United States: Section 1129(a)(10) And Artificial vs. Economic Impairment Of Claims

Last Updated: June 20 2013
Article by Peter C. Blain

In a very recent decision, the Fifth Circuit Court of Appeals considered the issue of whether an impaired class of creditors is truly "impaired" when the plan proponent has the economic ability to pay such creditors in full on the effective date but elects not to, thereby permitting the class to vote in favor of confirmation of the proponent's plan. This can be described as "artificial" vs. "economic" impairment.

A brief review of the relevant sections of the Bankruptcy Code helps to frame the issue. Section 1123(b) of the Bankruptcy Code provides that a plan of reorganization "[may] impair or leave unimpaired any class of claims." A claim is impaired if the claimant's legal, equitable or contractual rights are altered.1 Section 1129 of the Bankruptcy Code enumerates the requirements to confirm a chapter 11 plan, including § 1129(a)(10), which provides that if there is at least one class of claims impaired under the plan, in order for such plan to be confirmed, at least one impaired class must accept the plan. Accordingly, where a plan is going to impair a class of claims, it is important for the plan proponent to find at least one impaired class to vote in favor of the plan. The issue then becomes, to what extent can an impaired and accepting class be created by a plan proponent by temporarily delaying payments to creditors within that class?

In re Village at Camp Bowie I L.P.

In In re Village at Camp Bowie I L.P.,2 a mortgage-holder that was owed $32 million appealed the confirmation of a plan that provided for the payment in full, without interest, of a class comprised of 38 unsecured creditors owed $59,398. The plan contemplated that such payments would be made within three months of its effective date. All 38 unsecured creditors in that class voted to accept the plan, while the class controlled by the secured creditor's deficiency claim voted against confirmation. It was undisputed that the debtor had sufficient cash flow to pay the unsecured creditors in full at confirmation. The rejecting secured creditor asserted that the treatment of the unsecured creditors constituted "artificial" impairment violating § 1129(a)(10).

Confirming the plan, the bankruptcy court acknowledged that the unsecured creditors could have been left unimpaired. However, the court rejected the secured creditor's assertion that § 1129(a)(10) distinguishes between artificial and economic impairment. The secured creditor had also asserted that the impairment in the absence of economic necessity violated the requirement that the plan be proposed in good faith under § 1129(a)(3). The bankruptcy court rejected this argument also, concluding that artificial impairment did not amount to per se bad faith. The secured creditor appealed.

On appeal, the Fifth Circuit Court of Appeals began by reviewing the existing circuit court authority addressing the issue of artificial impairment. At one end of the spectrum was In re Windsor on the River Associates Ltd.3 In that case, a secured creditor, which was owed $9.8 million (approximately 99 percent of the claims in the case), appealed the confirmation of a plan that provided that the claims in a class of unsecured creditors, totaling approximately $13,000, would be paid in full 60 days after the effective date of the plan. Although the secured creditor acquired some of the claims in the class and voted against the plan, a sufficient number of the class members had voted to accept the plan before the claims were acquired such that the district court found that the class, which was impaired, was deemed to have accepted the plan.

On appeal, the Eighth Circuit Court of Appeals found that the claims of the unsecured creditors could have been paid on the effective date and were therefore "arbitrarily and artificially impaired."4 The court held that "a claim is not impaired [for purposes of § 1129(a)(10)] if the alteration of [the] rights in question arises solely from the debtor's exercise of discretion."5 The court concluded that § 1129(a)(10) recognizes impairment only to the extent that it is driven by economic need.6

The Fifth Circuit Court of Appeals also reviewed a Ninth Circuit opinion in In re L & J Anaheim Associates,7 which is at the other end of the spectrum. In that case, Kawasaki held a $13.2 million claim secured by a hotel, which was the debtor's only asset. When the debtor failed to propose a plan during the 120-day exclusivity period, as mandated by § 1121(b) of the Bankruptcy Code, Kawasaki proposed its own plan, which provided that the hotel would be sold at auction. The bankruptcy court ruled that Kawasaki was an impaired creditor and its vote accepting the plan met the requirements of § 1129(a)(10). Finding that the other requirements of § 1129 were also met, the court confirmed the plan.

On appeal, the debtor argued that Kawasaki's proposed treatment under the plan was an improvement of its pre-petition rights, so it was therefore unimpaired within the meaning of § 1129(a)(10). The Ninth Circuit ruled that "impairment" means that a creditor's legal, equitable or contractual rights are altered under the plan, and found that the plan changed Kawasaki's state law rights. However, the court found, no particular kind or degree of alteration is required under § 1124, regardless of whether the resulting impairment is discretionary or economically driven. Thus, any change in an accepting creditor's rights, even if the change is arguably an improvement, is sufficient for the purposes of § 1129(a)(10). The court cautioned, however, that while discretionary impairment will not offend § 1124, if the facts indicate abuse, the plan proponent could be found to have violated the good-faith requirement of § 1129(a)(3).8

After considering these two polar opposite decisions, the Fifth Circuit Court of Appeals expressly rejected In re Windsor on the River Associates Ltd. and adopted the Ninth Circuit's view in In re L&J Anaheim Associates that § 1129(a)(10) does not distinguish between discretionary and economically driven impairment.9 The court reasoned:

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 the 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.10

Like the Ninth Circuit in In re L&J Anaheim Associates, however, the Fifth Circuit concluded its decision with an acknowledgment that § 1129(a)(10) must be scrutinized in light of the good-faith requirements of § 1129(a)(3).11 Plan proponents that literally comply with § 1129(a)(10), the court warned, do not "enjoy a free pass from scrutiny under § 1129(a)(3)."12 The court went on to say that in the case at bar, the unsecured creditor class was comprised of independent third parties who extended ordinary course pre-petition trade debt to the debtor. However, an inference of bad faith might arise if a proponent creates an impaired accepting class out of whole cloth, particularly if the class members are parties related to the proponent, or there is evidence that the lending transaction is a sham.13

Conclusion

With the In re Village at Camp Bowie I L.P. decision, the Fifth Circuit Court of Appeals has joined the Ninth Circuit in determining that any impairment is sufficient for purposes of § 1129(a)(10) of the Bankruptcy Code. However, there is still a circuit split, with the Eighth Circuit in In re Windsor on the River Associates Ltd. ruling that only economic impairment is allowed. In addition, even in the Fifth and Ninth Circuits, literal compliance with § 1129(a)(10) does not exempt a plan proponent from satisfying the court that a plan is proposed in good faith, as required by § 1129(a)(3).

Originally published by ABI Committee News

Footnotes

1. 11 U.S.C. § 1124.

2. Western Real Estate Equities L.L.C. v. Village at Camp Bowie I L.P. (In the Matter of Village at Camp Bowie I L.P.), 710 F.3d 239 (5th Cir. 2013).

3. Windsor on the River Associates Ltd. v. Balcor Real Estate Finance Inc. (In re Windsor on the River Associates Ltd.), 7 F.3d 127 (8th Cir. 1993).

4. Id. at 132.

5. Id.

6. Id. at 132-33.

7. L & J Anaheim Associates v. Kawasaki Leasing International Inc. (In re L & J Anaheim Associates), 995 F.2d 940 (9th Cir. 1993).

8. Id. at 943.

9. In re Village at Camp Bowie I L.P., 710 F.3d at 245.

10. Id. at 245-46.

11. Id. at 247-48.

12. Id. at 248.

13. Id.

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