Wednesday, April 4, 2012

9th Circuit Bankruptcy Appellate Panel Permits
Separate Classification of Lender’s Unsecured
Deficiency Claim for Plan Voting Purposes

When a debtor wishes to confirm a Chapter 11 plan, it is required to obtain the acceptance of at least one class of creditors holding impaired claims. In deciding which creditors should be in which classes it is generally required that similarly situated creditors be in the same class for voting purposes. This is a huge issue in real estate bankruptcy cases because, if the secured lender is substantially under-secured with a large unsecured deficiency claim, and if that claim is placed in the same class as the general unsecured creditors, a lender could vote against the plan and insure there is no class of creditors that actually accepts the plan.

In re Loop 76 LLC, B.A.P. 9th Cir. No. 11-1113, the debtor, Loop 76, constructed and developed an office retail complex in Scottsdale, Arizona. It obtained a $23,125,000 construction loan from Wells Fargo secured by the property. Due to tightened credit markets and the downturn of Phoenix area real estate, Loop 76 was unable to find permanent financing to take out the Wells Fargo construction loan. It filed bankruptcy in 2009, by which time the property’s value had declined to approximately $17,000,000, leaving Wells Fargo with a very significant unsecured deficiency claim which far exceeded the amount of other unsecured claims, effectively giving Wells Fargo the ability to cast a blocking vote, since affirmative votes are determined both by the number of votes (more than one-half of the number of creditors) and the dollar amount (more than two-thirds of the total amount).
The debtor proposed alternative treatment for Wells Fargo, one if Wells Fargo selected an 1111(b) election and the other if it did not. If Wells Fargo chose the latter option, the Wells Fargo deficiency would be classified separately from the other unsecured creditors, which would put that class in a position to vote in favor of the plan. While there were other issues raised at confirmation, this post only addresses whether or not the separate classification was appropriate.

The Bankruptcy Court held, and was affirmed on appeal by the Bankruptcy Appellate Panel of the Ninth Circuit (“BAP”), that the Wells Fargo claim was sufficiently distinguishable from the general unsecured creditors that it could be separately classified. Whether a claim is substantially similar for this purpose is a fact-intensive inquiry requiring the evaluation of the nature of each claim. If the claims are not similar then they can be placed in different classes. Even if the claims are substantially similar, they may still be placed in different classes if the debtor can show a business or economic justification for doing so. The appellate court made particular note that these are two separate tests which many other courts have conflated.

Relying on prior Ninth Circuit decisions, the Bankruptcy Court held, and BAP affirmed, that Wells Fargo could be separately classified because it had a third-party source of payment for its deficiency claim through a guaranty which rendered it dissimilar to other unsecured claims. In so holding, the appellate panel specifically rejected Wells Fargo’s argument that, as it related to the debtor and the debtor’s assets, the claims were substantially similar and that the court should not look outside the bankruptcy to the non-debtor source of recovery since, vis-à-vis the debtor, the creditors held similar rights. BAP reviewed cases decided under the prior Bankruptcy Act that limited the similarity analysis to the assets of the debtor, holding such case law would not apply to a case under the current Bankruptcy Code.

This case if followed in other jurisdictions could significantly alter and improve a debtor’s ability to confirm a plan in a single-asset real estate case when there is a substantial deficiency and a third-party guaranty. In this regard, the case may shift the balance of power to debtors and improve their negotiating posture when dealing with a substantially under-secured lender.

Karen Lee (“Kitt”) Turner
Eckert Seamans Cherin & Mellott LLC


  1. This was incredibly helpful, although it seems the gerrymander simply can't be slain for good!

    --W Terry, Los Angeles

  2. Such a excellent article for this topic.... Its very helpful those who are looking for bankruptcy information...