Bankruptcy Code § 1129(a)(10) provides that in order for a plan proponent to “cram down” - i.e., force acceptance of - a plan of reorganization on a dissenting class of creditors, at least one impaired class of creditors must vote in favor of the plan. Because a plan is often not accepted by all classes entitled to vote, the ability to procure at least one impaired, accepting class in order to cram down a dissenting class is essential in achieving plan confirmation. Section 1124 explains that a class is impaired under a plan unless the plan “leaves unaltered the legal, equitable, and contractual rights” of the claim holders. This expansive definition of “impaired” allows a plan proponent to strategically and purposefully alter the rights of a friendly creditor class in order to artificially create an impaired, accepting class for purposes of § 1129(a)(10).
There is currently a split among the federal courts of appeal as to whether such “artificial impairment” is permissible. The Eighth Circuit analyzes the motives of a plan proponent and draws a distinction between artificial and economically driven impairment under § 1129(a)(10), prohibiting the former and allowing the latter. See Matter of Windsor on the River Assoc., Ltd., 7 F.3d 127 (8th Cir. 1993). In contrast, the Ninth Circuit has held that any alteration, no matter how minor, in a creditor’s rights constitutes impairment under § 1124 and § 1129(a)(10) regardless of the plan proponent’s motives in doing so. See Matter of L&J Anaheim Assoc., 995 F.2d 940 (9th Cir. 1993).
Last week in Western Real Estate Equities, L.L.C. v. Village at Camp Bowie I LP (In re Village at Camp Bowie I LP), 12-10271, 2013 WL 690467 (5th Cir. Feb. 26, 2013), the Fifth Circuit affirmed the bankruptcy court’s decision1 that a plan of reorganization proposing to pay unsecured trade creditors in full over a three month period after the effective date without interest could be considered permissible impairment under Bankruptcy Code § 1129(a)(10), allowing the Debtor to cram down acceptance on the dissenting secured lender. Further, the Fifth Circuit held that such “artificial impairment” is not per se bad faith, and may in fact be a legitimate strategy to permit a single-asset debtor to protect its equity. In so doing, the Fifth Circuit joined the Ninth Circuit, and expressly rejected the Eighth Circuit, in holding that the ability to artificially create an impaired, accepting class remains a viable tool to effectuate a cram down on a senior secured lender or other dissenting creditor class.
Western Real Estate Equities involved a partially developed parcel of real estate in Fort Worth, Texas (the “Property”). Prior to bankruptcy, Western Real Estate Equities LLC (“Western”) purchased the senior secured debt with the intent of taking over ownership of the Property. Immediately after acquiring the notes, which were already in default, Western posted the Property for a non-judicial foreclosure sale under Texas law, and the Debtor immediately filed its Chapter 11 petition to stay the foreclosure proceedings.
In the Chapter 11 case, the Debtor’s plan designated only two voting, impaired creditor classes: one consisting of Western’s secured claim and the other consisting of unsecured trade debt. Under the plan, Western would receive a new five-year note in the amount of its secured claim, with interest accruing at 5.84 percent per annum and a balloon payment of the remaining principal and accrued interest due at maturity. The plan also proposed to pay the trade creditors in full within three months from the effective date, without interest. Finally, the plan provided that the Debtor’s pre-petition owners and related parties would make a capital infusion of $1.5 million in exchange for newly issued preferred equity.
Every unsecured trade creditor voted to accept the plan, but Western voted its much larger secured claim against acceptance of the plan. The Debtor then attempted to cram down acceptance of the plan on Western. The Bankruptcy Court then considered whether the Debtor had met the cram down requirements under § 1129.
Western objected to confirmation of the plan and argued that the Debtor had artificially impaired the trade claims solely to create an accepting impaired class, pointing to the undisputed fact that the Debtor had the cash flow to pay off the trade claims in full at plan confirmation but instead chose to pay them out over a three-month period. In the alternative, Western argued that the Debtor’s tactics constituted an abuse of the bankruptcy process that violated the good faith requirement of § 1129(a)(3). Although agreeing that the Debtor had the financial ability to leave its trade creditors unimpaired, the bankruptcy court rejected both Western’s § 1129(a)(10) and § 1129(a)(3) arguments and confirmed the plan. The bankruptcy court reasoned that, in a single asset reorganization case like the one at bar, “the only way around control of the reorganization by the debtor’s lender . . . is through impairment and an affirmative vote of a class of unsecured creditors who will typically have small claims that could be readily satisfied through full payment with interest.” In re Village at Camp Bowie I, L.P., 454 B.R. 702, 709 (Bankr. N.D. Tex. 2011). For an in-depth summary of the bankruptcy court decision see Weathering the Storm: Bankruptcy Court Permits Minimal Artificial Impairment and Applies Investment Band Approach to Determine the Cram-Down Rate Under Till.
Western then appealed the bankruptcy court’s decision directly to the Fifth Circuit and again argued that the Debtor could not artificially impair the class of trade creditors solely to create the impaired accepting class necessary to satisfy § 1129(a)(10) and that doing so also violated the good faith requirement of § 1129(a)(3). On appeal, the Fifth Circuit upheld the bankruptcy court’s decision. The Fifth Circuit began its analysis by acknowledging the split among the circuits, but expressly and emphatically rejected the Eighth Circuit’s decision in Windsor. Instead, the Fifth Circuit sided with the Ninth Circuit’s holding that § 1129(a)(10) does not distinguish between discretionary and economically driven impairment. The Court reasoned that the definition of “impairment” in § 1124 was entirely devoid of any inquiry as to motive or materiality and “the Bankruptcy Code must be read literally, and congressional intent is relevant only when the statutory language is ambiguous.” (original emphasis). “By shoehorning a motive inquiry and materiality requirement into § 1129(a)(10),” the court explained, “Windsor warps the text of the Code, requiring a court to ‘deem’ a claim unimpaired for purposes of § 1129(a)(10) even though it plainly qualifies as impaired under § 1124.”
The Fifth Circuit similarly rejected Western’s theory that artificial impairment constitutes bad faith as a matter of law, stating that the theory has “no basis in the Code or our precedents.” The Court even stated that a single-asset debtor’s desire to protect its equity can be a legitimate Chapter 11 objective. The court, however, was careful to clarify that it was not holding that “a debtor’s methods for achieving literal compliance with § 1129(a)(10) enjoy a free pass from scrutiny under § 1129(a)(3).” As an example, the court suggested that “[a]n inference of bad faith might be stronger where a debtor creates an impaired accepting class out of whole cloth by incurring a debt with a related party, particularly if there is evidence that the lending transaction is a sham.” In any event, the court held that § 1129(a)(10) was a fact-specific inquiry within the purview of the bankruptcy court, which, in this case, did not abuse its discretion in finding that the Debtor had proposed its plan in good faith.
Accordingly, at least in the Fifth and Ninth Circuits, the ability to artificially create an impaired, accepting class remains a viable tool to effectuate a cram down on a senior secured lender or other dissenting creditor class.