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The Toolbox: Cramdown and the Absolute Priority Rule Under Section 1129(b)

Feb. 4, 2015, 7:48 PM

After the last couple of columns it makes sense to address cramdown under Section 1129(b) of the Bankruptcy Code (the “Code”). 111 U.S.C. § 101 et seq. So that’s what I’ll talk about this month.

Section 1129(b) states:

  • (b)(1) Notwithstanding Section 510(a) of this title, if all of the applicable requirements of subsection (a) of this Section other than paragraph (8) are met with respect to a plan, the court, on request of the proponent of the plan, shall confirm the plan notwithstanding the requirements of such paragraph if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.
  •    (2) For the purpose of this subsection, the condition that a plan be fair and equitable with respect to a class includes the following requirements:
  •     (A) With respect to a class of secured claims, the plan provides—
  •      (i)(I) that the holders of such claims retain the liens securing such claims, whether the property subject to such liens is retained by the debtor or transferred to another entity, to the extent of the allowed amount of such claims; and
  •       (II) that each holder of a claim of such class receive on account of such claim deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property;
  •      (ii) for the sale, subject to Section 363(k) of this title, of any property that is subject to the liens securing such claims, free and clear of such liens, with such liens to attach to the proceeds of such sale, and the treatment of such liens on proceeds under clause (i) or (iii) of this subparagraph; or
  •      (iii) for the realization by such holders of the indubitable equivalent of such claims.
  •     (B) With respect to a class of unsecured claims—
  •      (i) the plan provides that each holder of a claim of such class receive or retain on account of such claim property of a value, as of the effective date of the plan, equal to the allowed amount of such claim; or
  •      (ii) the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property, except that in a case in which the debtor is an individual, the debtor may retain property included in the estate under Section 1115, subject to the requirements of subsection (a)(14) of this Section.
  •     (C) With respect to a class of interests—
  •      (i) the plan provides that each holder of an interest of such class receive or retain on account of such interest property of a value, as of the effective date of the plan, equal to the greatest of the allowed amount of any fixed liquidation preference to which such holder is entitled, any fixed redemption price to which such holder is entitled, or the value of such interest; or
  •      (ii) the holder of any interest that is junior to the interests of such class will not receive or retain under the plan on account of such junior interest any property. 211 U.S.C. § 1129(b).

“Cramdown” is an often-misunderstood term. Clients often think it is a universally available device for forcing a Chapter 11 debtor’s will on recalcitrant creditors. 3Cramdown of secured creditors occurs in Chapter 12 and 13 pursuant to Sections 1225(a)(5)(B) and 1325(a)(5)(B) respectively. There is no provision for “cramdown” of unsecured creditors in those Chapters because it is unnecessary. In fact, cramdown refers only to confirmation of a plan of reorganization that has been accepted by the required majority vote 4Note that a class that receives nothing under a plan is deemed to vote against the plan and must be crammed down. 11 U.S.C. § 1126(f) and (g). A question exists about a class that doesn’t vote. Compare Heins v. Ruti-Sweetwater, Inc. (In re Rudi-Sweetwater, Inc.), 836 F.2d 1263, 10th Cir. with Bell Rd. Inv. Co. v. M. Long Arabians (In re M. Long Arabians), 103 B.R. 211, B.A.P. 9th Cir.; the former holds that a class in which no creditor votes is deemed to accept, the latter holds that the class does not accept (generally accepted as the correct view). of fewer than all classes of impaired creditors and equity holders. Because cramdown automatically brings into play the absolute priority rule, it often has serious adverse consequences for the debtor and its owners.

Let us begin with the absolute priority rule. The absolute priority rule in Section 1129(b) is a codified version of a court-made doctrine in old equity receiverships first enacted in Chapter X and its predecessor, Section 77B, of the former Bankruptcy Act. 5See Bankruptcy Act of 1898, ch. 541, 30 Stat. 544 (repealed 1978). Chapter X required that in order for a plan to be confirmed, it had to be “fair and equitable.” The courts construed the words “fair and equitable” as requiring giving full force and effect to the legal order of priority among claims: in other words, the plan had to meet the requirements of the “absolute priority rule.” Under the absolute priority rule as developed and applied in Chapter X, a plan had to provide full (i.e., 100% present value economic) return to senior debt (or equity) in order to provide any return to more junior claims (or equity interests). Thus, priority debt had to be paid before any return to unsecured creditors, senior unsecured creditors (if, e.g., one class of bond claims was subordinated to another) had to be fully satisfied—by cash or by notes or other consideration having a present value equal to the creditors’ claims—before any return to junior unsecured creditors, and the latter had to be fully satisfied before any return to equity. This rule applied to all plans, regardless of how creditors voted. 6A class could effectively “waive” its absolute priority rights only if every member of the class agreed. A single dissenter (or abstainer) in a class of thousands meant the rule would apply. Cf. Section 1129(a)(7)(A)(i). At whatever level value ran out (i.e., the most senior class to receive less than 100% present value for their claims or interests), all junior debt and equity would be wiped out.

In the Code, changes were made to the operation of the absolute priority rule. First, the rule has no application unless an impaired class of creditors or interest holders fails to vote to accept the plan. Second, the absolute priority rule need be satisfied only with respect to the dissenting class.

Thus, if the plan is consensual (i.e., if it satisfies Section 1129(a)(8)), the rule has no application. But if one or more classes of creditors or interest owners vote to reject the plan and confirmation is nevertheless sought (i.e., by cramdown), then, for confirmation to occur (i.e., to effect cramdown), as to dissenting classes the plan must meet, inter alia, the requirements of the absolute priority rule.

Section 1129(b)(1) requires that a plan, to be crammed down, must meet all of the tests of Section 1129(a) except (a)(8) (acceptance by all impaired classes). Note that pursuant to Section 1129(a)(10) at least one class of creditors must accept the plan without counting the acceptances of insiders. As the class must be impaired to vote on the plan, this means the plan proponent must persuade a requisite (Section 1126) majority of non-insiders in one impaired class to vote in favor of the plan.

Section 1129(b) sets specific requirements for cramdown. To be crammed down, a plan must, first, not discriminate unfairly and second, be fair and equitable (i.e., must satisfy the absolute priority rule). Unfair discrimination is not all types of discrimination. For example, in 203 North LaSalle Street Partnership, 7In re 203 N. LaSalle St. P’ship, 126 F.3d 955, 7th Cir., rev’d on other grounds sub nom. Bank of America N.A. v. 203 N. LaSalle St. P’ship, 526 U.S. 434, U.S. (mentioning in note 7 that classification gerrymandering was not under review). See also Bloomberg Law: Bankruptcy Treatise, pt. V, ch. 178 at §B.1.a. (D. Michael Lynn et al. eds., 2014) (noting that although the LaSalle court used a two-factor test to determine whether discrimination was unfair, courts have developed and applied numerous standards to evaluate fairness in discrimination). trade creditors could be treated better than the lender’s deficiency claim because they would be satisfied in full in a liquidation. 8Classification of unsecured claims in Chapter 12 and 13 must not discriminate unfairly. Much of what law there is on unfair discrimination has been developed in Chapter 13. See, e.g., Liberty Nat’l Enters. v. Ambanc La Mesa Ltd. P’ship, (In re Ambanc La Mesa Ltd. P’ship), 115 F.3d 650, 9th Cir. (adopting for Chapter 11 a standard developed in Chapter 13); In re Simmons, 288 B.R. 737, Bankr. N.D. Tex..

As for the “fair and equitable” test—the “absolute priority rule,” Section 1129(b)(2) explains what it includes. The requirements for treating a dissenting class of unsecured creditors in a “fair and equitable” manner (Section 1129(b)(2)(B)) are straightforward: If the plan does not provide members of the class with money or property (including stock, notes, satisfaction in kind, etc.) having a present value (“value, as of the effective date” as determined, in the case of anything other than cash, or a cash equivalent, by the court) equal to the allowed amount of their claims, then no junior (i.e. subordinated) creditor and no equity owner may receive anything under the plan “on account of” its claim or interest. 9See Bloomberg Law: Bankruptcy Treatise, pt. V, ch. 178 at §B.2.b. Section 1129(b)(2)(C) provides a similar definition of “fair and equitable” for holders of senior equity interest (typically preferred stock; note, however, the additional valuation issue posed by Section 1129(b)(2)(C)(i)).

Though the language of Section 1129(b)(2)(B)(ii) appears at first blush to be clear, it has, in one area, given rise to considerable litigation. The issue is whether a class junior to the dissenting class may participate if it provides “new value” in the form of money or money’s worth to acquire an interest in the reorganized debtor. The Supreme Court answered this question in LaSalle by holding that new value could only warrant participation of the class if it did not receive the participation or the right to participate by reason of its claim or interest. 10Bank of America N.A. v. 203 N. LaSalle St. P’ship, 526 U.S. 434, U.S.. See also Bloomberg Law: Bankruptcy Treatise, pt. V, ch. 178 at §B.2.b.iii.

Cramming down a class of secured claims can be complicated. Section 1129(b)(2)(A) offers three alternatives for satisfying the absolute priority rule with respect to a class of secured claims. Note that, since a secured claim deals with collateral, wiping out “junior” claims or interests is not one of the alternatives (a junior lienholder must receive treatment for its secured claim that earns its vote or satisfies Section 1129(b)(2)(A)). Section 1129(b)(2)(A)(ii) deems to be fair and equitable treatment sale of the secured creditor’s collateral, provided that the secured creditor retains its bid-in rights pursuant to Section 363(k); 11Section 363(k) states: “At a sale under subsection (b) of this section of property that is subject to a lien that secures an allowed claim, unless the court for cause orders otherwise the holder of such claim may bid at such sale, and, if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property.” in other words, the plan will be fair and equitable as to a secured creditor class if the class can bid its indebtedness against the collateral in a sale of the collateral. 12The secured creditor may bid up to its full claim, regardless of any bifurcation under Section 506. Section 363(k) enables bankruptcy courts to limit the secured creditor’s bid-in rights for cause in most sales. Although a court may deny a creditor the opportunity to credit bid, this is rare. See Bloomberg Law: Bankruptcy Treatise, pt. V, ch. 178 at §B.2.a.ii. (citing In re Pacific Lumber Co., 2009 BL 207935, 584 F.3d 229, 5th Cir.).

Section 1129(b)(2)(A)(i) provides that a plan is fair and equitable as to a secured creditor class if (1) the creditor retains its lien on the collateral; and (2) the plan provides a stream of payments having a present value (value as of the effective date of the plan) equal to the secured claim (i.e., pursuant to Section 506, the lesser of the allowed amount of the claim or the value of the collateral). 13See Bloomberg Law: Bankruptcy Treatise, pt. V, ch. 178 at §B.2.a.i. Thus, ordinarily “cramdown” of a secured claim under this provision will occur through treatment of the secured claim like a normal mortgage.

However, Section 1111(b) of the Code introduces a twist. This provision allows a class of undersecured creditors to elect to waive its unsecured claim and treat the allowed amount of the claim as secured by the collateral. If this election is made, the collateral cannot be sold later absent agreement of the creditor unless enough proceeds will be received to pay the creditor’s allowed claim in full. Cramdown of a class electing under Section 1111(b) if the collateral is to be sold under the plan (Section 1129(b)(2)(A)(ii)) is effectively automatic, since the election is unavailable under Section 1111(b)(1)(B)(ii) or mooted by Section 1111(b)(1)(A)(ii).

However, application of Section 1129(b)(2)(A)(i) will be different if the secured creditor class makes the election. Because Section 1111(b)(2) means that an electing class will have an allowed secured claim for the full amount of its claim and because that amount will be greater than “the value of [the secured claimant’s] interest in the estate’s interest in [the collateral],” 1411 U.S.C. § 1129(b)(2)(A)(i)(II). the stream of payments constituting fair and equitable treatment of a secured class electing under Section 1111(b) must meet two tests: first, just as with a non-electing class, the stream of payments must have a present value at least equal to the value of the creditor’s collateral; second, because that value is less than the “allowed claim,” the “cash payments [must total in gross amount] at least the allowed amount of such claim.” 15Id
.

Thus, if the claim is paid off in connection with a sale of the collateral, the creditor will receive at least its full allowed claim. For example: assume a debtor owes X $120,000 and the debt is secured by $100,000 in collateral; the interest rate on an obligation necessary to provide present value equal to face is 5% per annum. Therefore, if X elects Section 1111(b)(2) treatment the plan must provide X a stream of payments equal to $100,000 plus 5% per annum interest and the total of the payments, including interest, over the life of the obligation must equal at least $120,000. Moreover, if the collateral is sold (or the debtor repays X by some other means) before the principal and accrued or paid interest total $120,000, the debtor must nevertheless pay X enough to total $120,000. If the collateral appreciates in value, X will retain some of the benefit of that appreciation. Note that the class electing under Section 1111(b) does not have the benefit of the best interest test. 16See 11 U.S.C. § 1129(a)(7)(B).

The third way to satisfy the “fair and equitable” test for a class of secured claims is by providing the class with the “indubitable equivalent” of the class’s secured claims. In Brite v. Sun Country Development, the debtor satisfied a secured debt by transfer of promissory notes in lieu of its real estate collateral. 17Brite v. Sun Country Development, Inc. (In re Sun Country Development, Inc.), 764 F.2d 406, 5th Cir.. It has also been held that a creditor receives the “indubitable equivalent” of its secured claim if its collateral is turned over to it under the plan. In Sandy Ridge Development Corp. v. Louisiana National Bank, the Fifth Circuit Court of Appeals concluded that “[s]ince the value of the [secured creditor’s] secured claim is equal to the value of [its collateral], a plan which provides [the creditor] will realize the indubitable equivalent of [its collateral] will satisfy the requirements of Section 1129(b)(2)(A)(iii)… . [S]ince common sense tells us that property is the indubitable equivalent of itself, this plan satisfies the indubitable equivalent requirement.” 18Sandy Ridge Dev. Corp. v. La. Nat’l Bank (In re Sandy Ridge Dev. Co.), 881 F.2d 1346, 5th Cir.; see also Radlax Gateway Hotel, LLC v. Amalgamated Bank, 132 S.Ct. 2065, U.S.. For further discussion of “indubitable equivalents,” see Bloomberg Law: Bankruptcy Treatise, pt. V, ch. 178 at §B.2.a.iii.

Section 1129(b) provides counsel with a key tool. It is important not only in actual confirmations but as a yardstick to value proposed plan treatments. There, it plays a key role in negotiation of a plan.

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