On August 26, 2020, the Court of Appeals for the Third Circuit held that the Bankruptcy Code does not require subordination agreements to be strictly enforced in order for a court to confirm a cramdown plan, so long as the plan does not discriminate unfairly. As a result, Tribune's chapter 11 plan was properly confirmed over the objection of a dissenting class of senior noteholders that argued the plan improperly failed to give effect to the provisions of an otherwise enforceable subordination agreement. In so holding, the Third Circuit ruled that the plain language of section 1129(b) of the Bankruptcy Code allows confirmation of a so-called cramdown plan that would override an otherwise enforceable subordination agreement.
Between 1992 and 2005, Tribune Company (“Tribune”) issued unsecured notes (the “Senior Notes”) to certain creditors (the “Senior Noteholders”) pursuant to indentures which required repayment of the notes ahead of any other subordinated debt incurred by Tribune. In 1999, Tribune also issued $1.256 billion of unsecured subordinated notes (the “PHONES Notes”), which were subordinate in payment to all “‘Senior Indebtedness' of Tribune.” Tribune's debt also included $225 million of unsecured debt (the “EGI Notes”), which were subordinate in repayment to “Senior Obligations.” In addition, Tribune's debt included an unsecured $150.9 million “Swap Claim,” $105 million of unsecured claims by Tribune Media Retirees (the “Retirees”) and $8.8 million of unsecured claims by trade and miscellaneous creditors (the “Trade Creditors”).
Tribune filed for bankruptcy in 2008 following a failed LBO. During the bankruptcy proceeding, Tribune proposed a plan that classified its unsecured creditors into distinct classes. The plan paid both the Senior Noteholders (Class 1E) and the Swap Claims, Retirees and Trade Creditors (collectively, Class 1F) 33.6% of their outstanding claims from the initial distributions under the plan, which payments included recoveries that were reallocated based on the subordination of the PHONES and EGI Notes. The Senior Noteholders voted to reject the Plan. The Senior Noteholders also objected to the Plan, arguing that the Plan improperly allocated more than $30 million of their recovery from the subordinated PHONES and EGI Notes to Class 1F, when only the Senior Noteholders in Class 1E qualified as Senior Obligations entitled to benefit from those subordination agreements. Alternatively, the Senior Noteholders argued that the allocation of value to Class 1F unfairly discriminated against Class 1E by failing to give effect to the subordination provisions of the relevant subordinated note indentures.
The Delaware Bankruptcy Court considered whether the claims of other creditors besides the Senior Noteholders also qualified as Senior Obligations, thereby entitling them to recover additional payments on account of the subordination provisions in the PHONES and EGI Notes. The Bankruptcy Court found that the Swap Claim qualified as a Senior Obligation, which reduced the amount at issue with respect to the Senior Noteholders' unfair discrimination claim from $30 million to $13 million. The Bankruptcy Court did not, however, decide whether the Retirees' claim qualified as a Senior Obligation.
With respect to the Senior Noteholders' objections, the Bankruptcy Court determined that the cramdown plan provision of section 1129(b)(1) of the Bankruptcy Code does not require that the subordination agreements be strictly enforced for a plan to be confirmed. This is because section 1129(b)(1) allows confirmation of a plan “notwithstanding section 510(a)” of the Bankruptcy Code, which is the provision of the Code that provides for enforceability of subordination agreements in bankruptcy to the same extent they are enforceable outside of bankruptcy.
The Bankruptcy Court also rejected the Senior Noteholders' unfair discrimination argument. In considering whether unfair discrimination occurred, the Bankruptcy Court applied the “rebuttable presumption” test. This provides a rebuttable presumption of unfair discrimination where there is a dissenting class, another class of the same priority, and a difference in the plan's treatment of the two classes that results in a materially lower percentage recovery for the dissenting class.1 The Bankruptcy Court's unfair discrimination analysis compared Class 1E's initial distribution recovery percentage under the plan—33.6%—to its recovery if it and the Swap Claim were the only creditors to benefit from the subordination agreements—34.5%—and determined that 0.9% was not a material difference in recovery. Thus, it held that there was no unfair discrimination to bar plan confirmation.
The Senior Noteholders appealed confirmation of the plan to the District Court, arguing that the plan violated section 1129(b)(1) by failing to enforce the subordination agreements. Alternatively, the Senior Noteholders argued that: (1) the Bankruptcy Court's unfair discrimination analysis should have only compared Class 1E and Class 1F plan recoveries from the Tribune estate, as if no subordination agreements were in effect; and (2) the Bankruptcy Court should have compared the Class 1E percentage recovery to the Class 1F percentage recovery (as opposed to comparing Class 1E's plan recovery with its recovery had the subordination agreements been fully enforced). Those comparisons, the Senior Noteholders argued, result in a material difference in recovery between Class 1E and Class 1F, evidencing unfair discrimination that should have prevented plan confirmation. The District Court affirmed the Bankruptcy Court's decision, and the Senior Noteholders appealed to the U.S. Court of Appeals for the Third Circuit.
The Third Circuit first considered how the Bankruptcy Code's cramdown provision interacts with intercreditor subordination agreements. As mentioned above, section 510(a) of the Bankruptcy Code provides that a subordination agreement is enforceable to the same extent that it is enforceable under nonbankruptcy law. The Senior Noteholders argued that the plan violated the Bankruptcy Code's standards for confirmation because it did not fully enforce the relevant subordination provisions. However, section 1129(b)(1) of the Code states that a nonconsensual plan may be confirmed, or “crammed down,” on dissenting creditors “notwithstanding section 510(a).”2 The Third Circuit agreed with the lower courts and rejected the Senior Noteholders' argument as being at odds with the plain language of section 1129(b)(1) and held that the lower courts correctly evaluated the Senior Noteholders' claim under the unfair discrimination test, rather than a rigid application of section 510(a). The Third Circuit ruled that section 1129(b)(1) overrides section 510(a) because that is the plain meaning of “notwithstanding.”
The Third Circuit next detailed various principles framing the unfair discrimination standard. The requirement of section 1129(b)(1) that a plan not “discriminate unfairly” protects the interests of a dissenting class relative to other classes of the same rank by requiring that a plan does not discriminate unfairly against the dissenting class. An important initial step in the plan process is the proper classification of substantially similar claims. A plan may not provide a dissenting class a materially lower recovery relative to other equal ranking classes, or a materially greater risk to the dissenting class in connection with its proposed distribution, without satisfying various substantive requirements. The rebuttable presumption test, which was applied in this case, intentionally leaves open to bankruptcy court interpretation what is, under the circumstances, “material.”
When making an unfair discrimination determination where subordination agreements are involved, the Third Circuit stated that courts should first resolve which creditors are entitled to benefit from those agreements and then should make their class comparisons after including subordinated sums in the plan distributions. Where class-to-class comparison is difficult, a court may opt to be pragmatic and look to the discrepancy between the dissenting class's desired and actual recovery to determine the degree of its different treatment. Moreover, while the class comparison generally is between the allegedly preferred class and the dissenting class, a court may, in certain circumstances, consider the difference between what the dissenting class argues it is entitled to recover and what it actually recovers under the plan.
In this context, the Third Circuit held that the Bankruptcy Court did not err by comparing the Senior Noteholders' desired recovery, if Class 1E and the Swap Claim benefited from the subordination (34.5%), to the Senior Noteholders' actual recovery under the plan (33.6%). While 57% of Class 1F (the Swap Claim) is entitled benefit from the subordination provisions, and the Trade Creditors (and perhaps the Retirees) are not, the Third Circuit found that it was permissible for amounts to be allocated to other classes which would not otherwise benefit from the subordination provisions outside of bankruptcy, so long as that allocation is not presumptively unfair (and, if the allocation is preemptively unfair, the presumption is not rebutted). Because the claims of the Retirees ($105 million) and the Trade Creditors ($8.8 million), who shared a class with the Swap Claim, were so much smaller than the Senior Noteholders' claims ($1.283 billion), the Third Circuit found that the increases in the recovery percentage for the Retiree and Trade Creditor claims from the reallocated subordination amounts resulted in only a minimal reduction of the recovery percentage for the Senior Noteholders.3 Thus, for purposes of the analysis, unfair discrimination is to be determined from the perspective of the dissenting class, rather than the preferred class, even when intercreditor rights are at issue.4 Therefore, the Third Circuit held that the plan's allocation of a small portion of subordinated sums to Class 1F creditors does not unfairly discriminate against the Senior Noteholders.
As the Third Circuit noted, the phrase “discriminate unfairly” is simple and direct: you can treat differently (discriminate), but not so much as to be unfair. The Tribune decision provides helpful guidance when undertaking an unfair discrimination analysis, particularly where subordination rights are at issue. In holding that section 1129(b)(1) supersedes section 510(a), the Third Circuit noted that the cramdown provision “provides the flexibility to negotiate a confirmable plan even when decades of accumulated debt and private ordering of payment priority have led to a complex web of intercreditor rights.” As the Third Circuit pointed out, this is but one example of the flexibility provided by the Bankruptcy Code, which allows for an increased likelihood that a plan can be negotiated and confirmed, notwithstanding the existence of billions of dollars of debt and a very complex capital structure.
1 The “rebuttable presumption” test provides that a rebuttable presumption of unfair discrimination exists when there is: (1) a dissenting class; (2) another class of the same priority; and (3) a difference in the plan's treatment of the two classes that results in either (a) a materially lower percentage recovery for the dissenting class (measured in terms of the net present value of all payments) or (b) regardless of percentage recovery, an allocation under the plan of materially greater risk to the dissenting class in connection with its proposed distribution. The presumption may be overcome if the court finds that a lower recovery for the dissenting class is consistent with the results that would obtain outside of bankruptcy, or that a greater recovery for the other class is offset by contributions from that class to the reorganization. The presumption of unfairness based on differing risks may be overcome by a showing that the risks are allocated in a manner consistent with the prebankruptcy expectations of the parties.
2 If all of the confirmation requirements set forth in the Bankruptcy Code, other than the requirement that all impaired classes vote in favor of the plan, are met, a bankruptcy court can still confirm the plan if the plan does not “discriminate unfairly,” and is “fair and equitable,” with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.
3 Specifically, the subordinated sums allocated to the Retirees and Trade Creditors comprised 11.7 percentage points towards their 33.6 percentage recovery, but only reduced the Senior Noteholders' recovery by nine-tenths of a percent.
4 The Third Circuit clarified that in cases where a class-to-class comparison is difficult—such as in Tribune where some but not all members of the preferred class were potentially entitled to subordinated recoveries—a court may look to the discrepancy between the dissenting class's desired and actual recovery to determine the extent of its disparate treatment. But in any case, the perspective remains that of the dissenting class.
Originally published by Shearman & Sterling, September 2020
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.