United States: Village At Camp Bowie: The Fifth Circuit Weighs In On Artificial Impairment

Last Updated: March 20 2013
Article by Deborah Kovsky-Apap and Lesley Welwarth

A key tenet of reorganization under Chapter 11 is that if the debtor's plan impairs creditors, at least some of those creditors must agree to the plan.1 More specifically, "if a class of claims is impaired under the plan, at least one class of claims that is impaired under the plan has accepted the plan, determined without including any acceptance of the plan by any insider."2

The requirement to have an accepting, impaired class raises significant tactical issues where the only "truly" impaired creditors oppose the plan – as is often the case, for example, in single-asset real estate cases, where the plan seeks to cram down modifications to a loan's terms over the protests of the secured lender. How, then, can the debtor fulfill the obligations of the Bankruptcy Code and confirm a plan of reorganization?

Typically, the solution involves what is known as "artificial" impairment – deliberately altering the rights of a class of friendly and otherwise unimpaired creditors, who are expected to vote in favor of the plan and thus enable confirmation of the plan over the "truly" impaired creditors' objections. Because a well-developed body of bankruptcy law regards virtually any change in a creditor's rights as impairment, the artificial impairment usually is quite minor, such as a short post-confirmation delay in the payment of the claims of creditors in the class.

Courts have split on whether a plan can be confirmed based on the vote of an artificially impaired class. The Eighth Circuit reversed confirmation of a debtor's reorganization plan in In re Windsor on the River Associates, Ltd., holding that artificial impairment is contrary to the Bankruptcy Code's purpose of promoting consensual reorganization.3 On the other hand, the Ninth Circuit has taken the position that Section 1129(a)(10) of the Bankruptcy Code does not distinguish between discretionary and economically-driven impairment and that artificial impairment instead should be a factor examined in determining whether a plan is proposed in good faith as required by Section 1129(a)(3). In In Re L&J Anaheim Associates, it affirmed confirmation of the debtor's plan of reorganization, which used an artificially impaired class to achieve a cramdown on the dissenting secured lender.4

Both L&J Anaheim and Windsor were decided before the 1994 amendments to the Bankruptcy Code removed Section 1124(3)'s "cash-out" exception,5 thereby at least arguably rendering impaired even those creditors who receive payment in full as of a plan's effective date. However, although some commentators question whether, in light of that amendment, any impairment can still be called "artificial," courts in many circuits continue to grapple with the issue.6 Most recently, the Fifth Circuit Court of Appeals addressed artificial impairment in its debtor-friendly decision in Village at Camp Bowie.7

Village at Camp Bowie involved a single-asset real estate debtor. In the course of the case, it became clear that the debtor's secured lender, Western Real Estate Equities I, LLC (Western), which had already sought unsuccessfully to lift the automatic stay, would not support the debtor's plan of reorganization. Accordingly, the debtor formulated a plan that had two voting classes of impaired creditors: one class consisting of Western's $32 million secured claim, and the other of about $58,000 in unsecured trade debt. Under the plan, Western would receive a note in the amount of its secured claim plus interest, and a balloon payment of the remaining principal and accrued interest at maturity. Although the debtor conceded that it could have paid off the trade claims on the effective date without hardship, the plan altered the rights of the creditors in that class by proposing to pay the claims in full, but without interest, over three months.

Unsurprisingly, Western cried foul, arguing that the impairment was artificial, immaterial and violated the good-faith requirement for confirmation. The bankruptcy court confirmed the plan over Western's objections.

On appeal, the Fifth Circuit rejected both of Western's arguments, finding that there is no materiality requirement for impairment and that artificial impairment does not per se constitute bad faith. Rather, a fact-specific inquiry is required. The court suggested that, for example, the artificial impairment of a class holding claims related to non-substantive or sham lending transactions would raise an inference of bad faith. In the case at bar, by contrast, the court determined that the debtor had proposed a feasible plan that furthered the legitimate bankruptcy goals of reorganizing its debts, continuing its real estate venture and preserving existing equity.

The court's decision in Village at Camp Bowie is a welcome outcome for single-asset debtors (as well as other debtors struggling to find an impaired accepting class). It also raises a warning flag to real estate investors, who may be more likely to find themselves bound by a plan approved only by creditors with comparatively miniscule claims against the debtor.

Footnotes

1. Holders of unimpaired claims are deemed to accept the plan and are not entitled to vote on it.

2. 11 U.S.C. § 1129(a)(10). A class "accepts" the plan if holders of claims representing at least one-half in number and two-thirds in value of the claims in the class vote in favor of the plan.

3. 7 F.3d 127, 1993 U.S. App. LEXIS 26134 (8th Cir. 1993).

4. 99 F.2d 940, 1993 U.S. App. LEXIS 14293 (9th Cir. 1993).

5. Prior to the 1994 Amendments, Section 1124(3) provided that a claim was not impaired if a plan provided for cash payment to a creditor in the amount of the allowed claim on the plan's effective date.

6. Compare In re Swartville, LLC, 2012 Bankr. LEXIS 3809 (Bankr. E.D.N.C. Aug. 17, 2012) (plan denied confirmation after finding that artificial impairment was "indicative of bad faith"); Federal National Mortgage Association v. Village Green I, GP, 483 B.R. 807 (U.S. Dist. W.D. Tenn. 2012) (stating that "it is clear that even after the 1994 amendments, the majority view continues to be that artificial impairment runs afoul of the requirements for Chapter 11 confirmation"); In re All Land Investments, LLC, 468 B.R. 676, 691 (Bankr. D. Del. 2012) (plan denied confirmation where impaired classes had been artificially impaired with no "proper business purpose"); In re Gregory Rockhouse Ranch, 2007 Bankr. LEXIS 4343 (Bankr. D. N.M. 2007) (finding that "artificial impairment is not permissible where the change in creditor's rights is minimal, and where it is clearly apparent that impairment was engineered by the plan proponent solely for the purpose of complying with Section 1129(a)(10)"); Beal Bank, S.S.B. v. Waters Edge L.P., 248 B.R. 668 (D. Mass. 2000) (concluding that Section 1129(a)(10) is not satisfied unless creditors' rights are "legitimately impaired"); with In re 203 North LaSalle St. L.P., 190 B.R. 567, 593 (Bankr. N.D.Ill. 1995), aff'd, 195 B.R. 692 (N.D.Ill. 1996), aff'd, 126 F.3d 955 (7th Cir. 1997), rev'd on other grounds, 526 U.S. 434 (1999) (finding that "there appears to be a developing consensus among the decisions that the 'artificial impairment' objection is best seen, not as a ground for finding noncompliance with Section 1129(a)(10), but as an argument that a plan has not been proposed in good faith, a separate requirement for confirmation under Section 1129(a)(3)" and holding that the plan did not lack good faith); In re Duval Manor Associates, 191 B.R. 622, 626-29 (Bankr. E.D. Pa. 1996) (permitting artificial impairment of the "barest imaginable degree").

7. Western Real Estate Equities LLC. v. Village at Camp Bowie I, L.P. (In re Village at Camp Bowie I, L.P.), No. 12-10271 (5th Cir. Feb. 26, 2013).

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.

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