Can a Plan of Reorganization Separately Classify a Claim That Is Personally Guaranteed?

Recently, we’ve been seeing debtors try to confirm cram down plans of reorganization that are unfavorable to the secured creditor by “gerrymandering” the class of unsecured claims. The typical situation finds the secured creditor holding an undersecured loan. Under Section 506(a) of the Bankruptcy Code, the secured creditor’s claim is automatically bifurcated into a secured claim in an amount equal to the value of the collateral and an unsecured claim for the balance of the debt.

Here’s an example taken from a recent case that Ben Young, the author of this important article, and I handled. Our litigation partners, and Matt Kenefick, won a long, hard-fought jury trial in a fraudulent transfer case. Matt were victorious on appeal and perfected a judgment lien. The judgment debtor filed a Chapter 11 case, too late to avoid the judgment lien, and scheduled its co-judgment debtors as unsecured creditors. Our client’s claim was larger than the value of the collateral, so our client had both an secured claim and an unsecured claim.

The judgment debtor filed a plan of reorganization that treated our client very unfairly and sought to cram down that plan on our client. To succeed, the judgment debtor needed one class of her impaired creditors to vote for her proposed plan of reorganization. Let’s break down what this means:

• A plan of reorganization is supposed to treat substantially similar creditors alike. As a practical matter, that means that each secured claim is usually placed in its own class, and all unsecured claims are usually lumped together in one unsecured class.

• A debtor may obtain confirmation of its plan despite the negative vote of a class of creditors as long as at least one class of impaired creditors votes for its plan, and the plan itself meets certain other tests.

• A class of claims accepts the plan if creditors holding more than two-thirds in amount and more than one-half in number of the claims in the class vote for the plan, not counting the votes of any insiders.

In our case, the judgment debtor knew that our client’s unsecured claim was more than one-third of all unsecured claims. It also knew that our client would not vote for her plan. The judgment debtor’s clever solution was to argue that our client’s unsecured claim was not “substantially similar” to the other unsecured claims, and that the other claims should be placed in their own class. Since the other claimants were her co-judgment debtors and were friendly, the debtor figured it could get their votes and confirm the plan. Ultimately, Ben, and Matt were able to negotiate a settlement that paid our client’s judgment in full.

It is against this backdrop that Ben’s article on “gerrymandering” claims should be read. Workout professionals should be aware of this tactic and be able to recognize and respond to it.

Can a Plan of Reorganization Separately Classify a Claim That Is Personally Guaranteed?By
Bennett G. Young

Whether a plan of reorganization can classify a secured creditor’s unsecured deficiency claim separately from the claims of other unsecured creditors has been subject to much litigation in the bankruptcy courts. In general, the courts have been hostile to separate classification, giving lenders significant leverage. But what if there is a personal guaranty? Does the existence of a personal guaranty support separate classification of the lender’s deficiency claim? Two recent cases have reached opposite results. Compare Wells Fargo Bank, N.A. v. Loop 76 LLC (In re Loop 76 LLC), 465 B.R. 525 (Bankr. 9th Cir. 2012) (separate classification permitted) and In re 18 RVC, LLC, 2012 WL 5336733 (Bankr. E.D.N.Y. 2012) (separate classification rejected).

The relevance of separate classification is the cramdown power, the key tool in a debtor’s bankruptcy toolbox. In a cramdown, a debtor can force a secured creditor to restructure a secured loan on terms the lender might find extremely objectionable. The debtor can extend the maturity date, reduce the interest rate and change the payment terms.

The gating item to invoking the cramdown power is that the plan must be accepted by one impaired class of creditors. Since there often are only two classes of creditors, the lender and the unsecured creditors the only candidate for the accepting impaired class is the unsecured creditors. Because acceptance requires the affirmative vote of the holders of two thirds of the dollar amount of claims in the class that vote on the plan, if the lender has a large enough deficiency claim, the lender will have a veto and can prevent the unsecured class from accepting the plan. Without an accepting class, there can be no cramdown and a plan cannot be confirmed without the lender’s consent.

Debtors have sought to solve this problem by classifying the lender’s unsecured deficiency claim in its own separate class. If successful, this prevents the lender from controlling the vote in the unsecured class and opens the gate for use of the cramdown power.

Fortunately for lenders, debtor’s efforts to gerrymander votes to gain acceptance of a plan have usually met with little success. The courts generally ask whether the separately classified claim substantially similar to other claims. If it is, the claim cannot be separately classified unless there is a business or economic justification for the separate classification. See, e.g., Steelcase Inc. v. Johnston (In re Johnston), 21 F.3d 323 (9th Cir.1994); Boston Post Road L.P. v. FDIC (In re Boston Post Road L.P.), 21 F.3d 477 (2d Cir. 1994). Using this analysis, the courts have held that a lender’s unsecured deficiency claim is substantially similar to other unsecured claims and that the desire to obtain an affirmative vote on a plan is not a sufficient justification to classify a claim separately. As a result, debtors have generally had a very difficult time succeeding with separate classification.

In Loop 76, the Ninth Circuit Bankruptcy Appellate Panel held that the existence of a personal guaranty rendered the deficiency claim sufficiently unlike other the debtor’s other unsecured claims to permit separate classification. In doing so, the BAP declined to consider whether the lender’s rights against the assets of the debtor were substantially similar to the rights of other creditors. The court rejected that “narrow” approach and considered “sources outside of the debtor’s assets, such as the potential for recovery from a nondebtor or non-estate source.” In re Loop 76 LLC, 465 B.R. at 540. According to the BAP, because a creditor with a guaranty has access to a source of recovery not available to other creditors, the creditor’s claim is not substantially similar and may be separately classified. However, Bankruptcy Judge Bason of the Central District of California declined to follow Loop 76 in In re 4th Street East Investors, Inc., 2012 WL 1745500 (Bankr. C.D. Cal. May 15, 2012) because holding a guaranty is different from having collateral and there was no showing that the guaranty claim was collectible.

The Bankruptcy Court for the Eastern District of New York also rejected Loop 76. See In re 18 RVC, LLC, 2012 WL 5336733. There, the court held that the key question was whether the deficiency claim had the same rights against the debtor’s assets within the chapter 11 as did other creditors: “[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 gerrymander an impaired assenting class … should be classified together.” Id. at *6.

The analysis in 18 RVC appears to be the better approach. The question of whether two claims are substantially similar should be considered solely vis a vis the debtor in the context of the chapter 11 process. Chapter 11 focuses on claims, not creditors, and the classification analysis should focus on whether two claims have similar rights against the debtor. Whether the holder of one claim also has access to other sources of recovery is simply irrelevant to the chapter 11 process. After all, a creditor does not have to reduce a claim against the debtor by amounts recovered from other sources: “The rule is settled in bankruptcy proceedings that a creditor secured by the property of others need not deduct the value of that collateral or its proceeds in proving his debt.” Reconstruction Fin. Corp. v. Denver R. G. W. Ry., 328 U.S. 495, 529 (1946); see Ivanhoe Bldg. & Loan v. Orr, 295 U.S. 243 (1935); National Energy & Gas Transmission, Inc. v. Liberty Elec. Power, LLC (In re National Energy & Gas Transmission, Inc.), 492 F.3d 297 (4th Cir. 2007). If a creditor’s access to other sources of recovery does not affect a matter as fundamental as the amount of the claim, it should not affect classification either.

It is good practice at the outset of each Chapter 11 case to take stock of the bank’s claim and to try to create a path through bankruptcy to the ultimate resolution of the case. If the debtor has been uncooperative, steps can be taken at an early stage to minimize the problems that might arise down the road, such as the “gerrymandering” of the bank’s claim to facilitate a cram down.

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Ben Young is partner at Jeffer Mangels Butler & Mitchell LLP and represents parties in insolvency matters. He has extensive experience in workouts, restructurings, bankruptcies, and assignments for the benefit of creditors. His clients include lenders, financial institutions, secured and unsecured creditors, distressed investment funds, businesses, receivers, special servicers, and creditors’ committees. Contact him at BYoung@jmbm.com or 415.984.9626.dem
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