United States: Motive Matters? Not To The Fifth Circuit When Impairing A Class Of Creditors

The Decision

The Fifth Circuit recently considered the issue of "artificial" impairment in the context of confirmation of Chapter 11 reorganization plans and ruled that section 1129(a)(10) of the Bankruptcy Code does not distinguish between the motive for impairing a class of creditors, whether the motive is discretionary or economically driven.

See In Western Real Estate Equities, L.L.C. v. Village at Camp Bowie I LP (In re Village at Camp Bowie I LP), 12-10271, 2013 U.S. App. LEXIS 3949 (5th Cir. Feb. 26, 2013). The result is that Chapter 11 debtors can impair - meaning anything that changes the terms of the debt - a class of creditors in any way that may make it more likely to gain a voting class necessary for the plan of reorganization to satisfy Section 1129(a)(10), although the impairment is still subject to the requirement of good faith.

The Background

The Village at Camp Bowie I, L.P. (the "Debtor") owned a mixed-use development in Fort Worth, Texas known as the Village at Camp Bowie. Wells Fargo was the Debtor's secured lender until it sold the Notes to Western Real Estate Equities, LLC ("Western"). After acquiring the Notes, Western proceeded to schedule the real property (the "Property") for foreclosure in August 2010. The Debtor filed a Chapter 11 bankruptcy petition on August 2, 2010, to halt the foreclosure.

As of the petition date, the outstanding principle on the Notes was $32,112,711. The bankruptcy court later determined at a lift stay hearing that the value of the Debtor's property was $34,000,000. The Debtor had only $59,398 in unsecured debts owed to thirty eight independent trade creditors. The court denied Wells Fargo's request to lift the automatic stay to then foreclose on the Property based upon the equity in the Property.

About four months after the petition date, the Debtor filed its plan of reorganization. The plan included a proposed equity infusion from the owners of the Debtor, but the Bankruptcy Court ruled that it was too small to stabilize the value of the Property. The Debtor amended its plan to include a $1,500,000 capital infusion for the owners to keep their equity interests. The plan only had two voting, impaired creditor classes, one for Western's secured claim and the other for the unsecured trade debt. Western was to receive a new five-year note with interest at 6.4% and a balloon payment upon maturity. The unsecured trade creditors were to receive full payment without interest, to be paid over three months from the date of plan confirmation.

Western voted against plan confirmation with its large secured claim. All thirty-eight unsecured creditors voted in favor for the plan. At the confirmation hearing, Western objected to the plan based on the provisions of bankruptcy code section 1129, including 1129(a)(10), which requires the support of at least one class of impaired claims to vote for the plan. Western argued that the Debtor artificially impaired the unsecured class by extending the payment date past confirmation in order to gain the support it needed for the plan. It was undisputed that the Debtor had the cash flow to pay the unsecured creditors on the plan confirmation date and did not need the to additional three months. Western also argued that the Debtor's plan violated section 1129(a)((3)'s requirement of good faith.

The Decision

The Bankruptcy Court confirmed the plan, finding that the amended plan was proposed for the legitimate bankruptcy purpose of reorganizing its debts and preserving the value of the Property. It further held that artificial impairment does not automatically point to an absence of good faith. Nor did the court find any distinction in section 1129(a)(10) between artificial and economically-driven impairment of claims.

On appeal, the Fifth Circuit noted the circuit split between the Eighth and Ninth Circuits on the issue of distinguishing between artificial impairment and economically-driven impairment. It ultimately agreed with the Ninth Circuit, contrary to its usual preference, and held that there is no distinction in section 1129(a)(10) and thus a debtor can artificially impair a class of creditors, no matter how minor the impairment is or to what degree. It stated that to do otherwise would be "shoehorning a motive inquiry and materiality requirement into section 1129(a)(10)... and requiring a court to "deem" a claim unimpaired for purposes of section 1129(a)(10) even though it plainly qualifies as impaired under section 1124.

But the Fifth Circuit was careful to qualify its holding so that the good faith inquiry under section 1129(a)(3) was still "relevant" and artificial impairment could be a factor. It stated that the Court was not going to award a "free pass" to debtors to avoid the scrutiny under section 1129(a)(3). Thus, if the debtor artificially created an impaired class "out of whole cloth by incurring a debt with a related party," then it may qualify as a lack of good faith. The Debtor in this case had legitimate unsecured debt with independent trade creditors and was looking for a way keep the Property.

The Impact

For bankruptcy debtors, this decision provides an additional method of confirming a bankruptcy plan, so that so long as the plan is proposed in good faith, the debtor can propose to pay unsecured creditors over a short period of time after confirmation even if it has the ability to pay them at confirmation for the purpose of creating an impaired class of creditors to satisfy the Bankruptcy Code's requirement for one accepting class of impaired creditors.

For secured creditors, this decision must be understood in terms of the facts. There was substantial equity in the property and the equity owners contributed $1,500,000 to retain their equity. Facts less favorable to a debtor may provide the secured creditor with some objections to the proposed impairment of a class for voting purposes. A possible strategy to avoid the effect of artificial impairment in this case would be for the secured creditor to purchase unsecured creditors' claims to control or even eliminate the class of unsecured creditors who voted in support of the plan. By purchasing the impaired unsecured claims, the secured lender could effectively block confirmation of the plan and avoid the ability of the debtor to force unfavorable terms on the lender.

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