United States: Artificial Impairment Of Claims: Can The Tail Wag The Dog In Confirming A Plan?

Last Updated: July 8 2013
Article by Vicki R. Harding

To confirm the debtor's proposed plan of reorganization over the mortgage lender's objections, the plan had to be accepted by an impaired class of creditors.  There were two impaired classes:  (1) a class that consisted of the mortgage lender with a secured claim of ~$32 million, and (2) the unsecured trade creditors class, which consisted of 38 creditors holding a total of ~$60,000 in unsecured claims.  The trade creditors voted to accept the plan, while the mortgage lender voted against.

The trade creditors were impaired because the plan proposed to pay the claims within three months after the plan became effective without interest.  The lender objected on the basis that the trade claim class was artificially impaired, so that it could not count as the required impaired accepting class.   The bankruptcy court confirmed the plan, and the lender appealed.

As background, the debtor was unable to pay the loans secured by its property when they became due in January 2008.  There were a series of modifications that postponed maturity until 2010.  After the final forbearance period expired on July 9, 2010, Western Real Estate Equities, L.L.C. (Western) acquired the notes at a discount with the goal of becoming the owner of the property.  It immediately posted the property for a non-judicial foreclosure, and the debtor filed for bankruptcy.

Although Western requested relief from the automatic stay on the basis that the debtor had no equity in its real estate and no prospect of reorganizing, the bankruptcy court determined that the value of the real estate was $34 million, which was more than the total claims of creditors.

Under the plan of reorganization, Western was to be given a five year note with interest at 5.84% per annum and a balloon payment due at maturity.  The trade creditors were to be paid in full within three months after the effective date of the plan with no interest.  The plan also provided that the prepetition equity holders and related parties would contribute $1.5 million in exchange for new equity.

Western argued that the trade creditors were minimally impaired solely to create an accepting class.  It was undisputed that the debtor had sufficient cash to pay the trade claims in full upon confirmation.  Since the trade claims were "artificially impaired," Western argued that their acceptance could not meet the requirement in Section 1129(a)(10) of the Bankruptcy Code that a plan be accepted by at least one impaired class (not counting the votes of insiders).  It also argued that the debtor's tactics were an abuse of the bankruptcy process that violated the requirement in Section 1129(a)(3) that a plan be proposed in good faith.

While agreeing that the debtor could have paid the creditors in full, the bankruptcy court rejected the argument that Section 1129(a)(10) depends on whether impairment is artificial or economically driven.  With respect to the good faith requirement in Section 1129(a)(3), the bankruptcy court acknowledged that artificial impairment could be a consideration, but concluded that it was not bad faith per se.  In this case the court viewed the debtor as proposing a plan for the legitimate purpose of reorganizing and preserving its equity in the project, and thus the plan was proposed in good faith.

The 5th Circuit noted that the circuits are divided on whether there is a distinction between artificial and economically driven impairment.  On the one hand, the 8th Circuit held that a claim is not impaired if the impairment is within the debtor's discretion and is not driven by economic need.  On the other hand, the 9th Circuit held that Section 1129(a)(10) does not make a distinction based on motive (although it left open the issue of whether artificial impairment could impact the finding of good faith).  The 5th Circuit joined the 9th Circuit in holding that there is no difference between artificial and economically driven impairment for purposes of the requirement for an accepting impaired class under Section 1129(a)(1).

Western also argued that artificial impairment is a manipulation of the bankruptcy process, and rejecting artificial impairment is a logical extension of the prohibition on gerrymandering classes solely for the purpose of obtaining an accepting class.  The 5th Circuit retorted that the restriction on gerrymandering "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."

While rejecting the 8th Circuit's position that artificial impairment does not comply with Section 1129(a)(10):

[W]e 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)... An inference of bad faith might be stronger where a debtor creates an impaired accepting class out of whole cloth by incurring a debt with a related party, particularly if there is evidence that the lending transaction is a sham. Ultimately, the §1129(a)(3) inquiry is fact-specific, fully empowering the bankruptcy courts to deal with chicanery.

For cases where the mortgage lender is significantly undersecured, there is the additional hurdle that the debtor may not be allowed to separately classify the mortgagee's deficiency claim from the unsecured trade claims, so that the mortgagee can block acceptance.

However, if the mortgagee is fully secured, the strategy used in this case can be a powerful tool in those circuits that do not reject artificial impairment.  Typically the unsecured trade creditors hold a relatively small amount of claims.  If the claims are paid in full on confirmation, then they are not impaired and will not satisfy the requirement for an impaired accepting class.  However, if the debtor is allowed to create impairment through a short deferral of payment in full so that the trade creditors are likely to vote in favor of the plan — voila, an accepting class.

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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Vicki R. Harding
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