At the end of the summer, Delaware U.S. District Judge Richard G. Andrews issued an opinion in the case of Hargreaves v. Nuverra Environmental Solutions, which can have a profound benefit to unsecured trade creditors in bankruptcy cases where there is substantial leveraged secured debt and the value of the borrower’s assets is less than the amount of the secured debt. Heretofore, these creditors could expect no distributions from the bankruptcy case. Andrews’ opinion is one of the first opinions to uphold what is known as horizontal gifting in a Chapter 11 plan. Exploring this concept and opportunity for unsecured trade creditors is important in assessing that group’s rights and remedies in a bankruptcy case.
Under the provisions of the Bankruptcy Code, a Chapter 11 reorganization plan must comply with what is known as the absolute priority rule. Simply stated, the rule prohibits a distribution to a lower in status class of creditors or equity holders if a higher in status class has not either been paid in full or consents to the distribution to the more junior class. If a Chapter 11 plan as proposed by a bankruptcy debtor violates the absolute priority rule, if there is an objection by a creditor or group of creditors that is more senior in priority, the bankruptcy judge cannot confirm the plan.
In order to confirm a Chapter 11 plan, the provisions of Section 1129 of the Bankruptcy Code provides that the plan proponent must demonstrate among other things that there is no violation of the absolute priority rule, that the plan does not unfairly discriminate against one or more classes of creditors and that at least one class of impaired creditors has accepted the plan. In the all too often current situation where there is secured, and most often overly leveraged debt, where the value of the assets is insufficient to satisfy the claims of secured creditors, since there will be and can be no distribution to junior unsecured or trade creditors, the absolute priority rule prohibits satisfying some of these junior creditors to gain their vote for acceptance of the plan and continued business dealings with the reorganized debtor.
In the Nuverra case, the Chapter 11 plan provided that the secured creditor would swap its secured debt for a 100 percent equity interest in the reorganized entity, leaving no funds to be distributed to any junior class of creditors. In order to circumvent the absolute priority rule and to obtain an affirmative vote for a plan by a junior impaired class of creditors, the senior secured creditor agreed to “gift” 100 percent payment to trade creditors and 6.5 percent to certain unsecured bondholders. Thus, bondholders, junior secured creditors and other groups of unsecured creditors would receive little or nothing under the plan, while trade creditors would be paid in full. This concept is known as horizontal gifting which in essence permits the secured creditor to make a gift of a distribution to trade creditors and certain junior classes upon creditors of its choice from the secured creditor’s funds outside of the Chapter 11 plan.
Andrews applied what is known as the so-called Markell test to determine if the plan unfairly discriminated against the rights of the objecting bondholders. The test raises a rebuttable presumption of unfair discrimination if a similar class receives a materially lower percentage recovery under the Chapter 11 plan. Judge Andrews, in his opinion, stated that prior opinions and the Markell test do not say anything about gifting, which is solely within the purview of the senior secured creditor since it is using its own funds to make the “gift” distribution to unsecured creditors. Although there is a rebuttable presumption of unfair discrimination, Andrews found that horizontal gifting in the Chapter 11 plan does not, per se, constitute a violation of the provisions of the Bankruptcy Code relating to confirmations of Chapter 11 plans. Andrews also found that the objecting bondholders were not harmed by the larger recovery of the trade creditors since the bondholders received more than they would otherwise obtain in a liquidation or if there was no horizontal gifting at all.
While this may all seem somewhat complicated, in essence, unsecured trade creditors now have a valuable negotiating tool in Chapter 11 proceedings where secured creditors need to obtain the consent of an impaired class of creditors in order to confirm a Chapter 11 plan. Such trade creditors can now use significant negotiating strength to mandate horizontal gifting by the senior secured creditor in order meet the statutory requirements in order to obtain confirmation of the Chapter 11 plan with an equity for debt swap.
Attorneys, financial professionals and creditors can now utilize a new arrow in their quiver in order to seek for partial payment in bankruptcy where none was previously available.
Charles Tatelbaum is a director at Tripp Scott in Fort Lauderdale.