Ever since the first corporate reorganizations in the US, business owners have been looking for ways to retain ownership of their restructured companies while reducing debt. And ever since owners have been trying to retain ownership, courts have been resisting them.
Today, it is commonly understood that the equity holders of a reorganizing business cannot retain their ownership unless other, senior creditors are paid in full. This principle, known as the “absolute priority rule,” has been developed and refined through various decisions which date back to the 1860′s – before the concept of “corporate reorganization” was formally recognized as such.
Despite the pedigree of the “absolute priority rule,” equity owners nevertheless have continued undaunted in creative efforts to retain some piece of the (reorganized) pie even though creditors senior to them receive less than full payment. And courts, though stopping short of prohibiting it outright, nevertheless keep raising the bar for such ownership.
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Yesterday, the Second Circuit Court of Appeals raised the bar another notch with its decision in In re DBSD Incorporated.
The basic economic scenario in DBSD is a relatively common one for business reorganizations: DBSD was an over-leveraged “development stage” start-up company with reorganizable technology and spectrum licensing assets, but no operations – and therefore, no revenue. It was essentially wholly owned by ICO Global, which sought to de-leverage DBSD through Chapter 11 – but who also sought to retain an equity interest in DBSD.
To accomplish these goals, ICO Global negotiated a Chapter 11 Plan which (i) paid its first lien-holders in full; (ii) paid its second lien-holders in stock in the reorganized entity worth an estimated 51% – 73% of their original debt; and (iii) paid general unsecured creditors in stock worth an estimated 4% - 46%. The Plan further provided that ICO Global would receive equity (i.e., shares and warrants) in the newly organized entity.
One of the larger unsecured creditors objected, claiming that DBSD’s Plan violated the “absolute priority rule.” Both the Bankruptcy Court and the District Court found that that the holders of the second lien debt, who were senior to the unsecured creditors and whom the bankruptcy court found to be undersecured, were entitled to the full residual value of the debtor and were therefore free to “gift” some of that value to the existing shareholder if they chose to.
The Second Circuit disagreed. In a lengthy decision (available here), the Court of Appeals held, essentially, that merely calling a Plan distribution a “gift” doesn’t make it one. As a result, the Plan’s distribution of stock and warrants to ICO Global under the Plan was impermissible.
Nevertheless, the Second Circuit didn’t slam the door altogether on the “gifting” of stock from senior creditors to equity. Equity holders looking to de-leverage with the assistance of senior creditors may still consider the following approaches:
- A separate agreement for distributions outside the Plan. Though the DBSD decision notes that the “absolute priority rule” preceded the present Bankruptcy Code, and further devotes some discussion to the general policy reasons behind it, the Second Circuit stopped short of precluding such gifts altogether:
“We need not decide whether the Code would allow the existing shareholder and Senior Noteholders to agree to transfer shares outside of the plan, for, on the present record, the existing shareholder clearly receives these shares and warrants ‘under the plan.’”
This analysis suggests it may be possible to negotiate outside a Chapter 11 plan for the same economic result as that originally proposed (but rejected) in DBSD.
- A “consensual” foreclosure by a senior secured creditor. Along the way to its conclusion, the Second Circuit distinguished DBSD from another “gifting” case - In re SPM Manufacturing Corp., 984 F.2d 1305 (1st Cir. 1993).
In SPM, a secured creditor and the general unsecured creditors agreed to seek liquidation of the debtor and to share the proceeds from the liquidation. 984 F.2d at 1307-08. The bankruptcy court granted relief from the automatic stay and converted the case from Chapter 11 to a Chapter 7 liquidation. Id. at 1309. The bankruptcy court refused, however, to allow the unsecured creditors to receive their share under the agreement with the secured creditor, ordering instead that the unsecured creditors’ share go to a priority creditor in between those two classes. Id. at 1310. The district court affirmed, but the First Circuit reversed, holding that nothing in the Code barred the secured creditors from sharing their proceeds in a Chapter 7 liquidation with unsecured creditors, even at the expense of a creditor who would otherwise take priority over those unsecured creditors.
The Second Circuit held that DBSD‘s result should be different from SPM‘s because (i) SPM involved a Chapter 7 (where the “absolute priority rule” doesn’t apply); and (ii) the creditor had obtained relief from stay to proceed directly against its collateral – and therefore, the collateral was no longer part of the bankruptcy estate.
This distinction suggests that, under appropriate circumstances, a stipulated modification of the automatic stay and “consensual foreclosure” by a friendly secured creditor might likewise facilitate the transfer of property to equity holders outside the strictures of a Chapter 11 Plan.
DBSD offers interesting reading – both for its coverage of reorganization history, and for its implicit suggestions about the future of “creative reorganizations.”