Fifth Circuit Opines On Chapter 11 Voting Process

The Fifth Circuit Court of Appeals recently determined the issue of whether a chapter 11 plan that artificially impairs a class of creditors for purposes of complying with section 1129(a)(10) of the Bankruptcy Code is confirmable.  See Western Real Estate Equities, L.L.C. v. Village at Camp Bowie I, L.P. (In re Village at Camp Bowie I), No. 12-10271, 2013 WL 690497 (5th Cir. Feb. 26 2013).  In doing so, the Fifth Circuit adopted the approach used by Ninth Circuit Court of Appeals, allowing artificial impairment in certain instances, especially when a plan is feasible and submitted with a good faith purpose to reorganize.

Facts

The Debtor, Village at Camp Bowie I, owned a parcel of real estate in west Fort Worth Texas, consisting of unimproved land and several buildings, which were leased out. The Debtor acquired the property by investing $10,000,000 of its own capital and financing the balance of the purchase price through short-term loans, which were secured by the parcel of land.

After a series of defaults on the loans, the secured lender eventually sold and assigned the loans to Western Real Estate Equities, LLC at a discount.  Western purchased the loans with an eye towards displacing the Debtor as the owner.  Indeed, immediately after acquiring the loans, Western posted the real estate for non-judicial foreclosure.

The day before the foreclosure sale, the Debtor filed for chapter 11 bankruptcy, thereby staying the foreclosure sale. As of the filing date, the Debtor owed an outstanding balance of approximately $32 million to Western and also owed approximately $60,000 in unsecured debt to 38 trade creditors.

Relief from Stay

Shortly after the bankruptcy filing, Western motioned the bankruptcy court to grant relief from the automatic stay.  Section 362(a) of the Bankruptcy Code provides an injunction (or automatic stay) against the commencement or continuation of an action or proceeding to recover on a prebankruptcy claim, including a foreclosure proceeding to satisfy a debt with pledged property.  Section 362(d)(2) of the Code provides, however, that a creditor may request that the bankruptcy court “lift” (i.e., grant relief from) the automatic stay if (a) the debtor does not have equity in the property being targeted and (b) such property is not necessary to an effective reorganization.

In the Village case, the bankruptcy court refused to lift the stay, finding that, since the real estate was worth $34 million, the Debtor, in fact, had equity in the property, because such value exceeded the outstanding debts owed to all creditors.

Plan Confirmation

The majority of the opinion actually focuses on the process used by the Debtor to confirm its plan of reorganization.  The Debtor’s final plan contained the following components:

  • Western would receive a new five-year note in the amount of its claim, with interest accruing at 5.84% and a balloon payment at the maturity date;
  • Unsecured trade claims would be paid in full within 3 months of the effective date, but would not receive any interest; and
  • The Debtor’s prepetition owners and related parties would infuse $1.5 million in exchange for retaining equity in the Debtor.

Section 1129 of the Bankruptcy Code contains the requirements for a plan of reorganization to be approved (a.k.a. confirmed) by a bankruptcy court.  A plan normally divides creditors into various classes of claims, like secured, priority and unsecured nonpriority claims, and specifies the treatment for each class of claims.  For purposes of confirming a plan, section 1124 explains that a plan impairs a class of claims unless “it leaves unaltered the legal, equitable and contractual rights” of the claim holders.  In this case,  there were two impaired classes under the plan, Western’s and the unsecured trade creditors’, as each of the claims in each class was altered, albeit slightly in the instance of the unsecured creditor class.

Each impaired class of claims is entitled to vote on a plan, and Village‘s case both impaired classes voted on the Debtor’s plan, although in opposite directions.  In cases where a plan proponent does not receive approval of all impaired classes, it can still move to “cram down” its plan on a dissenting class of creditors by satisfying certain tests found in section 1129.  One of the tests is that “at least one class of claims that is impaired under the plan has accepted the plan.”  11 U.S.C. § 1129(a)(10)

In the Village case, in addition to rejecting the plan within its class, Western objected to confirmation of the plan on the basis that the Debtor “artificially” impaired the unsecured creditor class by not paying unsecured creditors in full, with interest, upon confirmation of the plan, even though the Debtor had sufficient funds to do so.  Western argued that, absent this artificial impairment, the Debtor’s plan would not have complied with section 1129(a)(10) of the Code, which requires that at least 1 impaired class of creditors vote in favor of a plan of reorganization.

While the bankruptcy court agreed that the Debtor had sufficient funds to leave the unsecured creditor class unimpaired, the court held that section 1129(a)(10) does not distinguish between artificial impairment and economically driven impairment.  The bankruptcy court further found that, while artificial impairment is a factor in determining whether a plan was submitted in good faith, as required by section 1129(a)(3) of the Code, this factor alone did not amount per se to a lack of good faith.  A more important factor in the Debtor’s favor was proposing a feasible plan that continued a going concern and preserved non-trivial equity interests.

Fifth Circuit Ruling

On appeal, the Fifth Circuit Court of Appeals examined the plain texts of sections 1129(a)(10) (impaired class voting requirement) and 1129(a)(3) (good faith requirement), in trying to reconcile whether a debtor could artificially impair a friendly class of creditors and still be compliant with the good faith requirement under the Code.

Seal of the 8th Circuit Court of AppealsThere is currently a split amongst Circuit Courts of Appeal as to what type of impairment is permissible in order to comply with section 1129(a)(10).  For example, the Eight Circuit Court of Appeals holds that “a claim is not impaired [for purposes of § 1129(a)(10)] if the alteration of the rights in question arise solely from the debtor’s exercise of discretion.”  In re Windsor on the River Assocs., Ltd., 7 F.3d 127, 132 (8th Cir. 1993).  Under the Eight Circuit’s approach, section 1129(a)(10) only recognizes impairment to the extent it is driven by economic need.  See id. at 132-33.

In contrast, the Ninth Circuit Court of Appeals does not distinguish between discretionary and economically driven impairment, observing that section 1124’s explanation of impairment contains no qualification as to what degrees of impairment are acceptable.  See In re L&J Anaheim Associates, 995 F.2d 940, 943 (9th Cir. 1993).  The Ninth Circuit’s approach still leaves open, however, the possibility that discretionary impairment could violate the duty of good faith under section 1129(a)(3).  See id. at 943 n. 2.

Noting that it had not previously given a clear direction on this issue, the Fifth Circuit finally held in Village that it rejected the Windsor approach and joined the Ninth Circuit’s holding that section 1129(a)(10) does not distinguish between discretionary and economically driven impairment.  In doing so, the Fifth Circuit found that Windsor ignored that (a) section 1124 of the Code plainly provides that any alteration constitutes an impairment and (b) section 1123(b)(1) of the Code (i) plainly provides that a plan proponent “may impair or leave unimpaired any class of claims” and (ii) does not contain a restriction that impairment can only be economically driven.

In siding against the Eighth Circuit’s approach, which relied on legislative intent, the Fifth Circuit found that the Code must be read literally and only when there exists ambiguity does legislative history become relevant.  According to the Court, “[it] could not ride roughshod over affirmative language in the Bankruptcy Code to enforce some Platonic ideal of a fair voting process.”  In this case, because sections 1123(b)(1), 1124 and 1129(a)(10) were clear and unambiguous, no legislative history was necessary to interpret these provisions.  Moreover, the Court found that such legislative history did not help Western, in any instance, as such history was scant and did not clearly reflect the purposes behind sections 1124 and 1129(a)(10).

Leaving the possibility that artificial impairment may violate the Code, the Fifth Circuit acknowledged that a plan proponent’s motives and methods for achieving compliance with the voting requirements of section 1129(a)(10) could be scrutinized under the rubric of section 1129(a)(3).  However, the Court noted that “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 § 1129(a)(3) is [generally] satisfied.”  See In re Cajun Elec. Power Co-op, Inc., 150 F.3d 503, 519 (5th Cir. 1998).  This was the case in the Village bankruptcy.

Conclusion

While the Fifth Circuit held that artificial impairment is permissible in certain instances where a plan is otherwise feasible and confirmable, the Fifth Circuit left bankruptcy courts with much discretion in making “good faith” determinations under section 1129(a)(3).  Thus, if a stronger case of artificial impairment could be made, e.g., in an instance where a debtor creates an impaired class by incurring a sham debt with a related party, according to the Fifth Circuit, section 1129(a)(3) leaves a bankruptcy court with the discretion to deal with such type of chicanery.

The Fifth Circuit’s opinion may also renew debates by the Circuit Courts and bankruptcy courts as to how far they will allow plan proponents to engineer impaired classes of claims in order to meet (or circumvent) section 1129(a)(10)’s requirement and be able to cram down plans against dissenting classes of creditors.  Right now, only the Eighth Circuit holds firmly that section 1129(a)(10) prohibits any artificial impairment, while the Ninth and Fifth Circuits hold that artificial impairment is not per se banned by the Code, especially when there is a legitimate reorganization effort.  Up to this point, the Third and Fourth Circuits have not specifically addressed the issue, although they have noted the split in Circuit-level opinions.  The other Circuit Courts have not weighed in yet, but it is only a matter of time before they do.



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