Do's & Don'ts Of Gifting In Bankruptcy: When A Court Will Look A Gift Horse In The Mouth

The gifting doctrine in bankruptcy is not new and often is used to obtain creditor consensus to a debtor's proposed exit - either through a chapter 11 plan or a 363 sale. A bankruptcy "gift" typically involves a structurally senior class voluntarily giving some of its property or distribution to a structurally junior class of creditors or equity holders. Bankruptcy courts across the nation have reached differing and, at times, seemingly inconsistent decisions regarding the gifting doctrine. Some courts view gifting as a voluntary arrangement between the senior creditors giving their property to junior creditors. Other courts have refused to approve gifting on grounds that the class-skipping transfer involves property of the debtor's estate and achieves an end-run around the Bankruptcy Code's distribution scheme and/or confirmation standards (e.g., the absolute priority rule).

Gifting in bankruptcy approaches can be broken to key categories: (i) gifting under a chapter 11 plan; and (ii) gifting carve-outs in the context of 363 sales (which are usually followed by either a liquidating plan or a structured dismissal of the bankruptcy case).

1. Gifting Under a Plan of Reorganization

   Bankruptcy courts that have analyzed the gifting doctrine in the plan context have been guided in large part by several factors. First, does the gift involve property of the estate? Second, is the gift being made "under a plan" and, if so, is the gift "on account of" a junior interest? Third, is any creditor being harmed by the proposed gift? In 2011, the U.S. Court of Appeals for the Second Circuit in DBSD North America circumscribed a debtor's use of gifting in chapter 11 plans.1 In DBSD, the Second Circuit denied confirmation of a chapter 11 plan that provided for a gift by a senior noteholder class to existing equity class, thereby skipping an intermediate dissenting class of creditors in which an unsecured creditor - the plan objectant - was classified. The Second Circuit's decision in DBSD was premised on the fact that the proposed gifting was to occur under a chapter 11 plan, and the recipient of the gift (i.e. existing equity) was receiving the gift on account of its equity interest in violation of the absolute property rule embodied in the Bankruptcy Code.2 The Second Circuit in DBSD left open the possibility that the Bankruptcy Code may allow gifting outside a plan.3

2. Gifting Carve-Outs in 363 Sales

   Until recently, one of the most frequently cited court decisions on gifting involved a 363 sale in which the senior secured lender agreed to carve-out from its lien an amount for general unsecured creditors.4 Just following the sale, the secured creditor had obtained relief from the automatic stay and obtained an order converting the case to chapter 7. The bankruptcy court in SPM refused to enforce an agreement between the secured creditor and the creditors' committee and directed the secured creditor to carve-out from its lien and net sale proceeds an amount to be paid to the trustee for distribution to the estate creditors in accordance with bankruptcy code priority scheme. The First Circuit reversed and enforced the proposed gifting arrangement. In doing so, the court observed that the secured creditor had valid liens on all of the sale proceeds and that any sharing that was to occur between the secured creditor and the unsecured creditors was to occur after distribution of estate property and therefore...