Introduction
Imagine this scenario: A real estate holding company in chapter 11 owes its secured lender approximately $32.1 million on a project with a value estimated at $34 million. The equity owners are willing to inject additional capital to keep the project, but the secured lender wants to foreclose. The holding company proposes a plan of reorganization in which the secured lender receives a new note for the full amount if its debt, and a class of unsecured trade creditors holding approximately $60,000 in pre-petition debt receives payment in cash of the face amount of that debt over three months but does not receive post-petition interest on that debt, an amount that would have equaled just $900 in the aggregate. The unsecured creditors (unsurprisingly) vote in favor of the plan, while the secured creditor votes to reject it. Did the plan proponent artificially impair the unsecured creditors in order to obtain a consenting class of impaired creditors so that it could "cram down" the plan on the secured lender, such that confirmation should be denied?
That was the issue faced recently by the Fifth Circuit Court of Appeals in Western Real Estate Equities, L.L.C., v. Village at Camp Bowie I, L.P.1 The Fifth Circuit affirmed confirmation, endorsing a literal application of section 1129(a)(10) and refusing to examine the plan proponent's motives. This decision may reignite a debate among the various circuits regarding whether the acceptance of a reorganization plan by an "artificially" impaired class of creditors will satisfy section 1129(a)(10)'s requirement that at least one class of impaired claims accepts a plan.
Background
Section 1129 of the Bankruptcy Code sets forth conditions that a plan proponent must satisfy in order to obtain confirmation of its plan of reorganization. A plan typically designates multiple classes of claims (e.g., secured claims, unsecured claims, priority claims), and specifies the treatment for holders of claims in each class. If such treatment in any way alters the legal, equitable, or contractual entitlements of the members of such class, the holders of claims in that class are deemed "impaired" and are therefore entitled to vote whether to accept or reject the plan.2 Where all such impaired classes vote to accept the proposed treatment, confirmation of the plan is virtually assured. In situations where one or more classes votes to reject the plan, however, the proponent may nonetheless seek to "cram down" the plan on a dissenting class of creditors by satisfying certain tests. One of these tests is set forth in section 1129(a)(10), which requires that "at least one class of claims that is impaired under the plan has accepted the plan."3 Some courts and commentators have noted that the purpose of section 1129(a)(10) is to "assure at least a little support" for what the plan proponent is doing.4 Assuming the plan is otherwise fair and equitable to the dissenting classes of creditors, and is not proposed in bad faith, the plan can then be confirmed and "crammed down" on the dissenting class of creditors.5
A creative plan proponent that needs to find a way to cram down a plan on a large dissenting claim holder therefore needs to alter a group of creditors' legal, equitable, or contractual rights just enough to identify (or create) an impaired class that will nonetheless be incentivized to vote to accept the plan. The question for the bankruptcy court in a contested confirmation hearing may therefore turn on the degree of impairment. The Western Real Estates Equities case led to the Fifth Circuit confronting a split in authority between circuit courts on whether the extent of impairment or motives for impairing a class should be considered in the section 1129(a)(10) context.
The Western Real Estate Equities Decision
In August 2010, the Village at Camp Bowie I, LLC (the "Village") sought relief under chapter 11 of the Bankruptcy Code. The Village's main asset was a parcel of real estate in Fort Worth, Texas, which it acquired in 2004 by issuing short-term promissory notes (the "Notes") secured by the property. The Notes were not paid at maturity, and a series of forbearance agreements followed. After the final forbearance period expired in July 2010, Western Real Estate Equities, LLC ("Western") acquired the Notes and immediately commenced non-judicial foreclosure proceedings against the Village. The Village filed for chapter 11 relief on August 2, 2010 — the day before the scheduled foreclosure sale.
The plan of reorganization proposed by the Village (the "Plan") contained only two impaired creditor classes eligible to vote. The first class consisted solely of Western's secured claim for the value of the Notes in the face amount of approximately $32.1 million. The second class consisted of 38 unsecured trade creditors holding pre-petition claims in the aggregate amount of approximately $60,000. Evidence established that the real estate project had a value of $34 million. The Plan provided that the Village's equity owners would make a capital infusion of $1.5 million and retain their ownership. Western would receive a new five-year note in the amount of its secured claim, with interest, and a balloon payment at maturity. In contrast, trade creditors would be paid in full within three months of the Plan's effective date, but without interest. The total economic impairment to such trade creditors apparently amounted to roughly $900. While each of the trade creditors voted to accept the Plan, Western rejected it.
Western argued that the Plan could not be confirmed because it "artificially" impaired the trade creditor class to create an accepting, impaired class. Western's argument was that the Village had sufficient cash flow to pay off the trade creditors in full at confirmation, and had no need to stretch the payments over three months.6 Because the Plan artificially created an impaired accepting class, Western argued that the trade creditors' accepting vote could not satisfy the requirements of section 1129(a)(10). Alternatively, Western argued that the Village's artificial impairment of the trade creditors' claims constituted an abuse of the bankruptcy process in violation of section 1129(a)(3), which requires a plan to be proposed in good faith.
The bankruptcy court agreed that the Village had the financial ability to pay the trade creditors in full. It held, however, that as "the definition of impairment in [Bankruptcy Code section 1124] is clear—and broad—and as Congress did not, as it might have, condition the accepting class requirement of section 1129(a)(10) on meaningful impairment of that class, the latter section cannot be read to require any particular degree of impairment."7 Moreover, the bankruptcy court found that artificial impairment does not amount per se to a failure of the good faith requirement, and held that the Plan at issue satisfied section 1129(a)(3).8 The Plan was confirmed, and Western appealed the bankruptcy court's decision directly to the Fifth Circuit.
On appeal, the Fifth Circuit noted that "Circuits have divided over the question of whether § 1129(a)(10) draws a distinction between artificial and economically driven impairment."9 On one hand, the Eighth Circuit Court of Appeals in In re Windsor on the River Assocs., Ltd. had previously held that a claim is not impaired under section 1129(a)(10) "if the alteration of the rights in question arises solely from the debtor's exercise of discretion."10 In Windsor, the debtor's plan provided that two classes of unsecured creditors would be paid 60 days after the plan's effective date, while the claim of the debtor's secured lender would, among other things, be paid down by $500,000 on the effective date of the plan and the loan would be extended for 10 years and be paid off by a balloon payment at maturity.11 The plan was crammed down on the secured lender after one of the "impaired" classes of unsecured creditors voted to accept. The secured lender appealed confirmation on the grounds that the unsecured creditor classes were not impaired. The Eighth Circuit reasoned that "[c]onfirmation of a plan where the debtor engineers the impairment of the only approving impaired class so distorts the meaning and purpose of [section 1129(a)(10)] that to permit it would reduce (a)(10) to a nullity."12 The Windsor court also stated that permitting artificial impairment would encourage "side dealing" between the debtor and some creditors to the detriment of other creditors.13 The circuit court opined that the debtor manufactured the 60-day delay in payment to unsecured creditors, and therefore the impairment was artificial.14 As the secured lender was the only class with an impaired claim, and had voted to reject the plan, the debtor's plan should not have been confirmed.15
In contrast, the Ninth Circuit Court of Appeals held that section 1129(a)(10) does not distinguish between "artificial" or discretionary impairment and economically driven impairment.16 In L&J Anaheim Assocs., a secured creditor proposed a plan that, among other things, impaired the secured lender's own rights by proposing to sell the debtor's sole asset at auction.17 The secured lender voted its impaired claim to accept the plan, while all other classes rejected the plan. The plan was confirmed. The debtor appealed confirmation on the grounds that the secured lender was not "impaired" under the plan, and asserted that the secured lender was actually better off with its asset being sold at auction.18 The Ninth Circuit rejected the debtor's argument and held that "the plain language of section 1124 says that a creditor's claim is 'impaired' unless its rights are left 'unaltered'" by the plan, and that "[t]here is no suggestion . . . that only alterations of a particular kind or degree can constitute impairment."19 The Ninth Circuit found that the secured lender's rights were impaired because the plan eliminated the lenders' pre-petition rights to pursue remedies under the California Uniform Commercial Code.20 The circuit court noted, however, that abuses of process could and should be addressed by considering whether confirmation should be denied on the ground that a plan was not proposed in good faith pursuant to section 1129(a)(3) but that abuses on the part of a plan proponent "ought not affect the application of Congress's definition of impairment."21
After weighing these competing approaches, the Fifth Circuit in the Western Real Estate Equities decision expressly rejected the Eight Circuit's approach in Windsor and embraced the Ninth Circuit's reasoning in L&J Anaheim Assocs. to hold that section 1129(a)(10) does not distinguish between artificial or discretionary impairment and economically driven impairment. The Fifth Circuit emphasized that section 1124 provides that "any alteration of a creditor's rights, no matter how minor, constitutes 'impairment.'"22 Accordingly, the Fifth Circuit took issue with Windsor's "warping" of the text of the Bankruptcy Code to "shoehorn[] a motive inquiry and materiality requirement" into section 1129(a)(10).23 The Fifth Circuit also found that Windsor's motive inquiry was inconsistent with section 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 solely by economic motives.24 Under the Fifth Circuit's reasoning, "the Bankruptcy Code must be read literally."25 The Fifth Circuit affirmed the decision of the bankruptcy court confirming the Plan.
The circuit court did caution, however, that its decision would not "circumscribe the factors bankruptcy courts may consider in evaluating a plan proponent's good faith" and that a plan proponent's motives and methods for achieving compliance with section 1129(a)(10) "must be scrutinized, if at all, under the rubric" of § 1129(a)(3)."26 The standard enunciated by the Fifth Circuit to evaluate "good faith" is highly deferential: Where a plan is proposed "with the legitimate and honest purpose to reorganize and has a reasonable hope of success, the good faith requirement of section 1129(a)(3) is satisfied." 27 The Western Real Estate Equities panel commented in dicta that "an inference of bad faith may 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."28 Whether a less egregious set of facts would cause a court in the Fifth Circuit to find that a particular plan satisfies section 1129(a)(10), but fails section 1129(a)(3), remains an open question.
Renewed Debate Regarding Artificial Impairment
The Fifth Circuit's decision in Western Real Estate Equities may renew debate among the Circuit Courts of Appeals and bankruptcy courts regarding how far a plan proponent may go in engineering an impaired class of creditors to cram down a plan. Currently, the Eighth Circuit is the only circuit court to hold squarely that section 1129(a)(10) prohibits artificial impairment of a class of creditors, while the Fifth and Ninth Circuits hold that any impairment that fits within section 1124 is sufficient to satisfy section 1129(a)(10). While the Third Circuit and the Fourth Circuit have both recognized the existence of the split, neither Circuit has expressly addressed the issue.29 The other Circuit Courts of Appeals have not yet weighed in.
Bankruptcy courts in the District of Delaware and the Southern District of New York, in the absence of controlling circuit authority, have arguably followed a path akin to that of the Eighth Circuit's Windsor decision rather than follow the literalist approach advocated by the Fifth and Ninth Circuits. Although the issue of artificial impairment has not been addressed with great frequency, decisions from these influential bankruptcy courts have inquired whether a legitimate business purpose exists for impairment, aside from obtaining the requisite vote to permit confirmation by cram down.30 Courts in both jurisdictions have denied confirmation of chapter 11 plans, at least in part, due to the artificial impairment of classes for the purpose of satisfying section 1129(a)(10).31 In these decisions, the courts have squarely rested their decision on the proponent's failure to satisfy section 1129(a)(10), rather than resorting to whether the proponent's artificial impairment of claims contravened the good faith requirement of section 1129(a)(3).32
Although the Second Circuit has not weighed in on the section 1129(a)(10) question, a decision from 2010 in Dish Network Corp. v. DBSD N. Am., Inc. (In re DBSD N. Am., Inc.) may suggest it would also follow the Eight Circuit's approach rather than the Fifth and Ninth Circuits' literal approach.33 DBSD affirmed a decision of the bankruptcy court that not only designated a creditor's vote pursuant to section 1126(e) as not having been cast in good faith to reject a plan, but also disregarded the entire class for purposes of section 1129(a)(8) despite the lack of an express statutory basis to do so. Section 1129(a)(8) requires every impaired class to have accepted the plan, not counting a vote designated under section 1126(e), in order to be confirmable in a non-cramdown situation.34 The bankruptcy court found that the creditor had purchased the underlying claims to "use as levers to bend the bankruptcy process toward its own strategic objective" of acquiring one of the debtor's strategic assets and "not toward protecting its claim."35 Because the designated vote was the only vote in its class, simply disregarding the vote would have meant that class effectively rejected the plan, rendering it unconfirmable under section 1129(a)(8) unless the stringent cramdown requirements were satisfied. In other words, the "bad faith" creditor whose vote was designated might still have been able to block confirmation in a cramdown scenario. Deeming that result to be inconsistent with the remedial purpose of section 1126(e), the bankruptcy court opted to ignore the class entirely for purposes of section 1129(a)(8), without citing any specific authority to support that result.36 The Second Circuit nonetheless endorsed the bankruptcy court's "common sense" approach as "consistent with (if not explicitly demanded by) the text of the Bankruptcy Code."37 Thus, faced squarely with a section 1129(a)(10) impairment issue, the Second Circuit might similarly be inclined to apply the less literal approach of the Eighth Circuit in reviewing the motives of a plan proponent to engineer an impaired class of accepting creditors, in order to protect the bankruptcy process.
Conclusion
The decisions in Western Real Estate Equities and L&J Anaheim Assocs. suggest that a plan proponent pursuing a strategy to cram down a plan of reorganization on a dissenting creditor by creating an impaired class of accepting creditors will have an easier time of it in courts within the Fifth and Ninth Circuits, rather than in the Eighth Circuit and, for now at least, in Delaware and the Southern District of New York. Regardless of their position on section 1129(a)(10), however, courts have taken pains to remind practitioners that the good faith requirement of section 1129(a)(3) remains a vital part of a bankruptcy court's review and is available to protect a dissenting creditor from a truly abusive cramdown scenario. Within the Fifth Circuit, at least, that standard is fairly easy to satisfy, absent a factual showing as egregious as the one the Western Real Estate Equities panel hypothesized. Whether a creditor seeking to oppose cramdown will be able to present sufficient indicia of bad faith when a proponent engineers an impaired accepting class, therefore, remains an open question in the Fifth and Ninth Circuits. Moreover, since the determination under section 1129(a)(3) is fact-specific, it should only be overturned on appeal if clearly erroneous, at least in these Circuits.
Footnotes
1 Western Real Estate Equities, L.L.C., v. Village at Camp Bowie I, L.P. (In re Village at Camp Bowie I, L.P.), No. 12-10271, 2013 WL 690497 (5th Cir. Feb. 26, 2013).
2 See 11 U.S.C. §§ 1124, 1126.
3 See 11 U.S.C. § 1129(a)(10).
4 See Western Real Estate Equities, 2013 WL 690497, at *4 n.29 ("The better view is simply . . . . that the purpose of § 1129(a)(10) is to assure at least a little support for what the debtor is doing[,] [and that] [w]hen trade creditors vote yes on their own impairment, creditor support has been demonstrated, even if trade creditors hold a low percentage of the total claim.") (citing David Gray Carlson, Artificial Impairment and the Single Asset Chapter 11 Case, 23 CAP. U.L. REV. 339, 376 (1994)).
5 Note that the question of whether and to what extent a class of claims is impaired is distinct from classification itself. Section 1122(1) of the Bankruptcy Code provides that "a plan may place a claim or an interest in a particular class only if such claim or interest is substantially similar to the other claims or interests of such class." A discussion of gerrymandering (e.g., classifying dissimilar claims together, or separately classifying similar claims to obtain a consenting impaired class) is beyond the scope of this client alert.
6 Western Real Estate Equities, 2013 WL 690497, at *2.
7 Id. (internal punctuation omitted).
8 Id. at *3. The bankruptcy court's finding in Western Real Estate Equities that the trade creditors were impaired was unquestionably correct because the slightest alteration of a creditor's rights, such as stretching payments over time, constitutes impairment for section 1124 purposes. See, e.g., In re Club Assocs., 107 B.R. 385, 401 (Bankr. N.D. Ga. 1989) ("Any alteration in a creditor's legal rights or privileges constitutes impairment."). Cf. Bank of Am. Nat'l Trust & Sav. Ass'n v. 203 N. LaSalle St. P'ship, 526 U.S. 434, 441 n.14 (1999) ("Claims are unimpaired [only] if they retain all of their prepetition legal, equitable, and contractual rights against the debtor."). If the Plan in Western Real Estate Equities had provided the identical treatment to trade creditors (i.e., payment in full over three months without interest) but had not allowed them to vote, they would have been able to object at confirmation that they were denied the right to vote. Therefore, the sole issue was whether the impairment was economically driven or "artificial."
9 Western Real Estate Equities, 2013 WL 690497, at *3-5.
10 7 F.3d 127, 132 (8th Cir. 1993).
11 Id. at 129-30.
12 Id. at 131 (internal quotations omitted).
13 Id. at 132.
14 Id. at 132-33.
15 Id. at 133.
16 L&J Anaheim Assocs. v. Kawasaki Leasing Int'l, Inc. (In re L&J Anaheim Assocs.), 995 F.2d 940, 943 (9th Cir. 1993).
17 Id. at 942.
18 Id. at 942-43.
19 Id. at 943.
20 Id.
21 Id. at 943 n.2. Although the appellant in L&J Anaheim Assocs. argued that the plan proponent acted in bad faith, the Ninth Circuit let stand, as "not clearly erroneous," the bankruptcy court's finding that the plan satisfied the good faith requirement of section 1129(a)(3). Id.
22 Western Real Estate Equities, 2013 WL 690497, at *4.
23 Id.
24 Id.
25 Id.
26 Id. at *5 ("In particular, 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).").
27 Id. at *6 (internal quotations omitted).
28 Id. at *7.
29 See In re Combustion Eng'g, Inc., 391 F.3d 190 (3d Cir. 2004); Schwarzmann v. First Union Nat'l Bank (In re Schwarzmann), No. 95-2512, 1996 WL 698072 (4th Cir. Dec. 6, 1996).
30 See In re All Land Investments, LLC, 468 B.R. 676, 692 (Bankr. D. Del. 2012) (finding under section 1129(a)(10) that two classes of claims had been impaired solely to obtain the requisite vote to permit confirmation by cram down and disqualifying votes for purposes of determining whether debtor has obtained the affirmative vote of an impaired class); In re Fur Creations by Varriale, Ltd., 188 B.R. 754, 760 (Bankr. S.D.N.Y. 1995) (disqualifying vote of creditor class under section 1129(a)(10) because debtor failed to meet its burden of proving that the class of claims was impaired for justifiable business reasons). Cf. In re Global Ocean Carriers, 251 B.R. 31, 42 (Bankr. D. Del. 2000) (rejecting claim of artificial impairment upon concluding that creditor was substantially impaired because plan affected over $5.6 million in cash collateral (more than 10% of creditor's outstanding loan balance), and deciding that debtors demonstrated reasonable basis for impairment as such funds were necessary to meet plan distribution requirements).
31 See In re All Land Investments, LLC, 468 B.R. at 693; In re Fur Creations by Varriale, Ltd., 188 B.R. at 760-61.
32 See In re All Land Investments, LLC, 468 B.R. at 689-93, 690 n. 14 (questioning proponent's good faith due to artificial impairment without denying confirmation due to failure to satisfy section 1129(a)(3)); In re Fur Creations by Varriale, Ltd., 188 B.R. at 759 (declining to deny confirmation under section 1129(a)(3) in favor of denying confirmation for failure to satisfy section 1129(a)(10)).
33 634 F.3d 79, 104 (2d Cir. 2010).
34 See 11 U.S.C. § 1129(a)(8).
35 DBSD, 634 F.3d at 104.
36 Id. at 105.
37 Id.
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