In a recent decision welcomed by creditors, the United States District Court for the Eastern District of North Carolina reversed a bankruptcy court order confirming a Chapter 11 debtor’s plan because the debtor engaged in “obvious gerrymandering” in order to secure the votes necessary to obtain confirmation of the plan.
In CW Capital Asset Management, LLC v. Burcam Capital II, LLC, the debtor, Burcam Capital II, LLC (“Burcam”), owned a commercial real estate development in Raleigh, North Carolina. CW Capital Asset Management, LLC (“CWC”) was the servicer of two purchase money deeds of trust on the property, and the debtor’s only secured creditor. In its initial proposed Chapter 11 plan, Burcam divided its unsecured claims into two classes – a class of general unsecured creditors and a second unsecured class for small claims (a so-called “convenience class”). Although the plan proposed to pay all creditors in full, CWC filed a motion to dismiss the bankruptcy case on the basis that the plan was not confirmable under statutory requirements of the Bankruptcy Code.
While CWC’s motion to dismiss was pending, the voting period to accept or reject Burcam’s proposed plan continued to run. During the voting period, CWC purchased 16 of the unsecured claims, representing nearly 70% of the general unsecured class. CWC subsequently cast rejecting ballots for its newly purchased claims. The only two unsecured claims to vote in favor of the plan were held by insiders of the debtor (who likely benefitted from reorganization more than non-insiders), and the remaining unsecured creditors failed to cast votes.
CWC’s rejecting ballots prevented Burcam from obtaining at least one impaired class of creditors voting to accept the plan. Realizing its hopes of obtaining confirmation were thwarted, Burcam obtained a continuance of the confirmation hearing and used the additional time to file a modified Chapter 11 plan. The modified plan created a third class of unsecured claims consisting entirely of the claims purchased by CWC. In other words, Burcam grouped all of the unsecured “no votes” into a new class. The debtor proposed to treat CWC’s newly purchased unsecured claims as claims secured by an additional deed of trust on the property securing CWC’s original claims with payment at 3.75% interest over ten years. By peeling off CWC’s unsecured claims from other general unsecured claims, Burcam was able to secure the requisite accepting vote from another impaired class of unsecured creditors, and obtained confirmation of the modified plan through cramdown over CWC’s objection. In addition to confirming the modified plan, the bankruptcy court denied CWC’s motion to dismiss the Chapter 11 case, finding Burcam had a “legitimate business justification” for separately classifying CWC’s unsecured claims from other general unsecured claims held by trade creditors because the debtor’s desire to continue doing business with the trade creditors made it imperative to pay their claims faster than CWC’s claims.
a. Impermissible Gerrymandering
CWC appealed the confirmation order to the district court, which reversed and remanded the case for further proceedings in the bankruptcy court. The district court ruled the bankruptcy court committed clear error when it found Burcam established a legitimate business justification for separately classifying CWC’s unsecured claims from the trade creditors’ unsecured claims. The sole evidence presented by Burcam to support separate classification was “self-serving” testimony from the debtor’s principal that the debtor wanted to keep trade creditors happy and continue using them for future business and did not have a similar reason for paying CWC on favorable terms because CWC was a large institutional creditor that could afford to receive payment over a longer period of time.
The district court agreed that in some circumstances paying a trade creditor more quickly than a large institutional creditor may constitute a legitimate business purpose for separate classification of claims. In this case, however, the court found “substantial evidence of gerrymandering” by the debtor. Declaring the bankruptcy court’s findings to be clearly erroneous, the district court noted Burcam’s failure to classify trade creditors separately from other unsecured claims in its original plan. The court also pointed out that the very trade creditors whose happiness was touted as vital to the debtor’s ongoing, reorganized business failed to cast any ballots regarding the original plan and appeared disinterested in the case.
b. Improper Treatment of Similar Claims
On appeal, Burcam also took the position that unsecured creditors are not created equal, and that the claim holder’s position and/or identity is a determinative factor in the classification and treatment of claims under a Chapter 11 plan. Burcam argued in favor of paying the “little guy” unsecured claims (the trade creditors) before the “big guy” unsecured claims (the institutional creditor) because their respective relationships with the debtor and interests were dissimilar. The district court rejected Burcam’s argument.
Under the Bankruptcy Code, claims may be grouped into the same class under the plan if the claims are substantially similar. The identity of the claim holder generally is not a factor. Further, the district court aptly noted the nature of a claim is unaltered by assignment. When CWC purchased the unsecured claims, the claims remained general unsecured debts owed to trade creditors. CWC’s purchase of the claims did not change the nature of the obligation. Therefore, because the trade creditors’ general unsecured claims were substantially similar to CWC’s unsecured claims, separate classification was improper.
c. Issues on Remand
While the district court’s opinion was a victory for the secured creditor, the last chapter in the Burcam saga has yet to be written. CWC requested that the district court reverse with instructions to the bankruptcy court to dismiss the entire Chapter 11 case. However, the district court deemed an instruction of dismissal “premature,” and tossed out a possible arrow for the debtor’s quiver on remand. Stating that its decision may seem inequitable to a debtor who is attempting to pay its debts in full through Chapter 11, the court ventured beyond what was necessary to render its opinion and suggested that, on remand, the debtor may want to challenge CWC’s rejecting ballots as being filed in bad faith for the sole purpose of blocking confirmation.
On the whole, the district court’s decision is positive for creditors. While CWC’s strategy of purchasing unsecured claims may backfire if Burcam establishes on remand that CWC’s rejecting ballots were cast in bad faith, the opinion nevertheless should subject Chapter 11 plans to heightened scrutiny when they segregate classes of similar claims seemingly for the purpose of gerrymandering votes for confirmation.