One of the prerequisites to confirmation of a cramdown
(nonconsensual) chapter 11 plan is that at least one
"impaired" class of creditors must vote in favor of the
plan. This requirement reflects the basic principle that a plan may
not be imposed on a dissident body of stakeholders of which no
class has given approval. However, it is sometimes an invitation to
creative machinations designed to muster the requisite votes for
confirmation of the plan.
"Strategic" classification can entail, among other
things, separately classifying similar, but arguably distinct,
kinds of claims in an effort to create an accepting impaired class
or to prevent a dissenting creditor from dominating a class because
its claim is so substantial that the creditor can "block"
the class's approval of a plan. This controversial practice,
which most commonly arises in a single-asset real estate case
involving an undersecured creditor holding a substantial deficiency
claim, is sometimes referred to as class "gerrymandering"
and has been held to be invalid by many courts, including the Fifth
Circuit in Phoenix Mut. Life Ins. Co. v. Greystone III Joint
Venture (In re Greystone III Joint Venture), 995 F.2d 1274 (5th
Cir. 1991), and the Fourth Circuit in Travellers Ins. Co. v. Bryson
Props., XVIII (In re Bryson Props., XVIII), 961 F.2d 496 (4th Cir.
1992).
Strategic classification can also take the form of
"manufacturing" an impaired class even though impairment
is unnecessary. For example, the plan could pay creditor claims
nearly, but not entirely, in full or modify the rights of the
creditors in the class in some incidental way—in either case,
with such minimal effect that creditors are still willing to vote
to accept the plan despite slight impairment of their claims.
Sometimes referred to as "artificial impairment," this
practice is also controversial. See In re Swartville, LLC, 2012 BL
211034, *2 (Bankr. E.D.N.C. Aug. 17, 2012) ("artificial
impairment" refers to a scenario where a debtor
"deliberately impairs a de minimis claim solely for the
purpose of achieving a forced confirmation over the objection of a
creditor"). So much so, in fact, that there is a split in the
federal circuit courts of appeal concerning its legitimacy.
That rift recently widened when the U.S. Court of Appeals for the
Fifth Circuit handed down its ruling in Western Real Estate
Equities, LLC v. Village at Camp Bowie I, LP (In re Village at Camp
Bowie I, LP), 2013 BL 50530 (5th Cir. Feb. 26, 2013). In Camp
Bowie, the Fifth Circuit joined the Ninth Circuit in holding that
section 1129(a)(10) of the Bankruptcy Code, which contains the
impaired-class acceptance requirement, "does not distinguish
between discretionary and economically driven impairment."
However, the court held that artificial impairment may be relevant
in assessing whether a chapter 11 plan has been proposed in bad
faith.
Voting and Plan Confirmation in Chapter 11
Confirmation of a chapter 11 plan is possible under two
circumstances: (i) the requisite majorities of creditors and equity
interest holders in every "class" (explained below) vote
in favor of the plan (or are deemed to have done so by reason of
being "unimpaired"); or (ii) despite the absence of
acceptance by all classes, the plan meets certain minimum standards
spelled out in the nonconsensual confirmation, or
"cramdown," provisions of the Bankruptcy Code.
Voting in chapter 11 is tabulated by classes rather than
individual creditors or shareholders. This means that a dissenting
individual creditor or shareholder can be outvoted if the remaining
class members hold enough of the claims or interests in the class
to achieve the voting majorities specified in the Bankruptcy Code
for class acceptance. As such, how a claim or interest is
classified can have a significant impact on the debtor's
prospects for confirming a chapter 11 plan. For example, as noted,
a creditor whose claim is substantial enough to give it voting
control of a class may be able to block confirmation.
Confirmation is possible only if at least one "impaired"
class of creditors or shareholders under the plan votes to accept
it (without counting insider votes). This requirement, which
appears in section 1129(a)(10) of the Bankruptcy Code, operates as
one of several statutory gatekeepers to cramdown. Cramdown is a
powerful remedy—it imposes a binding reorganization (or
liquidation) scheme upon a body of dissenting creditors and other
stakeholders predicated upon sometimes complicated judicial
determinations concerning asset and claim valuation, feasibility,
and other important issues. Section 1129(a)(10) is premised on the
policy that, before compelling stakeholders to bear the
consequences associated with cramdown, at least one class whose
members are not being paid in full (or whose claims or interests
are otherwise "impaired") is willing to go along with the
chapter 11 plan.
Cramdown Requirements
Section 1129(b) of the Bankruptcy Code sets forth the requirements
that must be met before a bankruptcy court can confirm a chapter 11
plan over the objections of a dissenting class of creditors whose
rights are impaired by the plan. Among these cramdown requirements
is the dictate in section 1129(b)(1) that a plan "not
discriminate unfairly" and that it be "fair and
equitable" with respect to a dissenting class of
creditors.
A plan discriminates unfairly if it treats a dissenting class of
creditors less favorably than other classes of creditors that are
similarly situated in terms of their legal rights to payment.
Section 1129(b)(2) addresses the "fair and equitable"
requirement for different types of claims. Section 1129(b)(2)(A)
provides three alternative ways to achieve confirmation over the
objection of a dissenting class of secured claims: (i) the secured
claimants' retention of their liens and receipt of deferred
cash payments equal to at least the value, as of the plan's
effective date, of their secured claims; (ii) the sale, subject to
a secured creditor's right to credit-bid its claim, of the
collateral free and clear of all liens, with attachment of the
liens to the proceeds and treatment of the liens on proceeds under
option (i) or (iii); or (iii) the realization by the secured
creditors of the "indubitable equivalent" of their
claims.
Section 1129(b)(2)(B) of the Bankruptcy Code provides that a plan
is "fair and equitable" with respect to a dissenting
impaired class of unsecured claims if the creditors in the class
receive or retain property of a value equal to the allowed amount
of their claims or, failing that, in cases not involving an
individual debtor, if no creditor of lesser priority, or no equity
holder, receives or retains any distribution under the plan
"on account of" its junior claim or interest. This
requirement is sometimes referred to as the "absolute priority
rule."
Impairment
Section 1123(b)(1) of the Bankruptcy Code provides that a chapter
11 plan may "impair or leave unimpaired any class of claims,
secured or unsecured, or of interests." Section 1124 defines
"impairment" as follows:
Except as provided in section 1123(a)(4) of this title, a class of
claims or interests is impaired under a plan unless, with respect
to each claim or interest of such class, the plan—
(1) leaves unaltered the legal, equitable, and contractual rights
to which such claim or interest entitles the holder of such claim
or interest [emphasis added]; or
(2) notwithstanding any contractual provision or applicable law
that entitles the holder of such claim or interest to demand or
receive accelerated payment of such claim or interest after the
occurrence of a default—
(A) cures any such default that occurred before or after the
commencement of the case under this title, other than a default of
a kind specified in section 365(b)(2) of this title or of a kind
that section 365(b)(2) expressly does not require to be
cured;
(B) reinstates the maturity of such claim or interest as such
maturity existed before such default;
(C) compensates the holder of such claim or interest for any
damages incurred as a result of any reasonable reliance by such
holder on such contractual provision or such applicable law;
(D) if such claim or such interest arises from any failure to
perform a nonmonetary obligation, other than a default arising from
failure to operate a nonresidential real property lease subject to
section 365(b)(1)(A), compensates the holder of such claim or such
interest (other than the debtor or an insider) for any actual
pecuniary loss incurred by such holder as a result of such failure;
and
(E) does not otherwise alter the legal, equitable, or contractual
rights to which such claim or interest entitles the holder of such
claim or interest.
Section 1123(a)(4) states that a plan must provide the same
treatment for creditors or interest holders in the same class
"unless the holder of a particular claim or interest agrees to
a less favorable treatment" of its claim or interest.
Section 1124 is derived from section 107 of chapter X of the
former Bankruptcy Act of 1898 (11 U.S.C. § 507; repealed in
1978), which provided that "creditors" or "any class
thereof" would be "affected" for purposes of a
plan—and therefore entitled to vote—"only if their
or its interest shall be materially and adversely affected
thereby." When section 1124 (and the remainder of the
Bankruptcy Code) was enacted in 1978, the legislative history
indicates that floor leaders for the final version of the bill
stated that the provision "defines the new concept of
'impairment' of claims or interests; the concept differs
significantly from the concept of 'materially and adversely
affected' under the Bankruptcy Act." 124 Cong. Rec.
H11,103 (daily ed. Sept. 28, 1978); 124 Cong. Rec.
S17,419‒17,420 (daily ed. Oct. 6, 1978).
Section 1124 originally included a third option for rendering a
claim unimpaired: by providing the claimant with cash equal to the
allowed amount of its claim. This option was removed by the
Bankruptcy Reform Act of 1994. The amendment overruled a bankruptcy
court's decision in In re New Valley Corp., 168 B.R. 73 (Bankr.
D.N.J. 1984). In New Valley, the court ruled that unsecured
creditors of a solvent debtor who are to be paid in full in cash
under a chapter 11 plan are unimpaired even though the plan does
not provide for the payment of postpetition interest on their
claims.
The 1994 amendment permits creditors slated not to receive
postpetition interest under a plan involving a solvent debtor to
vote against the plan. (Pursuant to sections 1126(a), (f), and (g)
of the Bankruptcy Code, only the holders of impaired claims or
interests are permitted to vote.) Assuming that the class of
creditors rejects the plan, it can be confirmed only if the plan
satisfies the cramdown standards in section 1129(b). Also, because
their claims are impaired, these creditors are entitled to the
protection of the "best interests of creditors" test in
section 1129(a)(7), which requires that they receive or retain at
least as much under a chapter 11 plan as they would receive in a
chapter 7 liquidation. Since 1994, most courts considering the
issue have held that payment in full in cash with postpetition
interest at an appropriate rate constitutes unimpairment under
section 1124(1).
Artificial Impairment
Courts disagree over the question of whether section 1129(a)(10)
draws a distinction between "artificial" and
"economically driven" impairment. For example, in Matter
of Windsor on the River Associates, Ltd., 7 F.3d 127 (8th Cir.
1993), the Eighth Circuit ruled that "a claim is not impaired
[for purposes of section 1129(b)] if the alteration of the rights
in question arises solely from the debtor's exercise of
discretion." According to this approach, section 1129(a)(10)
recognizes impairment only to the extent that it is caused by
economic "need."
Many courts have applied Windsor to deny confirmation of a chapter
11 plan impairing the de minimis claims of some creditors for the
purpose of contriving a class to accept the plan. See, e.g., In re
Combustion Engineering, Inc., 391 F.3d 190, 243‒44 (3d Cir.
2003); In re All Land Investments, LLC, 468 B.R. 676, 690 (Bankr.
D. Del. 2012); In re Daly, 167 B.R. 734, 737 (Bankr. D. Mass.
1994); see also In re Deming Hospitality, LLC, 2013 BL 93045, *6
(Bankr. D.N.M. Apr. 5, 2013) (stating that "[i]f there is no
economic justification for failing to pay Class 6 in full after
confirmation rather than the proposed 75%, then the impairment of
the class likely would be 'artificial' and
impermissible"). These courts reason that allowing
manipulation of this kind undermines the policy of consensual
reorganization expressed in section 1129(a)(10).
Other courts have concluded that artificial impairment does not
violate section 1129(a)(10). In L & J Anaheim Assocs. v.
Kawasaki Leasing Intl., Inc. (In re L & J Anaheim Assocs.), 995
F.2d 940 (9th Cir. 1993), for example, the Ninth Circuit ruled that
section 1129(a)(10) does not distinguish between discretionary and
economically driven impairment. According to the court, "the
plain language of section 1124 says that a creditor's claim is
'impaired' unless its rights are left 'unaltered'
by the plan," and "[t]here is no suggestion here that
only alterations of a particular kind or degree can constitute
impairment." Accord In re Greate Bay Hotel & Casino, Inc.,
251 B.R. 213 (Bankr. D.N.J. 2000); In re Duval Manor Assocs., 191
B.R. 622 (Bankr. E.D. Pa. 1996).
Many of these courts have reasoned, however, that artificial
impairment is relevant to the issue of the debtor's good faith
in proposing a chapter 11 plan. Section 1129(a)(3) of the
Bankruptcy Code provides that a plan may be confirmed only if
"proposed in good faith and not by any means forbidden by
law." Even if artificial impairment is not impermissible per
se, these courts have held, contriving an impaired class may
constitute bad faith. See, e.g., FNMA v. Village Green I, GP, 483
B.R. 807 (W.D. Tenn. 2012) (refusing to reject artificial
impairment outright but holding that, under either section
1129(a)(3) or 1129(a)(10), the debtor must demonstrate some
economic justification for delaying payment to de minimis
creditors); In re The Beare Co., 177 B.R. 886 (Bankr. W.D. Tenn.
1994).
The Fifth Circuit weighed in on the issue of artificial impairment
in Camp Bowie.
Camp Bowie
Village at Camp Bowie I, LLC ("VCB") owns real property
in Fort Worth, Texas, that includes several buildings leased out by
VCB for retail and office space. In 2010, VCB defaulted on loans
secured by the real estate. The day before a scheduled foreclosure
sale of the property, VCB filed for chapter 11 protection in
Texas.
At the time of the filing, VCB owed approximately $32 million to
the mortgagee, Western Real Estate Equities, L.L.C.
("Western"), which acquired the debt with the intention
of displacing VCB as the owner of the property. VCB's other
debts consisted of approximately $60,000 in miscellaneous claims
held by 38 trade creditors.
Western sought relief from the automatic stay, arguing that VCB
lacked both equity in the property and any prospect of proposing a
confirmable chapter 11 plan. The bankruptcy court ultimately found
that the real property was worth $34 million, such that Western was
oversecured and VCB had equity in the property.
VCB filed a series of proposed chapter 11 plans, the latest of
which designated two impaired-creditor classes. The first class
consisted of Western's secured claim, as to which VCB proposed
to give Western a new five-year balloon note accruing interest at
6.4 percent secured by the real estate. The other class included
all unsecured claims, which VCB proposed to pay in full within
three months of the effective date of the plan, without interest.
Finally, the plan provided that VCB's prebankruptcy owners and
certain related parties would receive 100 percent of the equity in
the reorganized VCB in exchange for a cash infusion of $1.5
million.
The unsecured class unanimously voted to accept the plan. Western
voted against the plan and argued at the confirmation hearing that
the plan violated section 1129(a)(10) because it impaired the trade
claims solely to create an accepting impaired class. According to
Western, VCB had the cash flow to pay off the trade claims in full
at confirmation. Western also claimed that VCB's tactics
constituted an abuse of the bankruptcy process in violation of the
good-faith requirement of section 1129(a)(3).
The bankruptcy court confirmed VCB's plan. It rejected
Western's theory that section 1129(a)(10) distinguishes between
artificial and economically driven impairment. It also concluded
that, although artificial impairment is a factor to consider in
determining whether a plan proponent has complied with section
1129(a)(3), "in the usual case, artificial impairment does not
amount per se to a failure of good faith." The court certified
an appeal of its ruling directly to the Fifth Circuit, on the basis
that the opinion addressed questions of law as to which there was
no controlling Fifth Circuit or U.S. Supreme Court precedent and
that an immediate appeal might materially advance progress of the
case.
The Fifth Circuit's Ruling
A three-judge panel of the Fifth Circuit affirmed. At the outset
of its analysis, the court noted that "this Circuit has yet to
stake out a clear position in the debate over artificial
impairment." The panel discussed prior Fifth Circuit case law
on the issue. In Brite v. Sun Country Development, Inc. (In re Sun
Country Development, Inc.), 764 F.2d 406 (5th Cir. 1985), the
debtor, to satisfy section 1129(a)(10), modified its treatment of
unsecured creditors under a chapter 11 plan from payment in full to
a distribution of nonnegotiable 90-day notes. The court ruled that
the plan did not violate section 1129(a)(3) because, among other
things, the bankruptcy court found that the change was
"necessary," as the debtor's cash flow was
insufficient to pay creditors in full on confirmation.
In Sandy Ridge Development Corp. v. Louisiana Nat'l Bank (In
re Sandy Ridge Development Corp.), 881 F.2d 1346 (5th Cir. 1989),
the Fifth Circuit remanded a case to the bankruptcy court for,
among other things, a determination as to whether artificial
impairment under a chapter 11 plan to create an accepting impaired
class satisfies the good-faith requirement of section
1129(a)(3).
With this preamble, the Fifth Circuit in Camp Bowie staked out its
position on the issue—this time unequivocally:
Today, we expressly reject Windsor and join the Ninth Circuit in
holding that § 1129(a)(10) does not distinguish between
discretionary and economically driven impairment. As the Windsor
court itself acknowledged, § 1124 provides that "any
alteration of a creditor's rights, no matter how minor,
constitutes 'impairment.' " . . . By shoehorning a
motive inquiry and materiality requirement into § 1129(a)(10),
Windsor warps the text of the Code, requiring a court to
"deem" a claim unimpaired for purposes of §
1129(a)(10) even though it plainly qualifies as impaired under
§ 1124. . . . Windsor's motive inquiry is also
inconsistent with § 1123(b)(1), which provides that a plan
proponent "may impair or leave unimpaired any class of
claims," and does not contain any indication that impairment
must be driven by economic motives. . . .
According to the Fifth Circuit, the Windsor court based its
"strained reading" of sections 1129(a)(10) and 1124 on
the premise that lawmakers enacted section 1129(a)(10) "to
provide some indicia of support [for a cramdown plan] by affected
creditors," and it reasoned that literal application of
section 1124 would "vitiate this congressional purpose."
That approach, the Fifth Circuit emphasized, is flawed because
"the Bankruptcy Code must be read literally, and congressional
intent is relevant only when the statutory language is
ambiguous." Moreover, the court explained, the scant
legislative history of section 1129(a)(10) "provides no
insight as to the provision's intended use," and Congress,
when it enacted section 1124, "considered and rejected
precisely the sort of materiality requirement that Windsor has
imposed by judicial fiat."
The Fifth Circuit also faulted Windsor's reasoning that
condoning artificial impairment would "reduce [section
1129(a)(10)] to a nullity." The Eighth Circuit's logic in
Windsor, the Fifth Circuit explained, is premised on "the
unsupported assumption that Congress intended § 1129(a)(10) to
implicitly mandate a materiality requirement and a motive
inquiry." According to the court, such an approach ignores the
determinative role the provision plays in the typical single-asset
bankruptcy, where the debtor has negative equity and the secured
creditor has an unsecured-deficiency claim that allows it to
control the unsecured class. "In such circumstances," the
Fifth Circuit wrote, "secured creditors routinely invoke
§ 1129(a)(10) to block confirmation, . . . aided rather than
impeded by the Code's broad definition of
impairment."
The Fifth Circuit rejected Western's argument that the Fifth
Circuit's 1991 condemnation of gerrymandering in Greystone
"enunciate[s] a broad, extraordinary, extrastatutory policy
against 'voting manipulation' " and that
"prohibiting artificial impairment is merely the next logical
extension of this policy." This contention, the court wrote,
"brushes over the fact that Greystone's
anti-gerrymandering principle resolves an ambiguity left open by
the classification rules set forth in § 1122." Greystone,
the Fifth Circuit observed, "does not stand for the
proposition that a court can ride roughshod over affirmative
language in the Bankruptcy Code to enforce some Platonic ideal of a
fair voting process."
Having concluded that a plan proponent's motives and methods
for satisfying section 1129(a)(10) must be scrutinized, "if at
all, under the rubric of § 1129(a)(3)," the Fifth Circuit
examined the bankruptcy court's finding that VCB had proposed
its chapter 11 plan in good faith. The court of appeals found no
clear error in this determination. VCB, the Fifth Circuit wrote,
"proposed a feasible cramdown plan for the legitimate purposes
of reorganizing its debts, continuing its real estate venture, and
preserving its non-trivial equity in its properties."
According to the court, "A single-asset debtor's desire to
protect its equity can be a legitimate Chapter 11
objective."
However, the Fifth Circuit cautioned that, "though we reject
the concept of artificial impairment as developed in Windsor, we do
not suggest that a debtor's methods for achieving literal
compliance with § 1129(a)(10) enjoy a free pass from scrutiny
under § 1129(a)(3)." According to the court, had the case
involved the creation of "an impaired accepting class out of
whole cloth" in a "sham" lending transaction with
related parties, rather than independent trade creditors who
extended prepetition credit to VCB in the ordinary course of
business, "[a]n inference of bad faith might be
stronger."
Outlook
Camp Bowie can be viewed as a positive development for
single-asset debtors with an oversecured creditor. By refusing to
invalidate artificial impairment outright, the Fifth Circuit made
it easier for a debtor to obtain confirmation of a nonconsensual
chapter 11 plan that impairs the claim of an oversecured creditor
by modifying its credit terms. Whether the possibility of such
adverse treatment may make it more difficult for single-asset
entities to obtain financing (at least in the Fifth Circuit)
remains to be seen.
An oversecured creditor in a single-asset bankruptcy case is far
from the norm. The more common scenario involves an undersecured
creditor and strategic classification—gerrymandering—to
isolate the unsecured-deficiency claim in a separate class and
thereby prevent the creditor from blocking confirmation. The Fifth
Circuit was careful to distinguish between artificial impairment
and gerrymandering.
Finding an accepting impaired class of creditors can also be
challenging in non-single-asset chapter 11 cases, where a debtor
typically wants to preserve its trade creditor and employee
relationships, while restructuring long-term debt and other
obligations. Camp Bowie will provide debtors in the Fifth Circuit
greater flexibility to technically impair "friendly"
classes of creditors to create an accepting impaired class under a
nonconsensual plan.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.