Horizontal Gifting Upheld in Chapter 11 Plan in the Third Circuit

by Kramer Levin Naftalis & Frankel LLP
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The Bottom Line

In Hargreaves v. Nuverra Environmental Solutions Inc. (In re Nuverra Environmental Solutions Inc.), 17-1024 (D. Del. Aug. 21, 2018), a Delaware district court upheld a bankruptcy court’s ruling that the secured creditors’ “gift” of cash and stock to holders of unsecured claims pursuant to a Chapter 11 plan did not violate the confirmation standards for approving a plan under Chapter 11, even though certain classes of unsecured claims (trade and business-related unsecured claims) received larger distributions from the gift than another class of unsecured claims (noteholders). The decision focuses on the permissible effect of “horizontal” gifting whereby the disparate treatment is among separate classes of the same priority level of creditors — here, separately classified general unsecured claims.

What Happened?

In this case, Nuverra Environmental Solutions Inc. and its 13 affiliated debtors filed a joint prepackaged plan of reorganization that contemplated secured creditors, who were not projected to receive 100 percent recovery on account of their allowed secured claims, making a voluntary payment (“gift”) in the form of cash and stock, otherwise distributable to the secured creditors, to general unsecured creditors who would otherwise not receive any distribution under the Bankruptcy Code’s waterfall priority scheme. The gifting, however, distinguished between the types of unsecured creditors by providing a disparate gift treatment. Specifically, the plan included a class of general unsecured creditors, made up of noteholders, receiving an aggregate recovery of only approximately 4 – 6 percent of their claims while trade and other general unsecured creditors, separately classified, received 100 percent recovery on account of the gifted distribution. The noteholder class voted against the plan and argued that the plan’s distribution scheme unfairly discriminated against them (as compared with the trade and other unsecured creditors) in violation of § 1129 of the Bankruptcy Code. The bankruptcy court disagreed that the disparate effect of the gifting was an unfair discrimination by the Debtors.

A noteholder appealed, arguing, among other things, that the plan unfairly discriminated against his class of claims since other unsecured creditors in separate classes would receive 100 percent recovery. The Debtors argued that the plan “treated unsecured creditors in distinct ways based upon their respective legal rights, their importance to the ongoing operation and the profitability of the Debtors’ businesses, and the practical limitations impeding the Debtors’ ability to provide such creditors with a recovery.” In re Nuverra Environmental Solutions Inc., 17-1024, *3 (D. Del. Aug. 21, 2018).

On appeal, the district court first concluded that the appeal was equitably moot, but nonetheless went on to address the merits of the appeal. The court began its analysis of the merits by noting that the Third Circuit has not yet articulated a standard to apply when assessing whether a plan discriminates unfairly in such a way that would prevent the plan from being confirmed under § 1129(b)(1) of the Bankruptcy Code. However, the court acknowledged that courts in the Third Circuit have applied the Markell test set forth by Bruce A. Markell, A New Perspective on Unfair Discrimination in Chapter II, 72 Am. Bankr. L.J. 227, 249 (1998), which establishes a rebuttable presumption of unfair discrimination when there is:

(1) a dissenting class; (2) another class of the same priority; and (3) a difference in the plan’s treatment of the two classes that results in either (a) a materially lower percentage recovery for the dissenting class (measured in terms of the net present value of all payments), or (b) regardless of percentage recovery, an allocation under the plan of materially greater risk to the dissenting class in connection with its proposed distribution.

Id. at *20-21 (citing In re Tribune Co., 472 B.R. 223, 244 (Bankr. D. Del. 2012) and In re Genesis Health Ventures, Inc., 266 B.R. 591, 612 (Bankr. D. Del. 2001)). The bankruptcy court had applied the Markell test and concluded that a rebuttable presumption of unfair discrimination had arisen but was rebutted, specifically because (i) no unsecured creditor was entitled to any distribution under the Bankruptcy Code’s priority scheme and (ii) the proposed treatment and classification of unsecured creditors facilitated a reorganization of the Debtors. Even though the bankruptcy court applied the Markell test, the district court observed that the Markell test did not address this situation in which the disparate treatment was occurring among classes receiving recoveries solely as a gift from a senior class. Yet the district court found that the bankruptcy court did not err in its application of the Markell test since in Genesis Health Ventures, a Delaware bankruptcy court also applied the Markell test and found that the presumption of unfair discrimination was rebutted where the distribution that led to the disparate treatment resulted from senior lenders agreeing to allocate a portion of value they would have otherwise been entitled to receive. Therefore, the district court concluded that here the bankruptcy court’s Markell analysis was consistent with the Genesis Health Ventures court’s analysis of “virtually identical facts,” and thus found no error in the bankruptcy court’s conclusion that the plan did not unfairly discriminate.

Next, the district court addressed the noteholder’s argument that in the rulings following Genesis Health Ventures, appellate courts have held that a plan may not circumvent § 1129(b) through the use of gifting. In response, the Debtors argued that there is a distinction between “vertical gifting,” where a class of claims is deprived of a gift while a more junior class receives a gift, and “horizontal gifting,” where two or more classes of claims that are pari passu in priority receive a gift but the gifting distribution may vary among the classes. The Debtors argued that cases, such as In re Armstrong World Indus., Inc., 348 B.R. 111, 121 (D. Del. 2006), did not flatly reject the concept of gifting but rather rejected vertical gifting in which a junior class of claims (such as equity) received a gifting distribution while a more senior class (such as general unsecured claims) is deprived of a gift (i.e., vertical gifting). In that instance, the Debtors argued, the gift would be skipping a class of claims in violation of the absolute priority rule. But since equity, the class junior to the general unsecured claims here, did not receive a distribution under the plan, the Debtors argued that the absolute priority rule was not implicated, and thus, there was no vertical gifting. The district court agreed with the Debtors’ argument, noting that courts in the Third Circuit have held that a horizontal gift is not unfair discrimination against the class that does not receive the larger gift.

Finally, the district court addressed the general unsecured claimant’s argument that the plan improperly classified his noteholder claims separately from other general unsecured claims. The district court noted that courts have (i) held that there is significant flexibility in classifying claims, (ii) permitted separate classification of trade claims from noteholder claims since such claims are legally distinct, and (iii) allowed trade claims to be separately classified from other general unsecured claims when trade claims are essential to a reorganized debtor’s ongoing business. According to the district court, the record supported the bankruptcy court’s finding that it was necessary to separately classify the trade and business-related unsecured claims to preserve the reorganized debtors’ ongoing business. Furthermore, according to the district court, nothing in the record suggested that the noteholder’s claims were classified separately from other general unsecured claims arbitrarily or for fraudulent purposes.

Why This Case Is Interesting

Debtors looking to pursue a reorganization may seek to provide a recovery to certain types of creditors (such as trade) within a class, but not others. Such discrimination is not permissible for value distributed by the debtor’s estate under a plan. Gifting has been a technique — subject to criticism (especially when class skipping is involved) — to provide disparate treatment. While the Third Circuit has not ruled on gifting, this latest Delaware district court decision supports the use of horizontal gifting. Such a decision will certainly be the focus of attention by supporters and critics of gifting.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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