This is the sixth in a series of alerts regarding the proposals made by the American Bankruptcy Institute Commission to Reform Chapter 11 Business Bankruptcies (the “Commission”). This alert covers the Commission’s recommendations regarding Chapter 11 plans of reorganization and Chapter 11 dismissal orders. It discusses the Commission’s proposed changes to plan confirmation and voting procedures, approving settlements contained in the plan, and releasing insiders from liability.

1. Recommended Changes to Confirmation and Voting Requirements.

Creditors are entitled to vote to accept or reject a Chapter 11 plan. Chapter 11 plans generally group creditors into “classes” and often propose different treatment for each class of creditors. Whether these classes “accept” the plan is important because (among other things) creditor support for the plan is determined on a class-by-class basis, and every plan must be supported by at least one impaired (not fully paid) class to be confirmed.

A. “Acceptance” of the Plan by Creditors; Dealing With Claims Buyers.

The Bankruptcy Code currently requires that a class of creditors “accepts” a plan when creditors holding at least two-thirds (2/3) of the dollar amount and holding at least one-half (1/2) of the claims actually voted in that class, vote to accept the plan. In recent years, it has become common for “claims traders” to acquire multiple claims in the same class, thus permitting the traders to vote multiple times.

The Commission believed that, along with other problems created by the current structure, strategic claims purchases had allowed creditors to skew the voting process. To prevent that result, the Commission recommended that the Bankruptcy Code, at Section 1126(c), define a creditor to include related entities, and determine acceptance by counting the creditors – rather than claims – in the class who vote to accept the plan. Specifically, a class would accept the plan if (i) creditors holding at least two-thirds (2/3) of the allowed claims in the class voted to accept, and (ii) more than one-half (1/2) of the creditors in the class voted to accept the plan. A “creditor” for purposes of Section 1126(c) would be defined as a single entity and all of its affiliates (as defined in the Bankruptcy Code) – regardless of how many claims that creditor holds. An exception to this so-called “one creditor, one vote” rule would apply to creditors holding separate claims in different capacities (e.g., one claim as a trustee and one claim as an individual creditor). Those creditors could still be permitted to vote once in each capacity.

B. Eliminate the Requirement That at Least One Impaired Class Vote to Accept a Plan.

Currently, Section 1129(a)(10) of the Bankruptcy Code requires that for a plan to be confirmed, at least one impaired class of creditors must vote to accept the plan. “Impairment” usually means the class would be paid less than what is owed. The Commission recognized that this requirement has led to “significant gamesmanship.” Plan proponents might seek to arrange classes to isolate creditors opposing the plan, or ensure that creditors supporting the plan control the class. The Commission concluded that creditor classes may fail to “accept” a plan as a result of gamesmanship, rather than a lack of creditor support for the plan.

The Commission therefore recommended eliminating Section 1129(a)(10) in its entirety from the Bankruptcy Code. This means a court could confirm a plan even if no class of creditors voted to accept.

C. Giving a Court More Power to Disallow Votes on a Chapter 11 Plan.

Section 1126(e) allows a court to disqualify a vote on a Chapter 11 plan if the vote was not obtained in good faith. Many of the commissioners believe courts are reluctant to take that step. The Commission therefore recommended expanding the description of circumstances that justify disqualifying a creditor’s vote. Under the Commission’s proposed change, the bankruptcy court could also disqualify a party’s vote if that party voted in a manner manifestly adverse to the economic interests of the other creditors in the class.

The Commission concluded that adding the second prong to the Section 1126(e) analysis would “preserve creditor autonomy, but also provide courts with statutory authority to protect the estate and general creditors when a class vote has been infected by a creditor’s conflict of interest.”

D. A Class That Fails to Vote on a Plan Would Be Treated as Rejecting.

Section 1129(a)(8) requires that each class of claims either votes to accept the plan or be “unimpaired.” A plan proponent that fails to satisfy Section 1129(a)(8) may still seek confirmation by complying with the Section 1129(b) requirements, a process commonly referred to as “cramdown.” Currently, some plan proponents include language in the plan stating that classes that fail to vote on the plan are treated as accepting the plan. Courts disagree over whether that type of language is permitted. The Commission recommended amending the Bankruptcy Code to make clear that a class that does not vote on the plan has rejected.

E. Invalidating Prepetition Waivers of Voting Rights.

It is common for creditors to enter into subordination or intercreditor agreements prior to the debtor filing its bankruptcy case. These agreements generally address the priority of payment from proceeds of shared collateral. The agreements may also limit the junior creditors’ rights to take action in a bankruptcy case, including for example, the right to (i) request adequate protection, (ii) participate in post-petition financing, (iii) foreclose on the collateral, or (iv) vote on a plan. Section 510(a) of the Bankruptcy Code provides that such agreements are enforceable in bankruptcy cases. But while courts generally enforce payment terms in subordination or intercreditor agreements, they are divided over whether a creditor should be permitted to waive voting rights prior to a bankruptcy case.

The Commission focused on two competing policy considerations: protecting the private contract rights of non-debtor parties, and protecting the underlying goals of Chapter 11. While the Commission respected the contract rights of private parties, plan voting is not just a creditor issue. As already discussed, procedures for voting affect the debtor too. The Commission was uncomfortable with non-debtor parties entering into prepetition agreements that could harm a debtor’s ability to confirm a plan that will be popular with all creditors.

The Commission recommended that prepetition contractual assignments or waivers of voting rights in favor of a senior creditor under an intercreditor agreement should not be enforced.

2. Proposed Uniform Standard for Approving Settlements and Compromises.

Settlements and compromises play a vital role in the bankruptcy process. In some ways, a Chapter 11 plan represents the debtor’s proposed settlement of all claims against the estate. However, Chapter 11 plans often contain very particular settlements that play a key role in facilitating the debtor’s emergence from bankruptcy. Bankruptcy settlements generally require court approval on notice. However, when the settlements are included in a Chapter 11 plan, the merits of the compromise may get lost in the whirlwind of confirmation activity. Some courts assess plan settlements as part of confirmation without requiring separate evidence to support the agreement. Other courts require separate evidence on the proposed settlement.

The Commission recommended that courts separately evaluate “[a] consensual resolution of a material dispute affecting property of the estate.”

3. Exculpatory Clauses and Third-Party Releases.

Chapter 11 plans often contain provisions that provide limited immunity or releases (exculpation) to the debtor’s directors, officers, professionals, and others with respect to their conduct during the Chapter 11 case. These provisions are different from third-party releases, which may also be included in a Chapter 11 plan. Third-party releases protect the identified non debtor parties (the released parties) from any liability for any claims or causes of action that creditors (the releasing parties) may hold against them. An example would be a release of a guarantor of debtor’s liabilities.

The Commission focused on the difference between the limited protection provided by exculpatory clauses and the more extensive third-party releases. The Commission recommended that exculpatory clauses should generally be permitted, so long as (i) the proposed exculpatory clause and the parties protected by it are clearly disclosed in the plan and disclosure statement, and (ii) the exculpatory clause protects only conduct amounting to simple negligence by the protected parties while participating in the Chapter 11 case before the effective date of the plan.

Third-party releases have been a much more controversial topic in bankruptcy. In a number of high-profile cases, including those of professional firms, the plan has been used to release owners from guaranty or “pass through” liability. Most insolvency professionals agree that a release, granted appropriately, can benefit the plan process, such as when a release allows an individual to put money into the plan, when the individual would otherwise keep the funds to defend against the personal exposure.

The Commission proposed a uniform standard to evaluate when third-party releases are appropriate. That standard would require a bankruptcy court to consider five factors before approving a third-party release:

(1) whether the suit against the non-debtor is, in essence, a suit against the debtor, or will deplete assets of the estate; (2) whether the non-debtor has contributed substantial assets to the reorganization; (3) whether the injunction is essential to reorganization; (4) whether a substantial majority of the creditors agree to such injunction – specifically, whether the impacted class or classes have “overwhelmingly” voted to accept the proposed plan treatment; and (5) whether the plan provides a mechanism for the payment of all, or substantially all, of the claims of the class or classes affected by the injunction.

4. Conclusion.

The Commission believes the sections of the Bankruptcy Code relating to Chapter 11 plan content, voting requirements, and confirmation standards had become vague and a means for abuse of the reorganization process. The Commission’s proposed changes were directed to providing the parties and bankruptcy courts more clarity in what were often conflicting standards governing certain Chapter 11 plan provisions, and allowing flexibility and discretion in considering confirmation of Chapter 11 plans.