The primary creditor (an undersecured lender) objected to the debtors’ proposed plan of reorganization on various grounds, including that the plan violated the “absolute priority rule,” its deficiency claim was improperly put in a separate class from other unsecured creditors, the plan was not feasible, and in essence the plan involved a sale of the property which meant that the lender had a right to submit a credit bid.
The debtors consisted of a group of approximately 30 limited liability companies that held undivided interests in property as tenants in common (debtor TICs). As a group the debtors held ~86% of the ownership of the property, and there were at least four additional tenants in common (non-debtor TICs) that owned the remaining ownership interests.
The proposed plan of reorganization was opposed by a lender owed ~$27 million secured by a first mortgage on the property. Since the property was valued at $21 million, the lender was treated as having a secured claim for $21 million and an unsecured deficiency claim of $6 million. Its deficiency claim was placed in a separate class (Class 5) from the other general unsecured claims (Class 4). Class 4 included claims totaling ~$43,000, and in the court’s view was the sole impaired class that voted to accept the plan.
In considering whether the plan was confirmable, the court expressed several areas of concern. One issue was whether the plan violated the “absolute priority rule.” Under Section 1129(b)(2)(B)(ii), if rejecting unsecured creditors are not paid in full, equity owners generally are not entitled to retain anything on account of their interests. However, under existing precedent (including the Supreme Court case of 203 N. LaSalle Street Partnership) if there is a contribution of sufficient “new value” equity holders may be allowed to receive equity in the reorganized debtor.
Among other things, LaSalle requires that the amount of new value be “market tested.” The Supreme Court left open what must be done to satisfy this requirement, although it mentioned options might include giving others the right to make competing bids or to file competing plans. In this case the debtors argued that it was sufficient that the exclusivity period had expired for one of the debtors so that the lender could have proposed a competing plan. However, exclusivity had not expired for some of the other debtors, so that the lender did not have an option to propose a competing plan in all of the cases. Thus, filing a competing plan was not a realistic optoin.
The debtors also attempted to rely on testimony by a workout consultant. To say that the court was not impressed would be an understatement (the witness had “some unexplained involvement with a couple of bankruptcies that he could not name them,” etc.). The court was also not impressed with the “desultory effort” made to find an outside investor, contrasting it with significantly more extensive activities in various other cases.
In sum, the court held that the debtors had to show “that the new money offered is the most and best reasonably obtainable after some ‘market testing’ in order to cramdown over the objections of a non-consenting class of unsecured creditors,” and the debtors did not carry their burden.
With respect to classification, the court noted that if the lender’s deficiency claim was not separately classified from the general unsecured claims, given the size of its claim it would be able to block approval (since approval requires both majority in number and two-thirds in amount of the claims in the class). Thus, the debtors were required to come up with a business justification to support their gerrymandering of the vote.
They offered the justification that there was a guarantee of the lender’s claim. While acknowledging that at least one court (the 9th Circuit) has held that the existence of a guarantee can be grounds for separate classification, the bankruptcy court agreed with other decisions that the mere existence of a guarantee is not determinative and that there must also be a showing that the guarantor is solvent so that the guarantee is meaningful. The court found that the debtors did not meet their burden to support the separate classification, characterizing the debtors’ evidentiary showing on the strength of the guarantee as “so thin as to be almost non-existent.”
As a fallback position, the debtors argued that a third class consisting of the claims of Ford Motor Credit Co. for ~$9,700 secured by a truck provided the required class approving this plan. Under the plan, Ford would receive 24 monthly payments with interest at a very competitive rate. The court questioned the reasons for purchasing the truck (since the property was already in foreclosure at the time) and for impairing the claim (since there were hundreds of thousands of dollars on deposit in the debtors’ operating account).
The court concluded that this was an instance of “artificial impairment” and was an impermissible form of gerrymandering in that it was designed solely to create a consenting impaired class. Thus the debtors did not have even one consenting impaired class, and the court questioned whether the plan was proposed in “good faith.”
Yet another area of concern was the debtors’ ability to implement the plan as proposed. The sources of postpetition funding identified by the debtors required 100% control of the TIC interests as a condition of funding. However, only 86% of the TICs were in bankruptcy. The debtors proposed to deal with the non-debtor TICs as a class under the plan of reorganization. However, that class rejected the plan.
The debtors also argued that they had obtained control of all TIC interests through exercise of a “call option” under a tenants in common agreement. However, the court’s analysis was that the debtors did not meet the pre-conditions for exercising the option.
Further, the court tended to agree with the lender’s argument that attempting to extinguish the rights of non-consenting non-debtor TICs over non-estate property for no consideration might constitute an unconstitutional taking of property without due process. In the court’s view, adjudication of what appeared to be a lynchpin of the plan was months and maybe even years away, calling into question the viability of the plan.
The lender also attempted to characterize the plan as a disguised sale, and consequently argued that it was entitled to do a credit bid. The plan involved restructuring from a series of limited liability companies into a single LLC, which in turn became the junior member of a new LLC which included the entities contributing capital. The debtor characterized the transaction as infusion of new capital in return for shares of the reorganized debtor, but the court acknowledged that it could also be described as a sort of sale of the TICs.
In the absence of definitive precedent, the court decided that the test of whether there was a “sale” was whether there was “an attempt to pry off the creditor’s lien onto cash or other identifiable proceeds, such as in a ‘free of liens’ sale.” In that context, allowing the lender to make a credit bid made sense. However, that was not the case here, so the court rejected the lender’s argument.
The bottom line was that the court found that the plan could not be confirmed based on violation of the absolute priority rule, the unjustified separate classification of the lender’s deficiency claim, and the fact that there was no valid consenting impaired class. Since there was no reason to think these issues could be resolved in the foreseeable future and the case had already been pending for over a year, the court granted the lender’s request for relief from the automatic stay.
Developing a confirmable plan in the context of a real estate bankruptcy over the objections of an undersecured mortgagee can be a real challenge. If there is a large deficiency claim, it is likely that it will be difficult to obtain an accepting class of creditors since (1) if the deficiency cannot be separately classified the lender can block acceptance by unsecured creditors, and (2) often there will not be any other classes that can serve as the accepting impaired class.