Eighth Circuit Upholds Backstopped Rights Offerings for Chapter 11 Plans

The Eighth Circuit joined three other circuits by holding that a plan with better treatment for creditors who backstop a rights offering does not violate the “same treatment” requirement in Section 1123(a)(4).

On an appeal challenging confirmation, the circuit court did not rule on whether the plan was equitably moot. By reaching on the merits and not taking the easy way out, the Eighth Circuit provided valuable guidance for lower courts regarding a frequently used device in major reorganizations.

The Peabody Coal Reorganization

The appeal arose following confirmation of a chapter 11 plan for coal producer Peabody Energy Corp. The plan included two $750 million, backstopped rights offerings. A group of creditors who had proposed an alternative reorganization plan opposed one of the offerings, a backstopped private placement of $750 million in new preferred stock.

The plan was overwhelmingly approved by all classes of creditors. Bankruptcy Judge Barry G. Schermer of St. Louis overruled the objection and confirmed the plan. Following confirmation, the debtor consummated the plan by taking in $1.5 billion under the rights offerings, issuing new common and preferred stock, and distributing $3.5 billion to creditors under the plan.

On appeal, the district court held that the appeal was equitably moot. However, the district court went on to visit the merits and concluded that the plan did not offend Section 1123(a)(4) and had been proposed in good faith.

The objecting creditors appealed a second time. In an August 9 opinion for the Eighth Circuit, Circuit Judge Michael J. Melloy did not consider whether the appeal was equitably moot because he found no error on the merits. Judge Melloy was a bankruptcy judge in Iowa before his appointment to the district court in 1992 and then to the Eighth Circuit in 2002.

Equal Treatment

Judge Melloy summarized the allegedly unequal treatment. He said that holders of second-lien notes and unsecured notes could buy significant amounts of new stock at a discount in the private placement and receive “significant premiums” in return for backstopping the rights offerings and agreeing to support the plan. Regardless of whether they participated in the private placement, second-lien noteholders had a projected recovery of 52.4% while the return on unsecured notes was an anticipated 22.1%.

The so-called equal treatment requirement for chapter 11 plans appears in Section 1123(a)(4). The statute provides that the plan must “provide the same treatment for each claim or interest of a particular class,” unless the holder agrees “to a less favorable treatment.” The statute does not define “same treatment,” nor has the Supreme Court provided a definition.

Judge Melloy described the Second, Fifth and Ninth Circuits as having ruled that a plan “may treat one set of claim holders more favorably than another so long as the treatment is not for the claim but for distinct, legitimate rights or contributions from the favored group separate from the claim.”

Analyzing the Peabody plan, Judge Melloy said that the ability to participate in the private placement was not treatment for the creditors’ claim. Rather, he said, it was “consideration for valuable new commitments . . . to support the plan, buy preferred stock that did not sell in the Private Placement, and backstop the Rights Offering.” In exchange, he said they “received the opportunity to buy preferred stock at a discount as well as premiums designed to compensate them for shouldering significant risks.”

The objecting creditors relied on Bank of America National Trust & Savings Ass’n v. 203 North LaSalle Street Partnership, 526 U.S. 434 (1999). Judge Melloy said that North LaSalle was distinguishable “in at least three ways.”

In North LaSalle, the Supreme Court ruled that the plan violated the absolute priority rule because prebankruptcy shareholders had the exclusive right to buy stock in the reorganized company. Unlike North LaSalle, Judge Melloy said that the participating creditors “gave something of value up front.” Furthermore, the objecting creditors had the ability to participate in the rights offerings, which was not true of creditors in North LaSalle, who had no ability to purchase new equity.

In short, Judge Melloy said that the plan did not offend Section 1123(a)(4) because “the right to participate in the Private Placement was not ‘treatment for’ a claim.”

N.B.: Judge Melloy said that his court has not ruled on whether review of a “same treatment” ruling is de novo or clearly erroneous. The judge said he would have reached the same conclusion under either standard.

Good Faith

Next, Judge Melloy upheld the bankruptcy court’s finding that the plan was proposed in good faith, as required by Section 1123(a)(3). To determine good faith, he used the clear error test to evaluate whether the bankruptcy judge properly analyzed the “totality of the circumstances.”

The objecting creditors argued that the plan was not proposed in good faith because the alternative plan they proffered was superior. Judge Melloy said that the court could not rely on the “potential virtues” of the alternative plan “while ignoring the potential risks involved.”

The objectors complained that seven holders of second-lien and unsecured notes received disproportionate ability to participate in the private placement. The seven creditors were responsible for negotiating the plan with the debtor and the official creditors’ committee.

Judge Melloy said the seven were entitled to disproportionate treatment because they “took on more obligations than other members of the class: They put themselves on the hook to buy more of the preferred stock if it did not sell.”

Observation: Backstopped rights offerings, like those sanctioned by Judge Melloy, seem to be a method developed by Wall Street for allowing subordinate creditors to realize a greater recovery under a chapter 11 plan without offending North LaSalle.