In the Matter of: Village at Camp Bowie I, L.P., No. 12-10271 (5th Cir., Feb. 26, 2013)
In a matter of first impression in the Fifth Circuit, the court affirmed the bankruptcy court’s confirmation of a chapter 11 cramdown plan, holding that the creation of an artificially impaired class of creditors was not per se impermissible. Instead, the Court of Appeals concluded that the creation of an artificially impaired class for purposes of satisfying section 1129(a)(10) was more appropriately considered under the fact-specific good faith inquiry set forth in section 1129(a)(3). Here, the court found no clear error in the lower court’s finding that the debtor had not acted in bad faith in creating the artificially impaired class for strategic reasons, and not out of any economic necessity.
The debtor, Village at Camp Bowie I, L.P., owned commercial property in Texas. This property secured first and second notes in favor of secured lenders, the combined outstanding balances of which were approximately $32 million as of the petition date. After the debtor defaulted on the loans, but prior to filing the bankruptcy petition, the institutional lender auctioned off the notes. Western Real Estate Equities, LLC purchased the notes at a discount with the intention of displacing Village as owner. Immediately after acquiring the notes, Western posted the property for foreclosure. The day prior to the foreclosure sale, Village filed for chapter 11 protection. Its schedules identified the existence of more than $32 million in secured claims owed to Western and unsecured trade debt of less than $60,000.
The debtor’s proposed reorganization plan designated two voting-impaired creditor classes – (i) a secured class consisting of Western’s claims; and (ii) an unsecured class consisting of the trade debt. The plan proposed to pay the unsecured creditor class in full within three months of the effective date, without interest. Western would be paid in full over five years at 5.83 percent interest. Western voted against the plan, and the unsecured creditors voted in favor of the plan. At the plan confirmation hearing, Western argued that: (i) the debtor had artificially impaired the unsecured creditors in order to satisfy the cramdown requirement that at least one impaired class approve the plan; and (ii) the debtor’s plan was not proposed in good faith.
The bankruptcy court agreed that the debtor had artificially impaired its trade creditors, but rejected Western’s argument that the acceptance of the plan by the artificially impaired class could not satisfy section 1129(a)(10). In addition, the bankruptcy court rejected Western’s argument that artificial impairment violated the good faith requirement of section 1129(a)(3). Western appealed.
The Fifth Circuit began its analysis by considering the artificial impairment of the unsecured class, and whether the accepting vote of that class could satisfy the requirements of section 1129(a)(10). The court recognized the split between the Eighth and Ninth Circuits as to whether section 1129(a)(10) distinguishes between artificial and economically driven impairment. The Eighth Circuit (in Matter of Windsor on the River Associates, Ltd.) holds that section 1129(a)(10) recognizes impairment only to the extent it is driven by economic "need," while the Ninth Circuit holds that the statutory language requires no particular degree of impairment and permits no inquiry into a debtor’s motivation for creating an impaired class. The court then examined its own precedents, noting that it had yet to stake out a clear position on the question.
The court expressly rejected the Eighth Circuit, and "join[ed] the Ninth Circuit in holding that section 1129(a)(10) does not distinguish between discretionary and economically driven impairment." The court disagreed with the Eighth Circuit’s reasoning, saying, "[b]y shoehorning a motive inquiry and materiality requirement in section 1129(a)(10), Windsor warps the text of the Code, requiring a court to ‘deem’ a claim unimpaired for purposes of section 1129(a)(10) even though it plainly qualifies as impaired under section 1124." It further noted that "Windsor’s motive inquiry is inconsistent with section 1123(b)(1), which provides that a plan proponent ‘may impair or leave unimpaired any class of claims,’ and does not contain any indication that impairment must be driven by economic motives." (Emphasis in opinion.) The court concluded that the statutory provisions "must" be read literally, and doing so here, the court held that an artificially impaired class should be treated no differently from a class impaired as a result of economic necessity.
The court then moved to the question of the debtor’s motives, stating that "a plan proponent’s motives and methods for achieving compliance with the voting requirement of section 1129(a)(10) must be scrutinized, if at all, under the rubric of section 1129(a)(3), which imposes on a plan proponent a duty to propose its plan in good faith." Good faith should be evaluated in light of the totality of the circumstances, bearing in mind the underlying purposes of the Bankruptcy Code. Generally, where a plan is proposed with the legitimate and honest purpose to reorganize and has a reasonable hope of success, the good faith requirement is satisfied.
The court, reviewing the bankruptcy court analysis only for clear error, could not conclude that the court clearly erred. The court affirmed that a single-asset debtor’s desire to protect its equity can be a legitimate chapter 11 objective. The court emphasized, however, that its decision did not circumscribe the factors bankruptcy courts may consider in evaluating good faith questions, and that artificial impairment does not "enjoy a free pass from scrutiny under section 1129(a)(3). Ultimately, the section 1129(a)(3) inquiry is fact-specific, fully empowering the bankruptcy courts to deal with chicanery."
This court removed the question of a debtor’s class impairment motivation from section 1129(a)(10), and placed it squarely in the good faith requirement of 1129(a)(3). Determining good faith is a fact-specific analysis, requiring a court to examine all relevant circumstances. The court noted that "it bears mentioning that Western here concedes that the trade creditors are independent third parties who extended pre-petition credit to the Village in the ordinary course of business. An 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," especially if there is evidence of a sham. In this case, the court disregarded the fact that the accepting class was owed only $60,000 and was artificially impaired by receiving their payments over a three-month period (where the debtor could have paid these creditors in full at the effective date), while Western was owed more than $30 million. Courts in the Fifth Circuit will still analyze artificial impairment cases closely, but this decision makes clear that courts may be able to analyze facts in a light more favorable to debtors.