Secured creditors often oppose plans where the only accepting class appears to be one created by the debtor through separate classification of claims when the claims have little in common but their acceptance of the plan and have more in common with other claims. A recent decision by the United States District Court for the Eastern District of North Carolina provides such creditors with additional support in their fight against separate classification.

Under 11 U.S.C. § 1129(a)(10), if any classes of claims are impaired under a chapter 11 plan, one impaired class must vote to accept the plan. Acceptance by one impaired class coupled with rejection by another impaired class triggers application of 11 U.S.C. § 1129(b), often referred to colloquially as the “cramdown” provision. This section gives a bankruptcy court the power to confirm a plan over the objection of an impaired class.

In order to satisfy 11 U.S.C. § 1129(a)(10) and trigger the cramdown provision, debtors often separately classify claims under the plan in such a way so as to create at least one accepting impaired class. Under 11 U.S.C. § 1122(a), claims or interest may be placed into the same class only if “such claim or interest is substantially similar to the other claims and interests in such class.” But this section does not require that substantially similar claims be grouped together. Secured creditors will often oppose attempts by debtors to separately classify their claims from other substantially similar claims, accusing the debtors of “gerrymandering” the classes for the sole purpose of obtaining an accepting impaired class.

In CWCapital Asset Management LLC v. Burcam Capital II LLC, 2014 WL 2864678 (E.D.N.C. June 24, 2014), the debtor owned a large commercial real estate development worth between $17.3 and $18.5 million. CWCapital acted as Special Servicer for the sole secured creditor (the “Servicer”), who was owed approximately $15.1 million. The total amount of unsecured claims was only $46,000. The debtor filed a plan that created two classes of unsecured creditors: a general unsecured class and a small unsecured class. The plan proposed to pay all unsecured creditors in full. In response to the plan, the Servicer filed a motion to dismiss, objected to the plan and purchased claims of certain unsecured creditors equal to approximately 68% of the total amount of unsecured claims. When the Servicer filed the secured creditor’s ballots rejecting the plan, it could not be confirmed since no impaired class had accepted the plan. The debtor filed an amended plan that created two new classes of unsecured creditors: all unsecured claims purchased by the secured creditor and all unpurchased claims. The amended plan proposed to pay the purchased claims over time with interest and to pay the unpurchased claims in full on the effective date. The Servicer objected to this classification, arguing that the classes were created solely for the purpose of manipulating the votes to satisfy 11 U.S.C. § 1129(a)(10). In response, the debtor argued that the claims were separately classified because the unpurchased claims were all trade creditors who the debtor needed to repay quickly. The bankruptcy court found that the debtor articulated a “legitimate business reason” for the classification and overruled the Servicer’s objection. After the bankruptcy court confirmed the amended plan, the Servicer appealed.

The district court reversed the bankruptcy court, holding that the separate classification of the purchased claims from the unpurchased claims was improper under existing Fourth Circuit law. Significantly, the district court found that the bankruptcy court’s finding that the debtor has articulated a “legitimate business reason” for the separate classification was clearly erroneous. The only evidentiary support for this finding was the proffer of debtor’s counsel that the debtor “desired” to pay its trade creditors right away. The debtor’s only witness testified that he had no knowledge of debtor’s negotiations with its trade creditors and did not know whether the proposed plan treatment would enhance or preserve the debtor’s relationships with its creditors. The district court also weighed the lack of evidence against the overwhelming evidence that the debtor engaged in improper gerrymandering. The debtor did not separately classify trade creditors until after the secured creditor bought 68% of the unsecured claims and several of the claims purchased by the secured creditor were claims asserted by trade creditors. While the debtor argued that it no longer had any business reason for paying the purchased claims right away since the secured creditor was the holder, the district court held that the identity of the claimant is not a basis for finding dissimilarity among claims. The district court also held that the post-petition purchase of a claim does not change the nature of the claim itself, so trade creditor claims purchased by the secured creditor remained trade creditor claims for purposed of evaluating classification.

This decision provides support for creditors arguing against separate classification of claims, but also provides guidance to debtors on how to prove as an evidentiary matter the “legitimate business justification” for creating separate classes. The district court’s opinion suggests that testimony by a knowledgeable corporate representative who has discussed payment terms with trade creditors may have helped the debtor show that the trade creditors required prompt payment to continue doing business with the debtor.

On July 16, 2014, the debtor appealed the district court’s decision to the Fourth Circuit so it will be interesting to see how the appellate court addresses these separate classification issues.