The U.S. Court of Appeals for the Sixth Circuit recently held that a bankruptcy court clearly erred in its finding that a debtor proposed a Chapter 11 plan in good faith, when the secured mortgagee would be paid only in part and very slowly after 10 years with no obligation by the debtor to maintain the building and obtain insurance, while a second class would be paid in full in two payments of $1,200 each over 60 days.

In so ruling, the Sixth Circuit held that the artificial creation of an “impaired” class under section 1124(1) of the Bankruptcy Code, 11 U.S.C. § 1124(1), must pass muster under a “good faith” analysis under 11 U.S.C. § 1129(a)(3).

A copy of the opinion in Village Green I, GP v. Federal Nat’l Mortgage Assoc. is available at:  Link to Opinion.

The debtor in this case defaulted on its monthly mortgage payment for an apartment building that it financed with the secured creditor.  Shortly after default, the debtor filed Chapter 11 bankruptcy to halt the secured creditor’s foreclosure action.  Aside from the $8.6 million owed to the secured creditor, the only other debts provided for in the proposed plan of reorganization was less than $2,400 owed in total to the debtor’s former attorney and accountant.

Debtor proposed two classes of claims in its plan of reorganization.  The secured creditor would be paid very slowly leaving a balance of $6.6 million after 10 years and the proposed plan removed the debtor’s obligation to maintain the building and obtain insurance.  The second class would be paid in full in two payments of $1,200 each over 60 days.

Because the second class was technically “impaired” (because they were entitled to be paid on their claims immediately), the bankruptcy court held that the second class satisfied the requirements of 11 U.S.C. § 1124(1).  Because the second class voted to accept the plan of reorganization, the bankruptcy court confirmed the plan pursuant to 11 U.S.C. § 1129(a)(10).

The secured creditor appealed to the district court, which vacated the bankruptcy court’s confirmation of the plan and remanded for a determination as to whether the plan was proposed in good faith pursuant to 11 U.S.C. § 1129(a)(3).  On remand, the bankruptcy court held that the plan was proposed in good faith, and the secured creditor again appealed to the district court that in turn vacated and remanded.  This led to the dismissal of the case by the bankruptcy court and the subsequent appeal to the Sixth Circuit.

The Sixth Circuit recognized that the “impairment” of the minor second class claims was impaired only in a technical sense, but noted “that this impairment seems contrived to create a class to vote in favor of the plan is immaterial” citing a Fifth Circuit opinion in In re Village at Camp Bowie, 710 F.3d 239, 245-46 (5th Cir. 2013).

However, the Sixth Circuit also found the debtor’s motives to be expressly relevant when analyzing a plan under the good faith standard of 11 U.S.C. § 1129(a)(3).

When analyzing the plan for good faith, the Sixth Circuit cited the bankruptcy court’s findings that the debtor had net income of $71,400 per month, “which renders dubious at best [its] assertion that it could not safely pay off the minor claims (total value: less than $2,400) up front rather than over 60 days.”

Considering also that the “impaired” claimants were also closely allied with the debtor increased the appearance that the “impairment” was contrived solely for the purpose of circumventing the purposes of 11 U.S.C. § 1129(a)(10).

Accordingly, the Sixth Circuit affirmed the district court’s ruling, and held that the bankruptcy court clearly erred when it found that the debtor proposed its plan in good faith.

Interestingly, although the Sixth Circuit agreed with the Fifth Circuit on the artificial impairment analysis, it parted ways with the Fifth Circuit on the good faith analysis.  The Camp Bowie opinion from the Fifth Circuit does not contain a significant good faith analysis of the plan at issue but rather only affirmed the bankruptcy court in the absence of clear error.