Wednesday, March 20, 2013

Artificial Impairment of Voting Classes

In order for a Chapter 11 plan to be confirmed, it must meet the requirements of 11 U.S.C. §1129(a), including the requirement that at least one impaired class vote in favor of the plan.  11 U.S.C. §1129(a)(10).  A class is impaired unless the plan leaves all of its legal equitable and contractual rights unaltered.  11 U.S.C. §1124(1).  Recently, the Fifth Circuit Court of Appeals had the opportunity to consider whether a plan could be confirmed where the one impaired class was “artificially” impaired.

In Village at Camp Bowie I, L.P. there was substantial equity in the property, meaning the secured creditor was fully secured.  Knowing that the secured creditor was going to vote against the plan, the debtor placed the unsecured creditors, thirty-eight trade creditors owed $59,398 in a class, which class was deliberately impaired by the debtor, by providing that they would receive full payment not on the effective date, but instead three months later.

Concededly, the debtor had sufficient funds on hand to pay the unsecured creditors in full on the effective date.  Since that class was the only class that accepted the plan, the secured lender, who had acquired the loan with the intent to become the owner of the property, contended that §1129(a)(10) prohibits artificially impairing a class or, in the alternative, that the plan failed the good faith requirement of §1129(a)(3).

After reviewing a split that has divided other circuits, the Court held that the clear language of §1129(a)(10) and the definition of impairment in §1124 permit any type of impairment and refused to adopt the position that it had to be driven by economic need.  It also determined that any motive analysis would be inconsistent with §1123, which gives a plan-proponent discretion to impair a class.

The Court determined that any analysis of motives and methods for achieving compliance with §1129(a)(10) should be scrutinized, if at all, under §1129(a)(3), which imposes upon a plan-proponent a duty to act “in good faith,” and not by any means forbidden by law.  The Court interpreted good faith in light the totality of all of the circumstances, being mindful of the purposes of the Bankruptcy Code, and determined that, when the plan is proposed with the legitimate hope to reorganize, the good faith requirement can be satisfied.

In conclusion, the Court affirmed the Bankruptcy Court’s determination that this plan-proponent acted in good faith, as it had a legitimate purpose of reorganizing, continuing its real estate venture and preserving its significant equity cushion in the property.  The secured creditor did not dispute that the reorganized debtor would be able to meet its obligations or that there was significant equity, relying solely on the argument that artificial impairment constituted bad faith as a matter of law, a position the Court expressly rejected.

This decision adds to the existing circuit split on artificial impairment, throwing important weight behind the Ninth Circuit view, which it followed.

Karen Lee ("Kitt") Turner
Eckert Seamans Cherin & Mellott, LLC
Philadelphia, Pennsylvania

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