One of the prerequisites to confirmation of any chapter 11 plan is that at least one “impaired” class of creditors must vote in favor of the plan. This requirement reflects the basic (but not universally accepted) principle that a plan may not be imposed on a dissident body of stakeholders of which no class has given approval. However, it is sometimes an invitation to creative machinations designed to muster the requisite votes for confirmation of the plan.

“Strategic” classification can entail, among other things, “manufacturing” an impaired class even though the impairment is immaterial. For example, the plan could pay creditor claims nearly, but not entirely, in full or modify the rights of the creditors in the class in some incidental way—in either case, with such minimal effect that creditors are still willing to vote to accept the plan despite slight impairment of their claims. Sometimes referred to as “artificial impairment,” this practice is controversial.

So much so, in fact, that there is a split among the federal circuit courts of appeal concerning its legitimacy. In Village Green I, GP v. Federal National Mortgage Association (In re Village Green I, GP), 2016 BL 20874 (6th Cir. Jan. 27, 2016), the Sixth Circuit weighed in on this debate as a matter of first impression. It joined the Fifth and Ninth Circuits in ruling that artificial impairment does not preclude a plan from satisfying the impaired class acceptance requirement, but instead is relevant in determining whether the debtor has proposed a chapter 11 plan in good faith.

Impairment

Only impaired classes of creditors are entitled to vote on a chapter 11 plan. Holders of claims that are not impaired by a plan are deemed to accept it. Section 1124 of the Bankruptcy Code provides that a class of claims is impaired under a plan unless the plan provides the following treatment for each claimant in the class: (1) “leaves unaltered the legal, equitable, and contractual rights” to which the claimant is entitled; or (2) cures any defaults (with limited exceptions), reinstates the maturity and other terms of the obligation, and compensates the claimant for resulting losses.

Section 1124 is derived from section 107 of chapter X of the former Bankruptcy Act of 1898 (repealed in 1978), which provided that “creditors” or “any class thereof” would be “affected” for purposes of a plan—and therefore entitled to vote—“only if their or its interest shall be materially and adversely affected thereby.” The legislative history indicates that when section 1124 was enacted as part of the present-day Bankruptcy Code in 1978, floor leaders for the final version of the bill stated that the provision “defines the new concept of ‘impairment’ of claims or interests; the concept differs significantly from the concept of ‘materially and adversely affected’ under the Bankruptcy Act.” 124 Cong. Rec. H11,103 (daily ed. Sept. 28, 1978); 124 Cong. Rec. S17,419‒17,420 (daily ed. Oct. 6, 1978).

Section 1124 originally included a third option for rendering a claim unimpaired—by providing the claimant with cash equal to the allowed amount of its claim. In In re New Valley Corp., 168 B.R. 73 (Bankr. D.N.J. 1994), the court ruled that a solvent debtor’s chapter 11 plan which paid unsecured claims in full in cash, but without postpetition interest, did not impair the claims. Due to the perceived unfairness of New Valley, Congress removed the “cash out” option from section 1124 in 1994.

Impaired Class Acceptance as a Condition to Cramdown

Even if all impaired classes of creditors do not vote to accept a chapter 11 plan, the plan may still be confirmed under the Bankruptcy Code’s nonconsensual, or “cramdown,” provisions. Among those is the requirement in section 1129(a)(10) for at least one impaired class to vote to accept the plan (without counting insider votes).

This requirement operates as one of several statutory gatekeepers to cramdown. Although there is some disagreement on this point, section 1129(a)(10) is supposedly premised on the policy that, before compelling creditors to bear the consequences associated with cramdown, at least one class whose members are not being paid in full (or whose claims are otherwise impaired) should be willing to go along with the chapter 11 plan.Compare In re Windsor on the River Assocs., Ltd., 7 F.3d 127, 131 (8th Cir. 1993) (interpreting legislative history to suggest that the purpose of section 1129(a)(10) “is to provide some indicia of support by affected creditors and prevent confirmation where such support is lacking”) with Final Report and Recommendations of the American Bankruptcy Institute Commission to Study the Reform of Chapter 11 (December 8, 2014) (the “ABI Commission Report”) p. 258 (recommending removal of section 1129(a)(10) from the Bankruptcy Code and stating that “[a]lthough some courts and commentators suggest that section 1129(a)(10) was intended to ensure that a plan had some creditor support, neither the legislative history nor the Bankruptcy Code indicate[s] such a purpose”) (citations omitted).

Artificial Impairment

Courts disagree whether section 1129(a)(10) draws a distinction between “artificial” and “economically driven” impairment. For example, in Windsor, the Eighth Circuit ruled that “a claim is not impaired [for purposes of section 1129(a)(10)] if the alteration of the rights in question arises solely from the debtor’s exercise of discretion.” According to this approach, section 1129(a)(10) recognizes impairment only to the extent that it is caused by economic “need.”

Many courts have applied Windsor to deny confirmation of a chapter 11 plan impairing the de minimis claims of some creditors for the purpose of contriving a class to accept the plan. See, e.g., In re Combustion Engineering, Inc., 391 F.3d 190, 243‒44 (3d Cir. 2003); In re All Land Investments, LLC, 468 B.R. 676, 690 (Bankr. D. Del. 2012); In re Daly, 167 B.R. 734, 737 (Bankr. D. Mass. 1994); see also In re Deming Hospitality, LLC, 2013 BL 93045, *6 (Bankr. D.N.M. Apr. 5, 2013) (stating that “[i]f there is no economic justification for failing to pay Class 6 in full after confirmation rather than the proposed 75%, then the impairment of the class likely would be ‘artificial’ and impermissible”); In re Swartville, LLC, 2012 BL 211034, *2 (Bankr. E.D.N.C. Aug. 17, 2012) (“artificial impairment” refers to a scenario where a debtor “deliberately impairs a de minimis claim solely for the purpose of achieving a forced confirmation over the objection of a creditor”). These courts have reasoned that allowing manipulation of this kind undermines the policy of consensual reorganization expressed in section 1129(a)(10).

Other courts, including the Fifth and Ninth Circuits, have concluded that artificial impairment does not violate section 1129(a)(10). In L & J Anaheim Assocs. v. Kawasaki Leasing Intl., Inc. (In re L & J Anaheim Assocs.), 995 F.2d 940 (9th Cir. 1993), the Ninth Circuit ruled that section 1129(a)(10) does not distinguish between discretionary and economically driven impairment. According to the court, “[T]he plain language of section 1124 says that a creditor’s claim is ‘impaired’ unless its rights are left ‘unaltered’ by the plan,” and “[t]here is no suggestion here that only alterations of a particular kind or degree can constitute impairment.” Accord In re Greate Bay Hotel & Casino, Inc., 251 B.R. 213 (Bankr. D.N.J. 2000); In re Duval Manor Assocs., 191 B.R. 622 (Bankr. E.D. Pa. 1996). In Western Real Estate Equities, LLC v. Village at Camp Bowie I, LP (In re Village at Camp Bowie I, LP), 710 F.3d 239, 245 (5th Cir. 2013), the Fifth Circuit joined the Ninth Circuit in holding that section 1129(a)(10) “does not distinguish between discretionary and economically-driven impairment” and that “any alteration of a creditor’s rights, no matter how minor, constitutes impairment” (citations and internal quotation marks omitted).

However, most courts taking this approach have concluded that artificial impairment is relevant to the issue of whether the debtor proposed its chapter 11 plan in good faith. Section 1129(a)(3) of the Bankruptcy Code provides that a plan may be confirmed only if “proposed in good faith and not by any means forbidden by law.” Even if artificial impairment is not impermissible per se, these courts have held, proposing a contrived impaired class may constitute bad faith. See Camp Bowie, 710 F.3d at 247; FNMA v. Village Green I, GP, 483 B.R. 807 (W.D. Tenn. 2012) (refusing to reject artificial impairment outright but holding that, under either section 1129(a)(3) or 1129(a)(10), the debtor must demonstrate some economic justification for delaying payment to de minimis creditors); In re The Beare Co., 177 B.R. 886 (Bankr. W.D. Tenn. 1994).

The Sixth Circuit had an opportunity to examine the concept of artificial impairment in Village Green.

Village Green

Village Green I, GP (the “debtor”) purchased an apartment complex in Memphis, Tennessee, in 2005 with secured financing provided by the Federal National Mortgage Association (“FNMA”). FNMA commenced a foreclosure proceeding after the debtor defaulted on the mortgage in December 2009. The debtor filed for chapter 11 protection in April 2010 in the Western District of Tennessee to halt the foreclosure proceeding.

At the time of the bankruptcy filing, the apartment complex—the debtor’s only asset—was valued at $5.4 million. FNMA was owed $8.6 million. Apart from FNMA, the debtor’s only creditors were its former accountant and lawyer, who were owed approximately $740 and $1,600, respectively, on an unsecured basis.

The debtor’s proposed chapter 11 plan classified FNMA’s secured claim into one class, while creating two separate classes of unsecured claims. The first class of unsecured claims contained FNMA’s deficiency claim (approximately $3.2 million). The other unsecured class contained the claims of the lawyer and the accountant, which totaled approximately $2,340.

Under the plan, FNMA was to receive deferred cash payments in respect of its $5.4 million secured claim for 10 years, secured by a mortgage on the property with slightly modified terms. At the expiration of the 10-year period, FNMA would receive a balloon payment from the proceeds of a mortgage refinancing. With respect to FNMA’s unsecured deficiency claim, the plan proposed to pay FNMA deferred cash payments for 10 years, with any remaining balance to be paid from the proceeds of the mortgage refinancing. The separately classified unsecured claims of the lawyer and the accountant were to be paid in full, but in two equal installments 30 and 60 days after the plan’s effective date.

Prior to voting on the plan, FNMA offered to acquire the claims of the lawyer and the accountant at 100 cents on the dollar, payable immediately. The lawyer and the accountant rejected the offer.

FNMA voted to reject the plan with respect to its secured and unsecured claims. The lawyer and the accountant voted in favor of the plan.

The bankruptcy court confirmed the plan. Among other things, the court ruled that: (i) the class consisting of the lawyer and accountant claims was impaired due to the 60-day payment delay; and (ii) because that impaired class voted in favor of the plan, the plan satisfied section 1129(a)(10).

FNMA appealed to the district court, which vacated the confirmation order and remanded the case below for a determination whether the debtor proposed the chapter 11 plan in good faith. The bankruptcy court found that the plan was proposed in good faith, reasoning that the debtor was “economically justified in rationing every dollar” under the plan. However, after the district court again vacated and remanded the ruling, the bankruptcy court ultimately lifted the automatic stay to permit FNMA to continue its foreclosure proceeding and, sua sponte, dismissed the debtor’s chapter 11 case. The district court affirmed those rulings, and the debtor appealed to the Sixth Circuit.

The Sixth Circuit’s Ruling

Even though the rulings below involved relief from the automatic stay and dismissal of the debtor’s chapter 11 case, the Sixth Circuit addressed two different, albeit related, issues on appeal: (i) whether the lawyer and accountant class was impaired for purposes of section 1129(a)(10); and (ii) whether the debtor proposed its chapter 11 plan in good faith, as required by section 1129(a)(3).

Addressing the first issue, the Sixth Circuit joined the Fifth and Ninth Circuits in holding that “Section 1124(1) by its terms asks only whether a plan would alter a claimant’s interests, not whether the debtor had bad motives in seeking to alter them.” Instead, the court wrote, the debtor’s motives “are expressly the business of § 1129(a)(3).” According to the Sixth Circuit, because section 1129(a)(3) expressly requires an inquiry into the debtor’s motives in proposing a plan, “there is no reason to graft that inquiry onto the plain terms of § 1124(1).”

The Sixth Circuit faulted the bankruptcy court’s good faith finding. In concluding that the debtor’s chapter 11 plan was feasible, the Sixth Circuit explained, the bankruptcy court found that the debtor would have more than sufficient cash on the effective date to pay off its minor unsecured claims immediately. Moreover, the Sixth Circuit wrote, the fact that the lawyer and the accountant were closely allied with the debtor “compounds the appearance that impairment of their claims had more to do with circumventing the purposes of § 1129(a)(10) than with rationing dollars.” The purported rationale underpinning good faith evaporated completely, the court noted, when the accountant and the lawyer rejected FNMA’s offer to pay their claims in full immediately.

Remarking that “the minor claims’ impairment was transparently an artifice to circumvent the purposes of § 1129(a)(10),” the Sixth Circuit affirmed the district court’s rulings.

Outlook

With Village Green, three circuits have now staked out the position rejecting any distinction between economically driven and artificial impairment for purposes of section 1129(a)(10). Under this view, if one or more claims are impaired in accordance with the plain meaning of section 1124, regardless of whether the claims are “materially or adversely affected”—a concept from prior law that was rejected in enacting section 1124—a class containing the claims which votes in favor of a plan can satisfy the impaired class acceptance requirement for confirmation of a cramdown chapter 11 plan. Artificial impairment under these authorities, however, is relevant in assessing whether a debtor has proposed its plan in good faith.

Interestingly, at the district court level, the debtor made two arguments that the Sixth Circuit did not consider on appeal. First, the debtor argued that elimination of the cash-out provision in section 1124 in 1994 had the effect of broadening the definition of impairment, thereby undermining the Eighth Circuit’s rule in Windsor that artificial impairment and the debtor’s “motives in creating the impaired class” are relevant for purposes of section 1129(a)(10). See Village Green I, GP v. FNMA, 523 B.R. 581, 591–92 (W.D. Tenn. 2014), aff’d, 2016 BL 20874 (6th Cir. Jan. 27, 2016). The district court rejected this argument, noting that the debtor “has not persuaded the Court that the 1994 amendments to § 1124 have any bearing on the issue of whether the plan impaired the de minimis claims without justification.”Id.

Second, the district court downplayed the debtors’ argument that artificial impairment essentially results in “single asset real estate cases [being] judged by a different standard than any other business Chapter 11 case.” According to the district court, the debtor “must demonstrate some economic justification for delaying payment to the de minimis creditors,” failing which, based on the totality of the circumstances, and thus not a generalized rule for single-asset real estate cases, the debtor will be found not to have proposed its plan in good faith. Id.

Finally, in the ABI Commission Report, the commissioners recommended that acceptance by at least one impaired class should not be required as a condition to confirmation of a chapter 11 plan and that section 1129(a)(10) should be removed from the Bankruptcy Code. The commissioners were skeptical of the policy considerations attributed to the provision, noting that, “given the variation in class composition and the different motives and objectives of creditors, a non-accepting class does not necessarily equate to lack of creditor support for the plan.” ABI Commission Report p. 258. The commissioners debated the advantages and disadvantages of the “gating role served by section 1129(a)(10),” but ultimately determined that “the potential delay, cost, gamesmanship, and value destruction attendant to section 1129(a)(10) in all cases significantly outweighed its presumptive gating role.” Id. at p. 261.