On June 24, 2014, the US District Court for the Eastern District of North Carolina, in CWCapital Asset Management, LLC v. Burcam Capital II, LLC, overturned a bankruptcy court's order confirming a plan of reorganization because of "obvious gerrymandering" by the debtor, who segregated all objecting votes into a single class in order to cram down its modified plan on its largest creditor (CWCapital Asset Mgmt., LLC v. Burcam Capital II, LLC, 5:13-CV-278-F, (E.D.N.C. June 24, 2014)).

On June 28, 2012, Burcam Capital II, LLC (Debtor) filed a voluntary Chapter 11 petition. At the time of petition, the Debtor's debts consisted of:

The Debtor initially proposed a plan that would provide full payment to all creditors. This plan divided the unsecured claims into two classes consisting of a class of general unsecured claims and a convenience class of small unsecured claims. CWC filed a motion to dismiss the bankruptcy case on the grounds that the Debtor could not propose a confirmable plan under the Bankruptcy Code. While the motion was pending, CWC purchased sixteen unsecured claims, representing about 68% of the general unsecured claims, and filed objecting ballots on behalf of those claims. Only two of the remaining unsecured creditors voted in favor of the plan and the majority, consisting mostly of trade creditors, did not vote.

Under section 1129(a)(10) of the Bankruptcy Code, at least one class of impaired creditors must vote to confirm a plan. When the Debtor realized that it did not have sufficient votes to confirm the plan, it obtained a continuance of the confirmation hearing. During the continuance, the Debtor modified its plan to create a third class of unsecured claims consisting entirely of the claims purchased by CWC.

CWC argued, among other things, that the Debtor impermissibly created a separate class of "no votes" solely to cram down the plan, despite CWC's ownership of a secured claim representing nearly 80% of the total value of the estate. The Debtor argued that it created the third class because it needed to pay trade creditors faster than claims owned by CWC to maintain business goodwill with these creditors. The bankruptcy court accepted this as a "legitimate business purpose" for the separate classification and confirmed the plan.

CWC appealed the confirmation order to the District Court.

The Court reversed the confirmation order, denied CWC's motion to dismiss and remanded the case to the bankruptcy court for further proceedings. The Court held that the bankruptcy court's legitimate business justification finding for separately classifying CWC's unsecured claims was clearly erroneous and that separate classification was not otherwise permitted under the Bankruptcy Code. Because of "overwhelming evidence" that the Debtor engaged in impermissible gerrymandering, the plan could not be confirmed.

Under section 1122(a) of the Bankruptcy Code, a debtor may place a claim in a class only if the claim is "substantially similar" to other claims of the class. However, similar claims may be classified separately if all claims placed in the particular class are substantially similar. Under Fourth Circuit precedent, a debtor has some flexibility to place similar claims in separate classes, but does not have unlimited discretion to propose a plan that "unfairly creates too many or too few classes, if the classifications are designed to manipulate class voting, or if the classification scheme violates basic priority rights" (quoting In re Bryson Props., XVIII, 961 F.2d 496, 502 (4th Cir. 1992)). Therefore, in order to withstand scrutiny, a debtor must articulate a legitimate business justification to support a separate classification. The Court noted that the Debtor's alleged need to pay trade creditors on a different timetable than other unsecured creditors is the most commonly-offered "legitimate business justification."

Applying a clearly erroneous standard, the Court found that the evidence failed to support the Debtor's purported business justification for separate classification. The Court recognized that in some cases paying trade creditors before larger institutional creditors is a legitimate business justification for separate classification of otherwise similar unsecured claims, especially if different treatment is necessary for an effective reorganization. However, in this case the Court held that any finding that separate classification was necessary to maintain good will with trade creditors was "highly suspect" because:

For these reasons, the Court held that the bankruptcy court's legitimate business finding was clearly erroneous and failed to account for the "substantial evidence of gerrymandering" in this case.

In addition, the Court held that the bankruptcy court's failure to consider the evidence of gerrymandering produced an error of law because it suggested that paying trade creditors more quickly is essentially a per se legitimate business justification. However, this is not the law in the Fourth Circuit, which meaningfully limits a debtor's considerable discretion to classify claims by requiring that a debtor provide documentary or other evidence that separate classification will actually enhance the chances for an effective reorganization.

The Debtor also argued that separate classification was warranted because the modified plan treated CWC-purchased claims and the trade creditor claims differently. Rejecting this argument, the Court explained that different treatment under the plan alone is not enough to warrant separate classification of similar claims and held that both different treatment and a legitimate business purpose are required.

Finally, the Debtor argued that all general unsecured claims are not created equal because it is the claimholder's identity that determines classification and treatment of claims under a plan. Therefore, it reasoned that once CWC acquired the unsecured claims, those claims were no longer "substantially similar" to the trade creditor claims, and the Bankruptcy Code required that they be separately classified. However, the Court rejected this argument and noted that generally it is the nature or legal attributes of the claims themselves, and not the identity of the holders of the claims, that renders claims similar or dissimilar for purposes of classification. The identity of the claimholder alone is not a basis to classify claims. Further, the Court noted that the nature of the claim is not altered by postpetition assignment, and therefore the legal nature of CWC's unsecured claims was the same as the trade creditors' claims.

Debtors should be wary of segregating classes of similar claims, even if they receive different treatment under a plan, as this decision suggests that courts may closely scrutinize a debtor's motives to determine if it designed the separate classification solely for the purpose of manipulating the vote on a plan. Without a legitimate business justification for classifying the claims separately, courts may not confirm the plan.

On balance, this decision is creditor-friendly in that it protected the creditor's right to cast a meaningful vote on the plan. However, because the Court recognized the unfairness of the outcome to the Debtor, who proposed to pay its debts in full under the plan, it offered an alternative remedy. Rather than a "transparent attempt to gerrymander the votes," the Court suggested that the Debtor instead argue on remand that CWC's objecting votes were cast in a bad faith attempt to block confirmation of the plan and seek to designate CWC's votes under section 1126(e) of the Bankruptcy Code (see Practice Note, Disenfranchising Creditors: Designating Votes on Chapter 11 Plans: Designating Votes Cast in Bad Faith).

For more information on confirming a Chapter 11 plan, see Practice Note, Bankruptcy: Overview of the Chapter 11 Process and Timeline of the Chapter 11 Plan Process.