On February 26, 2013, the United States Court of Appeal for the Fifth Circuit (the “Court”) effectively endorsed the use of “artificially” impaired classes as a strategy to cram-down a Chapter 11 plan of reorganization against an objecting secured creditor. Western Real Estate Equities, LLC v. Village at Camp Bowie I, LP (In re Village at Camp Bowie I, LP), No. 12-10271, 2013 WL 690497 (5th Cir. Feb. 26, 2013). Addressing an issue that already has produced a split among the federal circuit courts, the Court expressly approved a Chapter 11 debtor’s use of a plan that deliberately impaired a class for the sole purpose of garnering support for a cram-down of the debtor’s sole and fully secured creditor.
The case involved Village at Camp Bowie I, LP (the “Debtor”), a Chapter 11 single asset real estate debtor. Western Real Estate Equities, LLC (“Western”) held, as a successor-in-interest, claims against the Debtor pursuant to certain promissory notes that were executed under a construction loan in 2004. The Debtor’s sole asset was known as the Village at Camp Bowie (the “Property”) and was used primarily for retail and office space in Fort Worth, Texas. Upon the pre-petition maturity of the notes, which were secured by a mortgage over the Property, the Debtor owed roughly $31 million to Western, and since that time approximately $1.5 million in interest and other charges has accrued. The Property had previously been up for foreclosure at least three times, with the most recent foreclosure sale being posted on August 3, 2010. The Debtor filed its Chapter 11 petition on the eve of that last foreclosure sale.
Bankruptcy Court Confirmation of the Plan
The bankruptcy court denied Western’s request to lift the stay to foreclose on the Property, concluding that the value of the Property exceeded the amount of Western’s claim. Following the bankruptcy court’s rejection of an initial plan that had been filed by the Debtor, the Debtor increased its proposed equity contributions and filed an amended plan (the “Plan”).
The Plan provided for three classes of creditors: (1) Western as an impaired fully secured creditor, (2) general unsecured creditors (predominately trade) as impaired with $60,000 in claims, and (3) the impaired equity holders. The Plan, in the form of a cram-down, proposed (i) a five-year extension of the Western notes with annual interest payments and principal due at maturity, (ii) a no-interest three-month payout to the unsecured creditors in three equal installments, and (iii) an equity infusion of more than $1 million and the retention of equity interests by the infusing equity holders. Notably, the Plan’s treatment of the unsecured creditors provided for virtually no economic impairment, as the unsecured creditors would receive, over the course of three months after the effective date of the plan, full payment on their claims. The Debtor conceded that payment in full of the unsecured trade creditors on the effective date of the Plan would not cause any hardship on the Debtor. Accordingly, it is readily apparent (and seemingly undisputed) that the three-month payment installment feature was devised as a way of “impairing” the unsecured creditor class to allow it to vote on the Plan.
Western argued that the Plan could not be confirmed for several reasons, including (1) the unsecured class was artificially impaired (i.e., not for any economic reason, but simply for the purpose of permitting the unsecured creditors to vote), (2) the Plan was not proposed in good faith, (3) the Plan was not feasible, and (4) the Plan did not propose fair and equitable treatment of Western’s secured claim. The bankruptcy court disagreed and confirmed the Plan, even while acknowledging that the Debtor had the wherewithal to pay the unsecured creditors in full on the Plan’s effective date.
Fifth Circuit Affirmance
In considering the parties’ arguments on appeal, the Court first turned to section 1129(a)(10) of the Bankruptcy Code, which requires that at least one impaired class of creditors to vote in favor of a Chapter 11 plan if any other impaired class rejects it, and addressed a circuit split on the distinction between artificial and economically driven impairment. The Eighth Circuit recognizes only impairment that is driven by necessity and not “if the alteration of the rights in question arises solely from the debtor’s exercise of discretion.” Id. at 7 (citing Matter of Windsor on the River Assocs., Ltd., 7 F.3d 127, 132 (8th Cir. 1993)). The Windsor court acknowledged that any alteration of a creditor’s rights technically resulted in “impairment” under the Bankruptcy Code. However, the Windsor court reasoned that there was also a “materiality requirement” under 1129(a)(10) by which a court could “deem a claim unimpaired.” Id. at 8. Rejecting Windsor and the Eighth Circuit outright, the Court asserted that 1129(a)(10) is not restrained by any “materiality” requirement. Rather, the Court explained that it need only consider the good faith requirement under 1129(a)(3) in determining whether a class was ultimately impaired. Id. at 11.
The Court then addressed and agreed with Ninth Circuit precedent. The Ninth Circuit does not recognize any distinction between artificial and economic impairment, and has consequently ruled that creditors’ claims are impaired unless they are left “unaltered” by a plan. Id. at 11 (citing Matter of L&J Anaheim Assocs., 995 F.2d 940, 943 (9th Cir. 1993)). Following the Ninth Circuit’s lead, the Court rejected Western’s attempt to compare artificial impairment with voting manipulation through creditor class gerrymandering, which the Court conceded is prohibited. Id. at 11. The Court found it significant that gerrymandering arises in the case of an under-secured creditor, whereas artificial impairment typically arises in cases where the major creditor is fully secured. Id. at 11. Recognizing that the Court previously ruled that voting manipulation would not be allowed, the Court focused its analysis on section 1129(a)(3) and the requirement of proposing a plan in good faith. Id. at 11. Separate classification for the sole purpose of manipulating votes, such as classifying two similar groups of unsecured creditors separately, may support a lack of good faith if done for the purpose of garnering enough support from one impaired class for a plan. However, the Court determined that here, the Plan did not involve the separate classification of two similarly situated classes. Further, the Court noted that the Plan was reasonable and feasible, and it held that artificial impairment would not, as a matter of law, constitute bad faith in the absence of additional aggravating factors. Id. at 12.
The Fifth Circuit’s decision produces negative precedent for single-asset lenders, but one that comes with a decidedly silver lining. On the one hand, the Court made it significantly easier for a debtor to cram down a reorganization plan and impose new, suboptimal payment terms on lenders whose claims are over-secured. According to the Court, fealty to the plain language of section 1124 requires that result. On the other hand, the Court did not take its conclusion to its next logical step and hold that class gerrymandering is also permissible. The basis for the Court’s distinction is not entirely clear, or convincing, but the end result is that cram-down against undersecured single-asset lenders remains as challenging for debtors as it was before Village at Camp Bowie was issued.
The decision also has significant implications outside single-asset real estate cases as well. In complex Chapter 11 cases, finding an accepting impaired class of creditors can be challenging, particularly where the debtor or equity plan sponsor seeks to maintain its ordinary-course vendor, supplier, and employee relationships unimpaired, while adjusting only its longer term indebtedness (i.e., it wishes to effect only a balance sheet, rather than an operational, restructuring). The ability to technically impair these friendly classes of creditors while still paying them promptly and in full, thereby creating an “accepting impaired class” for cram-down purposes, is another potentially powerful arrow in the quiver of a debtor seeking to confirm a plan over the objection of its major debt-holders, be they secured or unsecured.
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This article was originally published by Bingham McCutchen LLP.