The Chapter 11 Plan
The goal of any Chapter 11 bankruptcy is to propose a viable plan of reorganization that is fair to both the debtor and its creditors. The Chapter 11 process to seek plan confirmation is much more rigorous than in a Chapter 13. The requirements to confirm a plan are set out in Section 1129 of the Bankruptcy Code. The biggest difference between Chapter 11 and Chapter 13 confirmation is the requirement of Chapter 11 debtors to obtain creditor approval of their plan. Don’t worry. This doesn’t mean the debtor is at the mercy of its creditors. To meet confirmation requirements under Section 1129(a)(10), the debtor only needs one (1) class of impaired claims to vote in favor of the plan.
How Do Classes of Claims Work?
Creditors in a Chapter 11 Plan are broken into different classes based on the types of claims they hold. Typically creditors with similar claims and rights will be lumped into one class together. For instance, a manufacturing business may have a first and second mortgage on its factory location and commercial loans on its delivery trucks. Since this business is going through a short-term liquidity problem, it will also have a few hundred thousand dollars of unsecured trade debt built up that it has trouble servicing. The mortgage lenders will each be put in their own classes. Mortgage Lender #1 could be put it, for example, Class 1, and the second mortgage holder could be put in Class 2. If the value of the real property is less than what is owed to the first mortgage company, we could use the plan to strip-off – or cancel – the second mortgage and convert their claim to an unsecured claim. The second mortgage holder will now have a deficiency claim that will be paid the same as other unsecured creditors. The commercial truck lender could be designated as Class 3. The unsecured creditors, including all trade creditors, business credit cards, and deficiency claims, could be Class 4. Class 5 would typically be the equity security holders of the reorganized business. Each class will have unique language that explains how they will be paid back under the Plan.
If a Class Has More Than One Creditor, How Are Votes Counted?
As we discussed earlier, one of the most important milestones to achieve in a Chapter 11 case is to get one impaired class to vote for your plan. For a class to be impaired, its rights under the Plan must be modified from the original contractual terms in a way that results in less benefit to the creditor. For instance, the hypothetical manufacturer from our previous scenario could not offer the commercial truck lender of Class 3 a better deal than it bargained for outside of bankruptcy to garner a vote in favor of the plan. Classes of creditors that are not impaired are automatically considered to consent to plan approval.
So now that we know what an impaired class is, next we need to know how to count votes of a class with dozens of creditors, such as the Class of general unsecured creditors. To get an approval of a class of impaired claims, the debtor must have more than one half in number and two-thirds in amount of claims vote in favor of the plan. In simple terms, 51% (not half, but MORE THAN half) of that class must vote for the plan. In the case of 10 voting creditors, 6 must vote in favor of the plan. If these 10 creditors hold $1,000,000 in claims, 6 creditors with claims totaling ~$666,666.67 (rounding up) must vote in favor of the plan. This prevents a large number of small creditors from taking over a plan. Fortunately, the debtor only counts the creditors that actually cast a vote. Creditors who do not vote are not tallied one way or another UNLESS they are the only creditor in that class. For instance, if a secured creditor in its own class does not vote for the plan, many districts, including the Northern District of Georgia, do not count silence as acquiescence.
Cramming Down Creditors and What Happens When a Class Rejects the Plan
Cram-down is a bankruptcy term that usually refers to a secured creditor’s claim being reduced or “crammed down” to the value of the collateral its claim secures. For example, if a debtor owns real property worth $1.2 million with a $2 million mortgage and can prove that the property is only worth $1.2 million, the debtor can reduce the principal balance of the bank’s claim to $1.2 million. The bank will then be left with a $1.2 million mortgage and an $800,000 deficiency claim (the bank can now vote in the unsecured creditors’ class as well). The debtor can also adjust the interest rate and extend the life of the loan out many years beyond the original maturity date.
Cramming down unsecured creditors simply means paying them less than the full value of their claims. If all classes of claims do not vote for the Plan, you must proceed under Section 1129(b) of the Bankruptcy Code – often colloquially referred to as the “Cram-Down” Section. In order to confirm the plan under this section, the debtor must prove that the plan is fair, equitable, and does not discriminate against a class of creditors.
For instance, if there are two or more creditors of the same class and one of those creditors receives a significantly lower recovery than the others of the same class, that could be considered discriminatory treatment. Similarly, if two classes are so similar that the court thinks they should receive the same recovery, it could block confirmation until the plan is amended to treat those two classes the same.
Cram-Down of Secured Creditors
To be treated fairly and equitably, a secured creditor must retain the liens securing their claims to the same extent and priority as existed prior to the petition date to the extent of the value of their claim and must receive deferred cash payments equal to the value of their collateral. In plain English, this means that the secured creditor remains a secured creditor and must receive regular payments that will equal the present value of its collateral. So in the case of our hypothetical mortgage holder and manufacturing debtor, if the real property is worth $1.2 million, it would be fair and equitable to treat that mortgage as a $1.2 million mortgage with a market rate of interest amortized over a reasonable period of time taking into consideration the risks the creditor originally bargained for. It would not be fair and equitable to extend an interest-only variable note with a 5-year maturity date to a 30-year fixed note. A debtor could, if the court approved, extend a 10-year commercial mortgage to 20 years at a slightly lower interest rate.
Cram-Down of Unsecured Creditors
If a class of unsecured creditors does not vote in favor of the Plan, the Plan must pay them 100% of the value of their claims or the owners of the debtor business cannot retain an interest in the reorganized debtor under the plan unless they contribute ‘new value’ to the plan. New value can take many forms and is a topic for another day. Just take note that getting the approval of a debtor’s unsecured creditors is always top priority in seeking plan confirmation. This is called the absolute priority rule, and many cases have been fought over this issue.
Other Confirmation Issues
For a Chapter 11 Plan to be confirmed, it must past the “best-interest of creditors test.” This simply means that creditors under the plan must receive as much as they would if the business were liquidated in a Chapter 7. The plan must also be “feasible,” and the court can take up the issue of feasibility on its own to ensure the debtor does not fail shortly after confirming a plan. Courts will look at the debtor’s monthly operating reports to determine if the business is making enough money to service the reorganized debts under the plan.