaceful and relatively smooth transition, the secured creditors offer a tip to old equity, essentially out of their own recoveries, by turning over a small portion of value to the former owners and bypassing unsecured creditors. This gifting practice became quite common and has been approved by a number of courts over the years, although some courts have called the practice into question. A recent decision by the Second Circuit Court of Appeals appears to have brought the practice to a screeching halt, at least in chapter 11 cases filed in the Second Circuit.

In an appeal arising in the chapter 11 case of In re DBSD North America, Inc., a panel of the Second Circuit overturned, on February 7, 2011, an order issued by Judge Gerber of the United States Bankruptcy Court for the Southern District of New York (the Bankruptcy Court) confirming a plan of reorganization that contemplated just such a gifting transaction. On an appeal brought by an unsecured creditor, the panel held, in a 2-to-1 decision, that such a plan of reorganization violated the absolute priority rule and could not be confirmed. The ruling is a game changer because it bars a common practice (at least in the Second Circuit) and has the potential to change the dynamics of chapter 11 plan negotiations among secured creditors, unsecured creditors and equity holders.


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