After the bankruptcy court denied confirmation of a debtor’s proposed chapter 11 plan of reorganization because there was no accepting impaired class, the debtor proposed an amended plan that placed a mortgagee’s large deficiency claim in one class and claims of other unsecured creditors in a separate “administrative convenience” class.
Acceptance of a plan of reorganization by a class of claims requires approval from holders of both (1) a majority in number and (2) two-third in amount of the claims in the class. Generally an undersecured mortgage claim is treated as a secured claim to the extent of the value of the collateral and an unsecured claim to the extent of the deficiency. Thus, if (a) a mortgagee has a very large deficiency claim relative to the other unsecured claims and (b) its claim is included in a single class with other unsecured creditors, the mortgagee will be able to block acceptance (i.e., since the class will not approve the plan by two-thirds in amount).
Under the initial plan of reorganization proposed by the debtor, there was a single class of unsecured creditors that was the only impaired voting class. The mortgagee’s claim of ~$975,000 was voted to reject the plan. As a consequence, the court denied confirmation since no voting impaired class accepted the plan. (As a technical matter, the court noted that in addition to including the mortgagee’s deficiency claim in the unsecured class, the plan should have included the secured portion of the mortgagee’s claim in a voting secured claim class. The court characterized the vote as a vote by the mortgagee of both its secured claim and its unsecured deficiency claim.)
When the debtor filed an amended plan of reorganization, it created two classes of unsecured creditors: those with general unsecured claims greater than $9,500 – including the mortgagee deficiency claim of ~$837,000, and general unsecured claims of $9,500 or less. The second class purportedly included claims totaling ~$12,500. The obvious objective was to isolate the mortgagee’s claim and create a separate class that would approve.
The debtor attempted to justify this separate classification under Section 1122(b) of the Bankruptcy Code, which authorizes creation of a class “consisting only of every unsecured claim that is less than or reduced to an amount that the court approves as reasonable and necessary for administrative convenience.” Typically this authority is used when there are a large number of very small claims so that dealing with them is burdensome.
However, in this case there were no more than seven general unsecured claims besides the mortgagee. The court did not believe that the debtor demonstrated that it was reasonable and necessary for administrative convenience to create a separate class.
The court also found no other basis for separately classifying the claims. It acknowledged that 6thCircuit precedent (U.S. Truck) had allowed separate classification of union interests because they “differed substantially from those of the other impaired creditors,” even though the debtor acknowledged that the purpose was to create a separate class that would vote in favor of the plan.
In considering whether the separate classification was permissible, the 6th Circuit noted that there had to be a limit on the power to classify creditors separately given the potential for abuse. The court’s conclusion to look to bankruptcy courts to exercise their broad discretion to determine proper classification based on the facts of each case.
This is a critical issue for real estate projects where the mortgage lender is significantly underwater. Note that not all jurisdictions would reach the same conclusion about whether the interests of a mortgagee are sufficiently different from those of other unsecured creditors to justify separate classification. Regardless, this is a battle that will need to be won by a debtor at the bankruptcy court level given that the standard of review will usually be an abuse of discretion.