On February 26, 2013, the US Court of Appeals for the Fifth Circuit issued an opinion in an adversary proceeding relating to the Chapter 11 single-asset real estate case of Village at Camp Bowie I, L.P., affirming the bankruptcy court's order confirming the debtor's plan of reorganization. The debtor artificially impaired a class of unsecured trade creditors for the purpose of cramming the plan down on the objecting secured lender. The Fifth Circuit joined the US Court of Appeals for the Ninth Circuit in holding that section 1129(a)(10) of the Bankruptcy Code does not distinguish between discretionary and economically driven impairment in confirming cramdown plans.

In 2004, the debtor, Village at Camp Bowie I, LLC acquired a parcel of real estate in Fort Worth, Texas that included unimproved land and several buildings that the debtor leased out as retail and office space. The debtor invested $10 million of its own equity capital and issued short-term promissory notes secured by the property to finance the balance. Through a series of bank mergers, Wells Fargo National Bank (Wells Fargo) acquired the notes, which were originally scheduled to mature on January 22, 2008. Because occupancy rates at the property were low, the debtor was unable to pay off the notes and entered into modification agreements that postponed the maturity date. On February 11, 2010, the debtor defaulted on the notes as they came due. The debtor and Wells Fargo then entered into a series of forbearance agreements. When the final forbearance period expired on July 9, 2010, Wells Fargo sold the notes at a discount to Western Real Estate Equities, L.L.C. (Western), which immediately brought non-judicial foreclosure proceedings against the debtor. The debtor filed for Chapter 11 relief on August 2, 2010, the day before the scheduled foreclosure sale.

On the petition date, the outstanding principal on the notes was over $32 million. Additionally, the debtor owed about $60,000 in unsecured prepetition debt to 38 miscellaneous trade creditors. On August 10, 2010, Western filed a motion for relief from the automatic stay. The bankruptcy court did not lift the stay because it concluded that the debtor had some equity in its property. It then determined that the property had a value of $34 million.

The debtor filed its original plan of reorganization on November 29, 2010 and later, after a series of amendments and modifications, filed its modified second amended plan. The modified plan contained only two impaired classes eligible to vote. One class consisted of Western's secured claim and the other consisted of the unsecured trade debt. Under the plan, Western would receive a new five-year note in the amount of its secured claim, with interest and a balloon payment due at maturity. The class of unsecured trade claims would be paid in full within three months of the plan's effective date, without interest. The debtor's equity owners would make a capital infusion of $1.5 million in exchange for newly-issued preferred stock.

All of the unsecured trade creditors voted to accept the plan, while Western voted its much larger secured claim against the plan. The bankruptcy court confirmed the cramdown plan, while acknowledging that the debtor had the cash flow to pay off the trade claims in full at plan confirmation. Doing so would have left the trade creditors unimpaired. Western appealed to the Fifth Circuit.

The main issue before the Court was whether a court may confirm a cramdown plan if it was only approved by an artificially impaired class. Under section 1129(b) of the Bankruptcy Code, a court may confirm a cramdown plan if it:

(See Practice Note, Chapter 11 Plan Process: Overview: Confirmation of a Plan: Cramdown Plans).

Courts are split over whether artificial impairment can be used to meet the cramdown requirement of section 1129(a)(10) of the Bankruptcy Code that one impaired class approves a plan.

The Fifth Circuit affirmed the bankruptcy court's confirmation of the plan. Western argued that the debtor had sufficient cash flow to pay off the trade creditors in full at confirmation but, by spreading the payments over three months with no interest, the debtor's plan minimally impaired a class of friendly creditors solely to meet the requirements of section 1129(a)(10) of the Bankruptcy Code. Alternatively, it argued that the debtor's artificial impairment of the trade claims was an abuse of the bankruptcy process in violation of section 1129(a)(3), which requires that a plan be proposed in good faith.

Under section 1129, a court may confirm a cramdown plan if it has been accepted by at least one class of claims impaired under the plan. Under section 1124 of the Bankruptcy Code, a plan impairs a class if it alters the legal, equitable and contractual rights of the claim holders. The Fifth Circuit noted that the circuits are split over whether section 1129(a)(10) distinguishes between artificial and economically driven impairment. The US Court of Appeals for the Eighth Circuit has recognized impairment only to the extent driven by economic need (see In re Windsor on the River Associates., Ltd., 7 F.3d 127 (8th Cir. 1993)). In contrast, the Ninth Circuit has held that section 1129(a)(10) does not distinguish between artificial and economically driven impairment, but suggested that artificial impairment could offend a plan proponent's duty of good faith (see In re L&J Anaheim Associates, 995 F.2d 940 (9th Cir. 1993)).

In affirming the bankruptcy court's confirmation of the plan, the Fifth Circuit adopted the Ninth Circuit's approach, reasoning that the plain language of section 1124 provides that any alteration at all of a creditor's rights constitutes impairment. The Fifth Circuit refused to read a materiality requirement and a motive inquiry into the statute. Therefore, it held that the debtor's impairment of the trade creditors' rights, despite its ability to pay them off at confirmation, was enough to satisfy the requirement of an impaired accepting class under section 1129(a)(10).

The Fifth Circuit next examined the debtor's good faith requirement under section 1129(a)(3), noting that when a plan is proposed with the honest and legitimate purpose to reorganize and has a reasonable hope of success, the good faith requirement is satisfied. The Fifth Circuit ruled that the bankruptcy court did not clearly err in determining that the debtor satisfied the good faith requirement because a single-asset debtor's desire to protect its equity can be a legitimate Chapter 11 objective. It noted that an inference of bad faith might be stronger in a case where a debtor creates an impaired class by borrowing from a related party, especially if there is evidence that the transaction is a sham.

This case suggests that, in the Fifth Circuit:

This decision has several implications in single-asset real estate cases in the Fifth Circuit. It shifts negotiating leverage to owners of distressed real estate and away from holders of secured mortgage debt by facilitating the cram down of reorganization plans on oversecured single-asset lenders. However, it may not have any impact on undersecured single asset lenders, if these lenders hold substantial unsecured deficiency claims which allow them to control the outcome of the vote in the unsecured creditor class. To counteract the effects of this decision, oversecured single-asset lenders should consider the following strategies:

This decision also has implications outside of single-asset real estate cases in the Fifth Circuit. By having the ability to artificially impair a friendly class of creditors, debtors can improve their chances of confirming cramdown plans in complex Chapter 11 cases where it is sometimes difficult to find an impaired accepting class.

Finally, this decision makes clear that the good faith requirement of section 1129(a)(3) of the Bankruptcy Code remains available to protect an objecting creditor from an abusive cramdown situation. However, the issue of bad faith requires a fact-specific inquiry.

For more information on confirming cramdown plans, see Practice Note, Chapter 11 Plan Process: Overview.