Third Circuit Favors Cramdown’s ‘Flexibility’ and ‘Rough Justice’ Over Strict Enforcement of Subordination Agreements
According to the appeals court, this “pragmatic approach” allows for flexibility in the plan negotiation and confirmation process while sufficiently protecting the interests of subordination agreement beneficiaries through application of section 1129(b)(1)’s cramdown requirements. When cramdown plans play with subordinated sums, a comparison of similarly situated creditors is tested through a more flexible unfair discrimination standard. Absent from the decision, however, is any guidance as to how much worse off a dissenting class must be to prevail on an “unfair discrimination” objection to a chapter 11 plan. The Court chose to leave that question unaddressed, concluding only that “nine-tenths of a percentage point . . . is, without a doubt, not material.”
Given the breadth of the decision, the dynamics between senior and junior debt holders have been altered and the likelihood of diminished distributions to senior holders has increased.
Questions for the Court of Appeals and the Decision
The procedural history leading to the Court’s decision is long and contentious. In short, Tribune’s confirmed chapter 11 plan (the Plan) allocated payments under certain prepetition subordination agreements to various classes of unsecured claims. The Plan distributed these subordinated payments among all unsecured creditors (other than the contractually subordinated noteholders) in order to achieve equal recoveries among the unsecured classes. Had the plan strictly enforced the subordination agreements, however, certain unsecured creditors would not have been entitled to share in the payments.
The holders of senior unsecured notes (the Senior Noteholders) who (i) stood to receive a greater recovery under strict enforcement of the subordination agreement and (ii) comprised their own unsecured class, voted against the Plan, which the Delaware bankruptcy court confirmed over their objection in 2012.
After eight years of litigation and multiple appeals, the questions addressed in the opinion authored by Judge Ambro of the Court of Appeals were as follows:
First, does Bankruptcy Code section 1129(b)(1) require that prepetition subordination agreements be strictly enforced in chapter 11 plans? The appeals court answered “no.”
Second, did the Plan “unfairly discriminate” against the Senior Noteholders by allocating a portion of subordinated payments to other unsecured creditors? The appeals court’s answer was, again, “no.”
Subordination Agreements Need Not be Strictly Enforced in a Chapter 11 Plan
The Senior Noteholders argued the Plan should not have been confirmed because it did not strictly enforce the prepetition subordination agreements at issue. The relevant provisions of the Bankruptcy Code are sections 510(a) and 1129(b)(1).
Section 510(a) provides “[a] subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law.”
Section 1129(b)(1), often referred to as the “cramdown” provision, in turn provides that a non-consensual plan may be confirmed “[n]otwithstanding section 510(a)”, so long as the plan otherwise complies with section 1129(a) and “does not discriminate unfairly, and is fair and equitable,” with respect to each impaired, dissenting class (such as the Senior Noteholders).
While the Senior Noteholders contended that section 1129(b)(1) cannot be read to interfere with section 510(a)’s enforcement of subordination agreements, the Court agreed with the lower courts and rejected this argument as running contrary to the plain language of section 1129(b)(1). The Court relied on its prior interpretations of the phrase “notwithstanding” to mean “in spite of” or “without prevention of obstruction from or by” and concluded that section 1129(b)(1) “overrides § 510(a) because that is the plain meaning of ‘[n]otwithstanding.’”
The Court found further support for its conclusion in the purpose of section 1129(b)(1)’s cramdown requirements, which, in this Court’s view, is to “provide the flexibility to negotiate a confirmable plan even when decades of accumulated debt and provide ordering of payment priority have led to a complex web of intercreditor rights.”
As a result, section 510(a)’s mandate for rigid enforcement of subordination agreements can be replaced with section 1129(b)(1)’s more flexible “unfair discrimination” test, the mechanism for ensuring fair treatment among classes of similarly situated creditors when a class is “crammed down.” Thus, the Court proceeded to consider whether the Plan unfairly discriminated against the Senior Noteholders.
The Plan Did Not Unfairly Discriminate Against the Senior Noteholders by Allocating a “Small Portion” of their Contractual Subordination Payments to Other Unsecured Creditors
When the Delaware bankruptcy court considered the Senior Noteholders’ unfair discrimination objection, it compared their actual Plan recovery of 33.6% to their recovery had the subordination agreements been strictly enforced – 34.5% – and concluded the 0.9% difference was not sufficiently material to be considered unfair discrimination.
The Senior Noteholders argued that this analysis was fundamentally flawed. Most notably, they contended that the bankruptcy court erred in relying on a comparison of the Senior Noteholders’ actual Plan recovery to their expected recovery if the subordination agreements were strictly enforced. Instead, the Senior Noteholders contended, the bankruptcy court should have conducted a “class-to-class” comparison, considering the difference between the Senior Noteholders’ recovery before allocating the subordination payments and the actual Plan recoveries to the other class of unsecured creditors. According to the Senior Noteholders, their proposed alternative methodology would have resulted in a recovery-gap much larger than 0.9%.
After a lengthy analysis, the Court rejected the Senior Noteholders’ arguments and affirmed the bankruptcy court’s conclusions. The Court promoted a “pragmatic” approach that favors “flexibility over precision”, resembling its analysis of the interplay between sections 1129(b)(1) and 510(a). The Court recognized that a plan can treat different classes differently or discriminate, but may not do so unfairly. According to the Court, the unfair discrimination test “becomes one of reason circumscribed so as not to run rampant over creditors’ rights.”
Moreover, while the Court conceded that the class-to-class comparison between the preferred class and the dissenting class endorsed by the Senior Noteholders is the most common and preferred approach, it acknowledged that alternative methods may also be appropriate in a bankruptcy court’s determination of the magnitude of the harm to the dissenting class. Unfair discrimination is determined from the perspective of the dissenting class. The Court concluded that “[i]n cases where a class-to-class comparison is difficult . . . a court may opt to be pragmatic and look to the discrepancy between the dissenting class’s desired and actual recovery to gauge the degree of its different treatment.”
The Court found that the facts here supported the bankruptcy court’s “pragmatic” approach, particularly since a class-to-class comparison would have been difficult and complex under the circumstances, requiring the bankruptcy court to consider and determine whether each sub-category of unsecured debt was entitled to subordination payments. Because unsecured claims other than the Senior Notes consisted of an interest rate swap claim, retiree claims, and trade debt, this would have been a difficult undertaking in an already complex and hotly contested plan confirmation proceeding.
Thus, the Court affirmed the Delaware bankruptcy court’s analysis, concluding the 0.9% difference in the Senior Noteholders’ recovery was the appropriate consideration for deciding whether the Plan unfairly discriminated against the Senior Noteholders. Having reached that determination, the Court summarily concluded that 0.9% was simply not a large enough difference to support the Senior Noteholders’ claim of unfair discrimination, noting that, because the claims of the Senior Noteholders class were significantly larger than the other class of unsecured creditor claims, the allocation of subordinated payment had a minimal and non-material effect on the Senior Noteholders. The Court expressly and conspicuously declined, however, to provide any further guidance as to what that materiality threshold should be, stating:
What constitutes a material difference in recovery when analyzing the effect of a plan on the dissenting class is a distinct and context-specific inquiry. We do not address the outer boundary of that inquiry here. where it may lie, the nine-tenths of a percentage point difference in the Senior Noteholders’ recovery is, without a doubt, not material.
The interplay between section 510(a)’s ratification of prepetition subordination agreements and 1129(b)(1)’s “cramdown” provision appears to be a matter of first impression for appellate courts. In fact, the Court was able to cite only a single bankruptcy decision considering the issue. See In re TCI 2 Holdings, 428 B.R. 117, 141 (Bankr. D.N.J. 2010) (“The phrase ‘[n]otwithstanding section 510(a) of this title’ removes section 510(a) from the scope of 1129([b])(1)[.]”).
Though the Court’s literal interpretation of the phrase “notwithstanding section 510(a)” is unsurprising, it nevertheless creates additional uncertainty for funded debt trustees and noteholders about ironclad enforcement of their contractual intercreditor arrangements in the context of a chapter 11 plan.
Senior debt holders who are entitled to be paid ahead of contractually subordinated creditors pursuant to a subordination agreement now need to closely review and scrutinize their treatment under a proposed chapter 11 plan.
The Court’s decision does not, however, entirely strip subordination agreements of their weight. Outside of a cramdown scenario, section 510(a) continues in full force. And even inside the cramdown scenario, senior creditors continue to have 1129(b)(1)’s protections against unfair discrimination, a meaningful safeguard against egregious disregard of prepetition subordination agreements. In other words, if a chapter 11 plan attempts to disregard a prepetition subordination agreement in a way that materially alters a senior creditor’s recovery, that creditor will retain its ability to oppose the plan on the grounds of unfair discrimination.
The Court left it to the bankruptcy courts to decide what level of discrimination is sufficiently material to be declared “unfair.” While funded debt trustees and bondholders should expect to see chapter 11 debtors test that outer boundary, it is not unexpected that less than a full percentage point failed to meet the materiality threshold.
More interesting for the cramdown landscape, however, is the significant flexibility this decision affords chapter 11 debtors and bankruptcy courts in conducting an unfair discrimination analysis. While most creditors would expect (as did the Senior Noteholders) that an unfair discrimination analysis would require comparison of recoveries between similarly situated classes, the Court validated the Delaware bankruptcy court’s alternative method of comparing the Senior Noteholders’ recoveries under alternative scenarios, namely their actual Plan recovery vs. their recovery under a strict enforcement of the subordination agreement.
In short, the Court promoted pragmatism and flexibility in the cramdown context, calling unfair discrimination “rough justice” that “exemplifies the Code’s tendency to replace stringent requirements with more flexible tests that increase the likelihood that a plan can be negotiated and confirmed.” Funded debt trustees and bondholders alike should be prepared for chapter 11 debtors in Delaware and elsewhere to invoke this decision’s endorsement of flexibility and attempt to push boundaries in their treatment of subordination agreements in chapter 11 plans. But as the Court noted, “flexibility is balanced by the Code’s inherent concern with equality of treatment”, and section 1129(b)(1)’s cramdown requirements remain as potent safeguards against, in this court’s words, “run[ning] rampant over creditors’ rights.”
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