In Loop 76, LLC, the Bankruptcy Appellate Panel for the Ninth Circuit (the “BAP”) recently held that a bankruptcy court may consider whether a creditor received a third party source of payment (e.g., a guaranty) when determining whether that creditor’s claim is “substantially similar” to other claims for purposes of plan classification under 11 U.S.C. § 1122(a). In re Loop 76, LLC, 465 B.R. 525 (B.A.P. 9th Cir. 2012). In Loop 76 LLC, the BAP permitted the separate classification of an unsecured deficiency claim (i.e., the unsecured claim of a secured lender resulting from the deficiency between its total claim and the value of its collateral) where the undersecured creditor held a non-debtor guaranty. This decision, if followed elsewhere, could have a profound impact on the classification of claims in “cramdown” bankruptcy cases---particularly those involving single asset real estate debtors where the debtor’s obligations are guaranteed by third party non-debtors or secured by other non-debtor sources of recovery.

Loop 76, LLC (“Debtor”) defaulted on a $23,125,000 construction loan made by Wells Fargo Bank, N.A. (“Wells”) and secured by the Debtor’s real property asset (the “Property”) and certain non-debtor guaranties. To ward off the appointment of a receiver, the Debtor filed its single asset real estate chapter 11 case in the Bankruptcy Court for the District of Arizona. Soon thereafter, Wells filed a separate action in Arizona state court against the non-Debtor guarantors.

Wells’s aggregate claim exceeded the value of the Property, and therefore its claim was bifurcated into a secured claim and an unsecured deficiency claim. Wells declined to exercise its section 1111(b) option to have its entire claim treated as a secured claim. The Debtor’s Chapter 11 Plan (the “Plan”) classified Wells’s secured claim as a Class 2 claim and, recognizing that Wells would not support its Plan, classified Wells’s unsecured Class 8(B) deficiency claim separately from all of the other unsecured Class 8(A) claims under the Plan. This separate classification allowed the Debtor to obtain the votes of three impaired classes, including Class 8(A), to cramdown the Plan over Wells’s objections.

With respect to the separate classification of claims, Wells argued that its unsecured deficiency claim was “substantially similar” to the Debtor’s other unsecured claims pursuant to section 1122(a), and therefore, separate classification was impermissible. Debtor countered by asserting that Wells’s unsecured claim was different from other claims because it was partially secured by non-Debtor guaranties, thereby affording Wells additional avenues of recovery. The Debtor further asserted that these differences caused rendered Wells’s unsecured claim to have a different legal character as compared to Class 8(A) general unsecured claims, allowing for separate classification. The bankruptcy court agreed with the Debtor, holding that a claimant with a third-party source of repayment for its claim is dissimilar from a claimant who lacks such an alternative source of recovery. Accordingly, the bankruptcy court overruled Wells’s objections and confirmed the Plan. Wells appealed to the BAP.

On appeal, the BAP affirmed the bankruptcy court’s rulings, holding that a determination of whether claims have been properly classified required a two-part analysis. First, the court must determine whether the subject claims are “substantially similar.” If the claims are not similar, then section 1122(a) of the Bankruptcy Code requires separate classification. Second, if the claims are “substantially similar,” then the claims may be classified together, or in separate classes if the court determines that the separate classification is supported by business justifications and not used to gerrymander an accepting class.

Utilizing this analysis, the BAP held that Wells’s Class 8(B) claim was not “substantially similar” to the Class 8(A) claims and, therefore, should be classified separately from the Class 8(A) claims.

In holding that Wells’s unsecured deficiency claim was not “substantially similar” to the Debtor’s other unsecured claims, the BAP held that creditors possessing a separate source of recovery are different or distinct from other unsecured creditors with no similar source. Citing the Ninth Circuit’s opinion in In re Johnston, 21 F.3d 323 (9th Cir. 1994), historical case law under the Bankruptcy Act, and the legislative history of section 1122, the BAP held that the Ninth Circuit permitted a flexible approach to analyzing claim classification issues. Consequently, when analyzing claim classification disputes, a bankruptcy court must not be limited to determining the nature of a claim’s relation to the “assets of the debtor.” Instead, the BAP held that a bankruptcy court should consider third party sources of recovery when analyzing the nature of a claim. Accordingly, the BAP determined that Wells’s pending lawsuit against the guarantors rendered its unsecured deficiency claims distinct from the Debtor’s other unsecured claims.

Finally, the BAP noted that Wells had another option to demonstrate that its deficiency claim was “substantially similar” to the Debtor’s other unsecured claims. In particular, the BAP cited, with approval, to the bankruptcy court holding that a third-party source of recovery may not justify separate classification “if [a secured creditor] could show that it was no longer pursuing the guaranty, or that all of the guarantors were insolvent.” Under these circumstances, “the existence of a guaranty [may not be] an appropriate distinguishing characteristic to render the claims dissimilar.” Wells declined the invitation from the bankruptcy court to demonstrate that it was no longer pursuing guaranty claims or that the guarantors were insolvent. In future cases, undersecured lenders may want to consider submitting evidence as to the collectability of any guaranties as a way to counter attempts to separately classify guaranteed deficiency claims. At the same time, a lender should be cautious in utilizing this approach, as such evidence potentially could be used against the lender in any action to actually enforce or collect on such guaranties.

This holding has substantial implications for undersecured lenders involved in bankruptcy proceedings in the Ninth Circuit. By allowing certain unsecured deficiency claims to be classified separately from other unsecured claims, the BAP’s holding makes it difficult for secured lenders to control a debtor’s impaired unsecured claims class for purposes of voting on a reorganization plan. The good news for undersecured creditors in other jurisdictions, however, is that there is a split of authority among courts on this issue ---some courts have held that the availability of a third party source of recovery does not render a claim separate from other similar claims. See, e.g., In re AOV Indus., Inc., 792 F.2d 1140, 1151 (D.C. Cir. 1986) (holding that classifying together unsecured claims with third party guaranties with unsecured claims without third party sources of payment is appropriate under Section 1122(a)); In re Quigley Co., Inc., 377 B.R. 110, 116 (Bankr. S.D.N.Y. 2007) (holding that tort claimants that had settled with debtor’s parent company should be classified together with tort claimants that had not settled with debtor’s parent company, even though only the settling claimants had a third party source for recovery).