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In re 56 Walker LLC—The Resurrection of the Gifting Doctrine?

By: Brianna Walsh

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

 

Recently, in In re 56 Walker LLC, a bankruptcy court overruled a debtor’s objection a secured creditor’s proposed order providing for the distribution of the proceeds from the sale of real property that was the debtor’s sole asset pursuant to the debtor’s confirmed plan of reorganization even though the secured creditor “gifted” a portion of its recovery to a junior class because, among other reasons, the court found that the distribution scheme would not violate the absolute priority rule.[1]  In 56 Walker, the debtor pledged a six-story mixed-use building, its sole asset, as security for an $8 million mortgage loan.[2]  After the debtor defaulted one year later, the bank that had acquired the mortgage loan from an FDIC receivership commenced a foreclosure action in New York state court.[3]  Subsequently, the debtor filed for bankruptcy under chapter 11 of the Bankruptcy Code in order to stay the foreclosure proceeding.[4]  This first case was ultimately dismissed.[5]  Following dismissal of the debtor’ first chapter 11 case, the bank resumed the foreclosure action in state court and moved for summary judgment.[6]  The debtor then crossed-moved for summary judgment, arguing that the bank had not provided adequate proof that it was the assignee of the mortgage or the note and that the bank was liable for certain lender-liability claims.[7]  The state court granted the bank’s motion for summary judgment of foreclosure and denied the debtor’s cross-motion.[8]  The debtor timely filed a notice of appeal.[9]  Prior to the state court entering the bank’s proposed judgment of foreclosure, the debtor filed a second chapter 11 case.[10]  Ultimately, the debtor confirmed a consensual plan of reorganization and sold the property for $18 million.[11]  After selling the property, the debtor objected to, among others, the bank’s claim.[12]  In its decision, the court overruled the debtor’s objection and directed the bank to settle an order to provide for the distribution of the sales proceeds.[13]  The bank then filed a proposed order, providing that (i) the bank would have a distribution in the amount of $15.1 million, (ii) another mortgage lender would have a distribution in the amount of $150,000, (iii) a mechanic’s lien holder would have a distribution in the amount of $400,000, (iv) another mechanic’s lien holder would have a distribution of $350,000, (v) the debtor’s counsel would have an administrative claim for fees and expenses capped at $250,000, and (vi) the remaining funds would be distributed to the debtor’s unsecured creditors.[14]  Equity would not receive a distribution under the proposed order.[15]  The debtor objected to the proposed order, arguing, among other things, that the proposed distribution to a mechanic’s lien holder was premature because the debtor’s previous objection to the mechanic’s lien holder’s claim was still pending.[16]  The court, however, overruled the debtor’s objection to the proposed order, noting that the only reason the mechanic’s lien holder would receive anything was the bank’s willingness to forgo part of its claim and “gift” it to the junior secured creditors.[17]

“Gifting,” in the context of bankruptcy, occurs when a senior creditor voluntarily relinquishes a portion of its distribution, provided for in a plan of reorganization, in favor of junior creditors.[18]  Courts have split over whether gifting is permissible, particularly if doing so would violate the absolute priority rule.  On one hand, the First Circuit, in In re SPM Manufacturing . Corp.,[19] held that while debtors and trustees are not allowed to pay not junior creditors ahead of priority creditors, there is generally nothing in the Bankruptcy Code that prevents creditors from doing what they wish with the bankruptcy dividends they receive, including sharing them with other creditors.[20]  On the other hand, the Second Circuit notably restricted the gifting doctrine in In re DBSD North America, Inc.,[21] holding that the plan of reorganization that included a “gift” from a senior creditor to a junior creditor violated the absolute priority rule.[22]  In particular, in DBSD, the debtor’s plan of reorganization provided  that the debtor’s secured and unsecured creditors would  only recover shares of the reorganized debtor worth a portion of their claims even though the debtors existing shareholder would receive shares and warrants in the reorganized debtor.[23]  The Second Circuit held that the plan violated section 1129 of the Bankruptcy Code,[24] finding that the plan violated the absolute priority rule because it provided the debtor’s existing shareholder received property under the plan even though the unsecured creditors were not paid in full.[25]  Similarly, in In re ArmstrongWorld Indus. Inc.,[26] the Third Circuit found that the “gifting” under a chapter 11 plan of reorganization triggered the absolute priority rule, and therefore, the plan could not be confirmed.[27]  In In Re World Health Alternatives,[28] however, the Third Circuit held that a plan could be confirmed because the absolute priority rule was not implicated since the distributions to junior creditors were redistributed pursuant to a settlement agreement reached outside of the plan.[29]  The Third Circuit noted that appropriate constraints have been placed on the “gifting” doctrine, emphasizing that distribution schemes that violate the absolute priority rule cannot be justified on the ground that a secured creditor entitled to distribution simply agrees to “gift” part of its distribution to a junior class member.[30]

The 56 Walker court concluded that the proposed distribution scheme was distinguishable from the schemes in the impermissible “gifting” plan because the scheme at issue, under which the bank agreed to waive principal to allow a distribution to other creditors, strictly complied with the absolute priority rule.[31]  In particular, the 56 Walker court noted that the proposed distribution did not violate the absolute priority rule because it provided a “distribution in strict conformity with the rights of secured creditors to all of the proceeds of their collateral paid in full, with any surplus to be paid to the unsecured creditors and then to equity.”[32]  The 56 Walker court noted that “there is no principle of bankruptcy law that precludes it from agreeing to waive interest or fees or even principal to allow a distribution to other creditors, which distribution is itself in strict conformity with the absolute priority rule.”[33]  Importantly, the 56 Walker court recognized that “[e]ven if the [d]ebtor were successful in its objection to [mechanic’s lien holder’s] claim, it would make no difference to the ultimate distribution of the sale proceeds because [mechanic’s lien holder’s] claim (Class 3) [wa]s paid after the claims of [the bank] (Class 1) and [other mortgage lender] (Class 2), and [the bank’s] secured claim—without its voluntary reduction made solely for purposes of the [p]roposed [o]rder—[wa]s greater than the available sale proceeds.”[34]

In re 56 Walker is a significant decision because it demonstrates that gifting is not completely dead in the Second Circuit.  Although the circuits are split as to whether “gifting” is permissible if doing so would violate the absolute priority rule, this should not be conflated with the question of whether “gifting” is permissible when a proposed plan strictly adheres to the absolute priority rule.  As illustrated by In re 56 Walker, there are circumstances where “gifting” is appropriate and more equitable than enduring seemingly endless litigation.  By electing to take less, the bank avoided further expense, delay, and uncertainty by convincing the court to authorize distributions of sale proceeds notwithstanding the fact that litigation with the borrower is ongoing.  In light of In re 56 Walker, parties should consider the cost surrendering a portion of their claim versus continued litigation when the surrender of a portion of the proceeds would not violate the absolute priority rule.

 

 



[1] In re 56 Walker LLC, No. 13-11571, 2014 WL 2927809 (Bankr. S.D.N.Y. June 27, 2014).

[2] In re 56 Walker LLC, No. 13-11571, 2014 WL 1228835 (Bankr. S.D.N.Y. Mar. 25, 2014).

[3] Id. at 1.

[4] MB Fin. Bank, N.A v. Walker, LLC, No. 105617/2009, 2013 WL 1774094 (N.Y. Sup. Apr. 22, 2013).

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] Id.

[10] 56 Walker LLC, 2014 WL 1228835, at *1 (Bankr. S.D.N.Y. Mar. 25, 2014).

[11] Id.

[12] Id. at 2.

[13] Id.

[14] In re 56 Walker LLC, 2014 WL 2927809, at *2.

[15] Id.

[16] In re 56 Walker LLC, 2014 WL 1228835, at *1. (The Court addressed various other issues that are not relevant to this analysis. The debtor’s first objection focused on an ongoing dispute with the purchaser regarding water damage and the costs related to the damage which occurred before closing the sale. Other objections were to the capping of counsel fees at $250,000 and that making any payments to the bank was improper due to the alleged additional information showing that the bank acted wrongfully.).

[17] In re 56 Walker LLC, 2014 WL 2927809, at *3.

[18] Mitchel Appelbaum & Elisabetta G. Gasparini, "Gifting" to Junior Classes: Can It Be Done?, Am. Bankr. Inst. J., Feb. 2007, at 16, 17

[19] In re SPM Mfg. Corp., 984 F.2d 1305 (1st Cir. 1993).

[20] Id.

[21] In re DBSD North America, Inc., 634 F.3d 79, 86 (2d Cir. 2011).

[22] Id.

[23] Id.

[24] 11 U.S.C. § 1129 (2010) (stating that a plan is not fair and equitable regarding a class of unsecured claims unless “the plan provides that each holder of a claim of such class receive or retain on account of such claim property of value, as of the effective date of the plan, equal to the allowed amount of such claim.” If such class of unsecured claims does not receive a distribution equal to the allowed amount of such claim the plan is not fair and equitable unless “the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property.”).

[25] In re DBSD North America, Inc., 634 F.3d at 86 (2d Cir. 2011) (“[t]he Code extends the absolute priority rule to ‘any property,’ not ‘any property not covered by a senior creditor's lien.’ The Code focuses entirely on who ‘receive[s]’ or ‘retain[s]’ the property ‘under the plan,’ not on who would receive it under a liquidation plan. . . . And it applies the rule to any distribution ‘under the plan on account of’ a junior interest, regardless of whether the distribution could have been made outside the plan, and regardless of whether other reasons might support the distribution in addition to the junior interest.”).

[26] In re Armstrong World Indus., Inc., 432 F.3d 507 (3d Cir. 2005).

[27] Id.

[28] In re World Health Alternatives, Inc., 344 B.R. 291 (Bankr. D. Del. 2006).

[29] Id.

[30] Id. (citing In re Iridium Operating LLC, 478 F.3d 452, 465–66 (2d Cir.2007)).

[31] In re 56 Walker LLC, 2014 WL 2927809, at *1.

[32] Id. at *3.

[33] Id.

[34] Id.