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23 October 2020
"Cramdown" chapter 11 plans, under which a bankruptcy court confirms a plan over the objection of a class of creditors, are relatively common. Less common are the subset of cramdown plans known as "cram-up" chapter 11 plans. These plans are referred to as such because they typically involve plans of reorganization that are accepted by junior creditors and then "crammed up" to bind objecting senior creditors.
Generally, cram-up plans provide for either: (i) reinstatement of an objecting secured creditor's claim according to the original terms of the debt after curing most defaults—thereby rendering the claim "unimpaired" and depriving the secured creditor of the right to vote on the plan; or (ii) the secured creditor's realization of the "indubitable equivalent" of its claim, which can include, among other things, reinstatement of its debt secured by substitute collateral or abandonment of the collateral to the creditor (referred to in some cases as "dirt for debt"). Here, we briefly discuss the mechanics of chapter 11 cram-up.
Confirmation of cram-up chapter 11 plans involving reinstatement of an objecting secured creditor's claim hinges on the Bankruptcy Code's definition of "impairment." Classes of claims or interests may be either "impaired" or "unimpaired" by a plan. The distinction is important because only impaired classes have the ability to vote to accept or reject a plan. Under section 1126(f) of the Bankruptcy Code, unimpaired classes of creditors and shareholders are conclusively presumed to have accepted a plan.
Section 1124 provides that a class of creditors is "impaired" unless the plan: (i) "leaves unaltered the legal, equitable, and contractual rights" to which each claimant in the class is entitled; or (ii) cures any defaults (other than certain non-monetary defaults specified in section 365(b)(2) of the Bankruptcy Code), reinstates the maturity and other terms of the obligation, compensates the claimant for reasonable reliance damages and certain resulting losses, and does not "otherwise alter the legal, equitable or contractual rights" of each claimant in the class.
Section 365(b)(2) provides that a debtor's obligation to cure defaults under an executory contract or an unexpired lease prior to assumption does not include: (i) cure of ipso facto clauses relating to the debtor's insolvency or financial condition, the bankruptcy filing, the appointment of a trustee or custodian; or (ii) "the satisfaction of any penalty rate or penalty provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease."
By reinstating an obligation and curing defaults under section 1124(2), a plan can "roll back the clock to the time before the default existed." MW Post Portfolio Fund Ltd. v. Norwest Bank Minn., N.A. (In re Onco Inv. Co.), 316 B.R. 163, 167 (Bankr. D. Del. 2004); see also 11 U.S.C. § 1123(a)(5)(G) (providing that a plan shall provide adequate means for its implementation, such as "curing or waiving of any default").
However, this does not mean that reinstatement relieves the debtor of the obligation to pay postpetition interest at the default rate specified in a loan agreement or applicable nonbankruptcy law. See In re New Investments, Inc, 840 F.3d 1137 (9th Cir. 2016); In re Sagamore Partners, Ltd., 620 Fed. App'x. 864 (11th Cir. 2015); In re Moshe, 567 B.R. 438 (Bankr. E.D.N.Y. 2017); see also 11 U.S.C. § 1123(d) (providing that notwithstanding the entitlement of oversecured creditors to collect postpetition interest under section 506(b), the "best interests" requirement of section 1129(a)(7), and the cramdown requirements of section 1129(b), "if it is proposed in a plan to cure a default[,] the amount necessary to cure the default shall be determined in accordance with the underlying agreement and applicable nonbankruptcy law"). As discussed in more detail below, a key point of contention in connection with reinstatement is whether there are any non-curable defaults unrelated to the borrower's financial condition, such as a loan agreement's "change in control" provisions.
For a chapter 11 debtor, reinstatement of a loan may be the preferable strategy if the loan bears an interest rate lower than the prevailing market rate and is otherwise subject to terms (including covenants) that are favorable to the debtor. Reinstatement may also allow the debtor to lock in a loan under favorable terms until post-reorganization financing becomes more available or attractive. Debt reinstatement grew in popularity during the aftermath of the Great Recession, when credit sources dried up and new financing to replace the cheap loans readily available before the recession became prohibitively expensive. It may reprise that role if the COVID-19 pandemic persists and ready sources of low-interest financing once again become scarce.
In order for a chapter 11 place to be confirmed, section 1129(a) of the Bankruptcy Code requires, among other things, that each class of claims or interests either votes to accept the plan or is not impaired (and thus deemed to accept the plan). However, confirmation is possible in the absence of acceptance by impaired classes under section 1129(b) if all of the other plan requirements set forth in section 1129(a) are satisfied and the plan "does not discriminate unfairly" and is "fair and equitable" with respect to each impaired, non-accepting class of claims or interests.
With respect to a dissenting class of secured claims, section 1129(b)(2)(A) provides that a plan is "fair and equitable" if the plan provides for: (i) the secured claimants' retention of their liens and receipt of deferred cash payments equal to at least the value, as of the plan effective date, of their secured claims; (ii) the sale, subject to the creditor's right to "credit bid" its claim under section 363(k), of the collateral free and clear of all liens, with attachment of the creditor's lien to the sale proceeds and treatment of the lien or proceeds under option (i) or (iii); or (iii) the realization by the secured creditors of the "indubitable equivalent" of their claims.
The Bankruptcy Code does not define "indubitable equivalent," but courts interpreting the term have defined it as, among other things, "the unquestionable value of a lender's secured interest in the collateral." In re Philadelphia Newspapers, LLC, 599 F.3d 298, 310 (3d Cir. 2010); accord In re Sparks, 171 B.R. 860, 866 (Bankr. N.D. Ill. 1994) (a plan provides the indubitable equivalent of a claim to the creditor where it "(1) provides the creditor with the present value of its claim, and (2) insures the safety of its principle [sic]"); see generally Collier on Bankruptcy ("Collier") ¶¶ 361.03( and 1129.04[c][i] (discussing the derivation of the concept from In re Murel Holding Corp., 75 F.2d 941 (2d Cir. 1935), and explaining that "abandonment, or unqualified transfer of the collateral, to the secured creditor," substitute collateral and the retention of liens with modified loan terms have been deemed to provide the "indubitable equivalent").
Providing a secured lender with the indubitable equivalent of its claim rather than reinstating the loan, allowing the creditor to retain its liens to secure a restructured loan, or selling the collateral may be the best course of action depending on the circumstances. For example, a chapter 11 debtor might determine that it would be preferable to abandon collateral to a secured creditor because it does not need the property as part of its reorganization strategy or because a sale of the property during the bankruptcy case may not be possible or beneficial. The availability of alternative financing and prevailing interest rates and loan terms at the time of confirmation may also have an impact.
Cable television company Charter Communications ("Charter") filed a prepackaged chapter 11 case in 2009 that proposed to reinstate its senior debt at the interest rate provided for in the prepetition credit agreement (which was below-market at the time) and effectuate a debt-for-equity swap with junior creditors.
The credit agreement between Charter's operating company ("borrower") and its senior creditors included as an event of default any "change in control" of the borrower. A "change of control" was defined as the failure of the borrower's controlling shareholder to retain at least 35% of the company's voting power or the acquisition by any entity or group of more than 35% of the voting power unless the controlling shareholder held a greater percentage.
Charter's chapter 11 plan proposed a settlement with the controlling shareholder, whereby he would retain 35% of the voting power in the reorganized company and receive $375 million in cash, but would retain no meaningful ongoing economic interest in the reorganized Charter. The settlement and the plan reinstated the senior debt under terms favorable to Charter and preserved $2.85 billion in net operating losses that would have been forfeited in the event of a change in control.
The senior lenders objected to Charter's plan, arguing, among other things, that the proposed reinstatement violated the change of control provision because: (i) the credit agreement required the controlling shareholder to retain an ongoing economic interest in addition to a 35% voting interest; and (ii) four of the borrower's junior bondholders would be holding more than 35% in aggregate of the voting power in the reorganized company, and the four bondholders constituted a "group" under federal securities laws.
In In re Charter Commc'ns, 419 B.R. 221 (Bankr. S.D.N.Y. 2009), appeal dismissed, 449 B.R. 14 (S.D.N.Y. 2011), aff'd, 691 F.3d 476 (2d Cir. 2012), the bankruptcy court overruled the senior lenders' objections and confirmed the cram-up chapter 11 plan. The court noted that the senior lenders acknowledged that their objections were premised on a desire to obtain higher interest rates available in the prevailing market. The court further noted that the senior lenders were being paid in full, together with default-rate interest.
The court analyzed the language of the credit agreement and concluded that the requirement that the controlling shareholder retain not less than 35% of the ordinary voting power did not require that he likewise have a commensurate ongoing economic interest in the borrower. The court also determined that the prohibition in the credit agreement of the acquisition of a voting interest exceeding the controlling shareholder by any "group" did not apply to the bondholders because there was no proof that any formal agreement had been concluded among them.
Television company Young Broadcasting, Inc. ("YBI") filed for chapter 11 protection in 2009 intending to sell its assets under section 363(b) of the Bankruptcy Code to a senior lender. YBI later pursued the sale as part of a chapter 11 plan after its business and cash flows improved.
YBI's plan provided for an exchange of all the senior secured debt for equity, $1 million to be distributed to general unsecured creditors, and the distribution of equity warrants to noteholders accepting the plan. A competing plan proposed by YBI's unsecured creditors' committee provided for: (i) reinstatement of the senior secured debt; (ii) a $1 million distribution to general unsecured creditors; and (iii) noteholders' receipt of 10% of the reorganized company's common stock and an opportunity to participate in a rights offering for preferred and common stock.
With YBI's consent, the bankruptcy court considered first whether the committee's plan should be confirmed. YBI's lenders argued, among other things, that reinstatement of their loans was not possible because the plan violated the change of control provision in their credit agreement. That provision mandated that YBI's founder retain control of at least 40% of the company's voting stock, whereas the committee's plan proposed to give the founder stock entitling him to cast 40% of the total number of votes for the reorganized company's board, but only permitted him to elect one of the seven directors.
The bankruptcy court ruled in favor of the senior lenders, finding that the committee's plan did not satisfy section 1124(2) due to the plan's proposal to materially modify the credit agreement's change of control provision. See In re Young Broadcasting, Inc., 430 B.R. 99 (Bankr. S.D.N.Y. 2010). The court rejected the committee's argument that, in accordance with Charter, as long as a plan allows for a "formalistic retention of control," there will be no default under a change of control provision, notwithstanding the shift in economic ownership. According to the court, the benefit of the bargain struck by the lenders and the plain meaning of the credit agreement required the founder to have the power to influence 40% of the composition of the board—not simply the power to cast 40% of the total votes for directors.
The court confirmed YBI's chapter 11 plan instead.
Prior to filing for chapter 11 protection in 2009, satellite communications company DBSD North America, Inc. ("DBSD") had a $51 million first-lien working capital facility with a 13-month term. The loan bore interest at 12.5% per annum (later increased to 16% pursuant to forbearance agreements) payable at maturity and was secured by a lien on substantially all of DBSD's assets.
During the bankruptcy case, one of DBSD's second-lien noteholders purchased the first-lien claim to acquire a blocking position with respect to any DBSD chapter 11 plan. DBSD proposed a chapter 11 plan under which the first lien creditor would receive the "indubitable equivalent" of its claim, in the form of an amended loan facility with a four-year term and payment-in-kind ("PIK") interest at 12.5%. The new loan was secured by a first lien on substantially all of the reorganized company's assets, except for certain auction rate securities and DBSD stock previously pledged by DBSD's parent. The amended facility included a standstill provision restricting the first-lien creditor from enforcing its rights against the collateral, eliminated or loosened certain covenants, and included less restrictive cross-default provisions. The second-lien noteholder class (notwithstanding the first-lien creditor's vote of its second-lien claim to reject the plan) and DBSD's unsecured creditors' committee supported the plan, which provided for a debt-for-equity swap.
The first-lien creditor objected to confirmation and voted against the plan. In addition to disqualifying ("designating") the first-lien creditor's votes because the court found that the creditor acquired its claim in bad faith, the bankruptcy court concluded that the plan was fair and equitable because it provided the first-lien creditor with the indubitable equivalent of its claim under section 1129(b)(2)(A)(iii). See In re DBSD N. Am., Inc., 419 B.R. 179 (Bankr. S.D.N.Y. 2009), aff'd, 2010 WL 1223109 (S.D.N.Y. Mar. 24, 2010), aff'd in part, rev'd in part on other grounds, 634 F.3d 79 (2d Cir. 2011).
In so ruling, the court explained that: (i) the first-lien creditor's claim was comfortably oversecured because the value of the substitute collateral securing its post-confirmation claim vastly exceeded the face amount of the claim; and (ii) the 12.5% PIK interest rate was an appropriate rate of interest for the four-year amended loan facility, given the prevailing low interest rates on treasury securities.
River East Plaza, LLC ("River East") owned a building in Chicago valued at $13.5 million. The property secured a loan from LNV Corporation ("LNV") in the amount of $38.3 million. River East defaulted on the loan early in 2009. LNV commenced foreclosure proceedings, but River East filed for chapter 11 protection shortly before the foreclosure sale was to occur.
The bankruptcy court denied confirmation of River East's initial chapter 11 plan after LNV elected to have its claims treated as fully secured under section 1111(b) of the Bankruptcy Code. In its second proposed chapter 11 plan, River East sought to provide LNV with the indubitable equivalent of its claim by substituting 30-year U.S. Treasury bonds with a face value of $13.5 million for LNV's existing collateral. According to River East, because (at the then-prevailing rate of interest) the value of the bonds would grow in 30 years to equal $38.3 million—the full face value of LNV's claim—the bonds represented the indubitable equivalent of LNV's secured claim within the meaning of section 1129(b)(2)(A)(iii).
The bankruptcy court disagreed, stating "flatly" that a secured creditor electing section 1111(b) treatment cannot be forced to accept substitute collateral. It accordingly denied confirmation of River East's second plan. The court later refused to consider a third plan proposed by River East and dismissed the bankruptcy case. The bankruptcy court certified a direct appeal of its rulings to the Seventh Circuit.
The Seventh Circuit affirmed. See In re River East Plaza, LLC, 669 F.3d 826 (7th Cir. 2012). "Substituted collateral that is more valuable and no more volatile than a creditor's current collateral," the court wrote, "would be the indubitable equivalent of that current collateral even in the case of an undersecured debt." However, the court noted, such was not the case here. According to the Seventh Circuit, the 30-year U.S. Treasury bonds were not the indubitable equivalent of LNV's collateral because: (i) the bonds carried a different "risk profile"; and (ii) they impermissibly stretched out the time period over which LNV would be paid.
The risk profile of the bonds was different, the court explained, because although Treasury bonds carry little default risk, long-term Treasury bonds carry "substantial inflation risk, which might or might not be fully impounded in the current interest rates on the bonds." In addition, River East might default under a plan providing for LNV to retain its lien on the building in a relatively short time period, allowing LNV potentially to realize increased value by foreclosing upon and selling the building. However, the court explained, the value of the Treasury bonds could not be realized for quite some time, regardless of how soon River East defaulted, and would likely be lower at that time due to inflation and/or rising interest rates.
According to the Seventh Circuit, the substitution of the bond collateral was impermissible, but not only because it demonstrated that the bonds were something other than the indubitable equivalent of the building: such an approach would also improperly conflate cramdown under section 1129(b)(2)(A)(iii) with cramdown under section 1129(b)(2)(A)(i). Under the latter, the court explained, cramdown confirmation is possible if a secured creditor retains its lien on collateral, but the maturity of the debt is extended. River East could not both extend the maturity date (by substituting 30-year bonds) under subsection (i) and substitute collateral as an "indubitable equivalent" under subsection (iii). "By proposing to substitute collateral with a different risk profile, in addition to stretching out loan payments," the Seventh Circuit wrote, "River East was in effect proposing a defective subsection (i) cramdown by way of subsection (iii)."
After filing for chapter 11 protection in 2009, RadLAX Gateway Hotel, LLC and an affiliate (collectively, "debtors"), the owners of a failed airport hotel construction project, proposed a liquidating chapter 11 plan under which they would sell substantially all of their assets at auction free and clear of their secured creditor's liens and repay the creditor with the sale proceeds. Rather than allowing the secured creditor to credit-bid under section 1129(b)(2)(A)(ii), the debtors argued that the proposed auction satisfied section 1129(b)(2)(A)(iii) because the proceeds of the auction sale represented the "indubitable equivalent" of the secured creditor's claim.
The Seventh Circuit ultimately disagreed and held that when a debtor proposes to sell assets subject to a lien in a chapter 11 plan, the debtor must comply with either section 1129(b)(2)(A)(i) or section 1129(b)(2)(A)(ii), but may not rely on section 1129(b)(2)(A)(iii). According to the court, the debtor must either: (i) sell the collateral with the secured creditor retaining its liens; or (ii) sell the collateral free and clear of liens, with the liens attaching to the sale proceeds, and permit the secured creditor to credit-bid as part of the sale.
The U.S. Supreme Court affirmed the Seventh Circuit's ruling. See RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 566 U.S. 639 (2012). It concluded that the debtors' reading of section 1129(b)(2)(A)—under which clause (iii) would permit exactly what clause (ii) prohibits—was "hyperliteral and contrary to common sense." Writing for a unanimous court, Justice Scalia explained:
[C]lause (ii) is a detailed provision that spells out the requirements for selling collateral free of liens, while clause (iii) is a broadly worded provision that says nothing about such a sale. The general/specific canon explains that the general language of clause (iii), although broad enough to include it, will not be held to apply to a matter specifically dealt with in clause (ii).
Thus, the Court determined that when the conduct at issue falls within the scope of both provisions, the specific provision presumptively governs, whether or not the specific provision also applies to some conduct that falls outside the general provision. In reaching this conclusion, the Supreme Court noted that section 1129(b)(2)(A)(ii) addresses a subset of cramdown plans and that section 1129(b)(2)(A)(iii) applies to all cramdown plans, including all of the plans within the narrower description in section 1129(b)(2)(A)(ii).
Other notable rulings discussing indubitable equivalence include: In re LightSquared Inc., 513 B.R. 56 (Bankr. S.D.N.Y. 2014) (a chapter 11 plan proposed by a satellite communications company that would provide a first-lien secured creditor, a special purpose entity ("SPE") through which a principal of one of the debtors' competitors had acquired approximately $844 million of the debtors' secured debt, with a note secured by a third-priority lien on existing and new collateral, including the debtors' spectrum assets, did not provide the secured creditor with the indubitable equivalent, where there was enormous disagreement as to valuation and unresolved regulatory hurdles); and In re Colony Beach & Tennis Club, Inc., 508 B.R. 468 (Bankr. M.D. Fla. 2014) (a proposed chapter 11 plan under which the collateral securing the claims of an undersecured lender that elected to have its claim treated as fully secured under section 1111(b) would be sold free and clear of liens in exchange for receiving either payment in an unspecified amount one year or the right to have its collateral transferred back to it did not provide the indubitable equivalent of its claim), aff'd, 2015 WL 3689075 (M.D. Fla. June 12, 2015).
Another category of indubitable equivalence cases involve "dirt-for-debt" exchanges, whereby a secured creditor is given all or part of its collateral under a plan as a way to satisfy the fair and equitable requirement. See generally Collier at ¶ 1129.04[c][i] (noting that courts have generally not approved "dirt for debt" plans). The key issue in such cases is almost always the valuation of the collateral the plan proposes to abandon to the secured creditor. See, e.g., Bate Land Co., LP v. Bate Land & Timber LLC (Bate Land & Timber LLC), 877 F.3d 188 (4th Cir. 2017) (upholding confirmation of a partial dirt-for-debt plan under which the secured lender would be given eight of the 79 tracts of land that originally secured its claim plus postpetition interest in cash, where the "highest and best use" appraisals for the properties indicated that their value exceeded the outstanding principal amount of the debt); In re Nat'l Truck Funding LLC, 588 B.R. 175 (Bankr. S.D. Miss. 2018) (confirming a chapter 11 plan under which the secured creditor had the option of either retaining its liens on the sale proceeds of the debtor's leased trucks and receiving deferred cash payments or receiving the truck collateral as the indubitable equivalent of its claims); In re Wiggins, 2018 WL 1137616 (Bankr. E.D.N.C. Feb. 28, 2018) (confirming a chapter 11 plan under which the secured creditor would receive a portion of the four tracts of land securing its claim as the indubitable equivalent after performing a "highest and best use" appraisal inquiry); see also Havasu Lakeshore Investments, LLC, v. Fleming (In re Fleming), 2020 WL 1170722 (B.A.P. 9th Cir. Mar. 10, 2020) (a chapter 11 plan providing that the secured lender would receive a cash payment of $500,000 on the effective date, 49 units of real property valued at $3.7 million, and five annual payments of $241,000 with interest at 5% did not provide the lender with the indubitable equivalent of its $5.4 million claim because it did not provide compensation for the necessary time to sell the property and unfairly shifted the risk of selling it to the lender).
Depending on the circumstances, a cram-up chapter 11 plan may be part of a beneficial reorganization strategy that might otherwise be impossible due to the objections of a senior secured creditor or class of creditors. In a financial and lending climate fraught with uncertainty, cram-up plans may be an attractive alternative to more traditional chapter 11 cramdowns. With the recent significant decrease in corporate lending interest rates and the ready availability of inexpensive credit for certain corporate borrowers, reinstatement of loans under a plan may not be as common a restructuring strategy as it was under different conditions. Even so, corporate credit conditions may once again cycle to a point where it becomes an attractive option.
For further information on this topic please contact Stacey L Corr-Irvine or Mark Douglas at Jones Day by telephone (+1 216 586 3939) or email (email@example.com or firstname.lastname@example.org). The Jones Day website can be accessed at www.jonesday.com.
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