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Cram Downs and Artificial Impairments – Can a Debtor Rewrite its Own Credit Terms in a Bankruptcy?

It is a principle of credit lending that creditors should charge less in interest if they take on less risk, but can charge more interest (and thus make more profit) if they take on a greater risk. The “secured,” more “senior” creditors of a company (those whose debt is collateralized by some specific property that the company holds, or who would otherwise be first in line to be made whole in a liquidation) are thus in an inherently less risky, and thus less profitable, position. One would think that as long as the creditor is not under-secured (i.e., the value of the assets used as collateral is not less than the amount owed) the creditor would be virtually immune from the risks that other creditors face in a bankruptcy case, right? Ah, but that is not always true.

Consider the cram down (see also on this site here and here).  Bankruptcy law provides that a confirmed plan of reorganization will govern payment of claims (amounts, timing, form, and other terms) of each class of creditors encompassed within the plan.  Where a plan is not accepted by each class of creditors, it may nevertheless be confirmed if (among other things) one impaired class (“impaired” meaning that such creditors will receive less than 100% of their claims) votes to accept the plan.  Thus, they will  “cram down” the other dissenting classes. Sometimes it is a lower-tiered class like general unsecured creditors which rejects a plan that is nevertheless confirmed by cram down. It can happen to secured creditors as well, though. In such instances, a secured lender may end up forced to accept less favorable terms regarding timing and amounts for the discharge of obligations owed to them by the debtor.

To understand how this all works, we should first walk through some basic bankruptcy procedures. When a company chooses to go into chapter 11, it initially has a 120-day period in which it alone is permitted to file a plan of reorganization.  The plan groups creditors into classes.  Ordinarily, a plan of reorganization must be approved by each class.   Each creditor in a class that is impaired is afforded the opportunity to vote, and the vote must come in for approval by over 50% in number of voting creditors and at least 66% in dollar value of the claims held by voting creditors.[i]  When one or more classes vote against the plan, but one impaired class votes in favor of the plan, the plan can be approved through a cram down if certain requirements are met, including that the plan must not “discriminate unfairly” and must offer “fair and equitable” treatment with respect to each impaired class of claims.[ii]

Thus, cram down may allow the debtor to win confirmation of a plan of reorganization even if some of its most powerfully-situated creditors oppose the plan if, speaking summarily, the debtor can persuade the court that the terms are fair and in the best interests of all concerned. In crafting the plan, the debtor can simply delimit one impaired class of creditors that it knows (through negotiation) or hopes will approve the plan, and use that approving class as the cram-down lever to force the plan on other disapproving classes. We note that this approving impaired class need not be significantly impaired, or demonstrably more impaired than the disapproving dissenting classes. In In re L&J Anaheim Associates, the 5th Circuit Court of Appeals held that any impairment, no matter how small, could suffice.[iii]  Some parties decry “artificial impairment,” in which a debtor designs a plan class to be burdened by an arguably token impairment which does not seriously harm recoveries for the creditor(s) in the class but still allows the class to vote and satisfy the voting requirements for the cram-down.

In In Re Village at Camp Bowie I, L.P.,  a dissenting secured creditor appealed the bankruptcy court’s order approving confirmation of a cram-down plan of reorganization, which the creditor argued was based on an “artificial impairment.”[iv]  The Fifth Circuit Court of Appeals rejected the appeal and upheld the bankruptcy court’s ruling. The unfortunate secured creditor, Western Real Estate Equities, held a mortgage on property valued at $34 million that secured the debtor’s obligations to pay $32 million.  Otherwise, the debtor owed a mere $60,000, in toto, to 38 unsecured creditors. The debtor‘s plan proposed to pay the unsecured creditor class in full within 3 months after confirmation, but without interest.  That “impaired” class agreed. Meanwhile, the plan also provided that the far larger secured claim of Western would be paid via a new 5-year 5.83% note, with a balloon payment on maturity – which was very different from the terms of the mortgage and original note.  Even Western, an oversecured mortgage-holder, ended up with its rights and claims to money being tied up far longer than it expected prior to the bankruptcy filing.

The case now serves as a warning to distressed investors—especially regarding single asset real estate companies. Western bought the mortgage with the expectation that Bowie (the debtor) would default, whereupon Western would foreclose and take ownership of the property, thus adding a nice high-profile property to its portfolio. The last-minute bankruptcy filing by Bowie not only disrupted foreclosure, it ultimately left Western with little say in its treatment under the plan (though the treatment it received had to comply with other requirements discussed here). Western found that it had failed in its bid to control and liquidate its collateral, and also that it had to swallow altered credit terms drawn up by the defaulting and bankrupt company!

Sometimes two relatively similar creditor classes can end up with quite divergent outcomes. In In re Creekstone Apartments Associates, L.P. , the court confirmed the debtor’s cram down plan even though it inflicted a 90% haircut on one unsecured creditor class while paying another unsecured creditor class in full.[v] The design was not accidental, and prevailed notwithstanding the requirement that a cram down plan must offer the same treatment for creditors of the same class “unless the holder of a particular claim or interest agrees to a less favorable treatment” of its claim or interest.[vi] The creditor class subjected to the haircut did not agree.  Nevertheless, the court allowed the unequal distribution of payments, reasoning that the creditor receiving full payment was a significant trade creditor, and that its ongoing relationship with the debtor was “critical” for the restructured debtor’s operations.

We note that not all courts would have approved the Creekstone plan. In In re 18 RVC, LLC , the Bankruptcy Court for the Eastern District of New York held that, “[T]he rights of various parties outside of chapter 11–whether in chapter 7 or outside of bankruptcy altogether–are irrelevant…. [C]reditors of equal rank with equal rights within chapter 11, in the absence of a purpose independent of the debtor’s desire to [cram down] an impaired dissenting class … should be classified together.”[vii]

The obvious takeaway here is that investors in distressed properties should know how a cram down could disrupt their well-laid plans, how this added risk should be factored into their overall model, and what strategies they should employ to ensure the greatest amount of leverage should their collateral fall into bankruptcy.

[i]    Classes composed of creditors or equity interest holders who will receive nothing under the plan are called “deemed to reject” classes and do not vote.  The expense and effort to solicit votes from such classes would be a waste.

[ii]   The requirements that the plan must not “discriminate unfairly” and must offer “fair and equitable” treatment with respect to each impaired class of claims or interest are discussed in the articles linked above and in Commercial Bankruptcy Litigation, 2d Edition (Jonathan P. Friedland, Elizabeth Vandesteeg & Christopher M. Cahill eds., 2015) §§ 10: 17-21.

[iii]  In Re L&J Anaheim Associates,99 F.2d 940, 1993 U.S. App. LEXIS 14293 (9th Cir. 1993). Submitted April 5, 1993. Decided May 14, 1993

[iv]   Western Real Estate Equities LLC. v. Village at Camp Bowie I, L.P. (In re Village at Camp Bowie I, L.P.), No. 12-10271 (5th Cir. Feb. 26, 2013). Filed February 26, 2013

[v]   In re Creekstone Apartments Associates, L.P. ([68 B.R. 639 (Bankr. M.D. Tenn. 1994).

[vi]  See 11 U.S.C. § 1123(a)(4).

[vii] In re 18 RVC, LLC, 2012 WL 5336733 (Bankr. E.D.N.Y.  2012).

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Jon Peterson

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