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Bankruptcy Guide (Ch. 7 and 13)

Know Your Rights in Bankruptcy
An Unofficial Guide from M. Hedayat & Associates, P.C.

Generally

What is it?
Bankruptcy is the Federal process that grants relief from debt for the person or entity that owes money (the Debtor) to the person or entity that gave them a loan or credit in the first place (the Creditor). Since the process is run by the Federal government it operates in largely the same way all over the country with certain differences by State and County in the way the system is carried out. Long-story short, if you know Bankruptcy is one State you probably know it in nearly all States.

Who can be a debtor?
The benefits of the Bankruptcy Code are available to a municipality or to any person or company that resides or has a domicile, a place of business, or property in the United States. This means that any foreign company that has property or a place of business in the United States may file a bankruptcy petition in the United States. The Bankruptcy Code is not available to insurance companies, banks, and similar institutions. These entities are subject to reorganization or liquidation under the laws of the individual states where they are incorporated or under other federal statutory methods.

Structure of the Bankruptcy Code and Rules
The Bankruptcy Code is divided into eight chapters, all of which have odd numbers (except for Chapter 12). This peculiar numbering system was devised in order to allow for future expansion.

Chapter 1: “General Provisions” This Chapter contains a number of definitions which apply throughout the Bankruptcy Code (§101), as well as important provisions concerning the broad powers of the bankruptcy courts to administer bankruptcy cases (§105), and definitions of what types of legal entities may and may not be debtors under the Bankruptcy Code (§109).

Chapter 3: “Case Administration” This Chapter contains provisions for how a bankruptcy case is commenced (§§301–304); how trustees, attorneys, and other professionals are retained and paid (§§326–331); and how creditors meet at the beginning of a case (§341). This Chapter also has several critical sections concerning the nature and scope of the automatic stay (§362); the ability of a debtor to use, sell, or lease its property during the case (§363); the ability of a debtor to borrow money during the case (§ 364); and the treatment of executory contracts and unexpired leases during the case (§365). This chapter also describes the requirement that a Debtor provide adequate protection to creditors for actions which may otherwise impair their interests (§361).

Chapter 5: “Creditors, the Debtor, and the Estate” This Chapter deals with the means for filing and litigating claims against the debtor (§§501–505); establishes priorities of secured and unsecured debts (§§506–510); provides for the discharge of the Debtor and the effects of such discharge (§§521–525); and determines the extent of the property of the Debtor’s estate, including the recovery of fraudulent and preferential transfers (§§541–554). Chapter 5 also contains special provisions for the liquidation of certain specialized financial contracts during a bankruptcy case (§§555–560).

Chapter 7: “Liquidation” This chapter provides the mechanism for conducting a liquidation case of an individual or business entity. This Chapter provides for the appointment or election of a trustee for the estate (§§701–704) and the collection and liquidation of the assets of the estate (§§721-728). There are also special provisions for liquidation of stockbrokers (§§741–752), commodity brokers (§§761–766), and clearing banks (§§781–784).

Chapter 7 Bankruptcy Process Chart
image courtesy of Prof. Lynn LoPuki of the University of California

Chapter 9: “Adjustment of the Debts of a Municipality” This chapter deals with the filing, administration, and resolution of a bankruptcy case filed by a municipal entity. In many respects Chapter 9 cases resemble Chapter 11 cases.

Chapter 11: “Reorganization” This chapter provides the means for proceeding with a Chapter 11 case, forming a committee of unsecured creditors, and appointing a trustee if one is warranted (§§ 1101 –1108). This Chapter also describes the requirements for filing, confirming, and implementing a plan of reorganization (§§1121–1146). Finally, this Chapter has a special (but little-used) provision for reorganizing a railroad company (§§1161–1174).

Chapter 12: “Adjustment of Debts of a Family Farmer with Regular Annual Income” This chapter provides the special requirements for a family farmer to reorganize her business. These provisions are also similar to those found in Chapter 11.

Chapter 13: “Adjustment of Debts of an Individual with Regular Income” This chapter provides the requirements for an individual to reorganize her debts by proposing a payment plan to her creditors. This Chapter contains the required elements for proposing and confirming a plan (§§1321–1325), as well as the mechanism for administering the plan (§§1326–1330).

Chapter 13 Bankruptcy Process Chart
image courtesy of Prof. Lynn LoPuki of the University of California

The Federal Rules of Bankruptcy Procedure are divided into nine parts, and have specific provisions for, among other things, the types of pleadings and information that must be filed to open a bankruptcy case, the types of notice that must be given to creditors concerning actions taken within the bankruptcy case, specific rules concerning the proposal and balloting of plans of reorganization, procedural mechanisms for implementing the administrative provisions of the Bankruptcy Code, the importation of most of the Federal Rules of Civil Procedure, and the rules for appealing the decision of a bankruptcy court in a contested matter. The Bankruptcy Rules contain a great deal of procedural information that practitioners should consult before taking action in a bankruptcy case.

Chapter 7

What is it?
Chapter 7 is the liquidation of a debtor’s estate and distribution of cash proceeds to creditors according to a pre-arranged scheme or set of priorities. To accomplish this goal the Court must appoint an independent 3rd party (the Trustee) to take control of the debtor’s possessions and move in the direction of their sale. This third party is usually an Attorney but can also be an Accountant. Although the United States Trustee makes the initial appointment of the Chapter 7 Trustee, the creditors may insist on an election at which they can install anyone of their choosing, so long as he or she is “disinterested” (more on this later).

Who can be a debtor?
Chapter 7 is available to any person or entity except railroads (and as otherwise noted above). Cases which start under other Chapters can be converted to Chapter 7 at almost any time. Typically, this happens when the Debtor’s business cannot be salvaged, and continued operation will only result in increased losses.

How are assets disposed of?
While the Court may authorize the Trustee to operate the Debtor’s business for a short time if doing so would increase the creditors’ recovery on the Debtor’s assets, Chapter 7 frequently involves selling the Debtor’s assets on a piecemeal basis, rather than as a going concern. For example, trustees routinely operate a business to complete work-in-progress if there is a reasonable likelihood that the resulting inventory can be sold (rather than selling the work-in-progress for scrap value). Sales are conducted via public auction or a negotiated private sale.

What factors go into a successful asset sale?
The degree to which such the sale of a debtor’s assets succeeds depends on factors such as a Trustee’s contacts among likely buyers, the advertising budget, and the Trustee’s willingness to engage in aggressive marketing. The more successful a sale, the more creditors receive and the higher the Trustee’s commission –- note however that the debtor sees no difference regardless of the price at which assets are sold. The benefit to the debtor is merely release from debt – or so the theory goes.

Chapter 11

What is it?
Chapter 11 is primarily a tool for reorganizing an ongoing business enterprise. Chapter 11 may also be used by individuals, but was not designed for them and generally does not provide a good fit. A company entering Chapter 11 remains in possession of its assets and in control of its affairs. Management remains the same, and the business remains in the control of the board of directors.

A Chapter 11 debtor is provided with a certain amount of time (180 days, subject to extension) in which to analyze its situation, negotiate with its creditors, and develop a plan for reorganizing itself. Chapter 11 provides for the appointment of a group of unsecured creditors (usually between three and seven) to an official committee. This Committee has an important role in the bankruptcy case. The Debtor generally conducts its plan negotiations with the Committee (acting on behalf of the unsecured creditors). The Committee, with bankruptcy court approval, is permitted to hire professionals (for example, attorneys and financial advisors) at the Debtor’s expense. The expenses of the Committee members are also paid for by the Debtor. The Committee has a persuasive voice with the bankruptcy court. Chapter 11 is geared toward the negotiation and consummation of a plan of reorganization, which will generally expunge the Debtor’s old debts and repay them with new debt or equity instruments. Where the Debtor’s creditors depend on future recoveries in this manner, they become, in essence, “business partners” with the Reorganized Debtor, and often their percentage of recovery is tied to the success of the reorganized entity.

There is no prohibition in the Bankruptcy Code, however, against liquidating a company under Chapter 11. A liquidating Chapter 11 case essentially means that the Debtor (rather than a Chapter 7 Trustee) sells its own assets (presumably as a going concern) and files a plan of liquidation which does little more than distribute the proceeds of the Debtor’s assets under Chapter 11.

Who can be a debtor?
Chapter 11 is available to any person or entity (including railroads), except stockbrokers and commodity brokers. Brokers can only file for bankruptcy under certain special provisions of Chapter 7. Chapter 11 therefore is available to individuals and family farmers even though there are special Chapters for them. Chapter 11 is not geared towards individuals (and would not be efficient for individuals); therefore, unless ineligible, individuals should generally file under Chapter 7, 12, or 13. There is no requirement that a Debtor be “insolvent” to file a petition under Chapter 11. There have been many entities (i.e., Johns-Manville and Dow Corning) which have filed Chapter 11 cases for legitimate business reasons rather than as a result of liquidity crises. Indeed, perhaps because of the difficulty in reorganizing when management is spending its time just trying to keep their company alive, some of the most successful Chapter 11 cases have been those which were filed before the Debtor’s business problems became extreme.

Chapter 13

What is it?
Chapter 13 is designed to provide individuals with a method of financially restructuring their debts without liquidating their assets. A Chapter 13 Debtor remains in possession of her assets and control of her affairs, but is required to propose a plan of debt repayment (which will be based primarily on the Debtor’s future earnings). Although Chapter 13 requires the appointment of a Chapter 13 Trustee, the Chapter 13 Trustee’s role is essentially limited to the distribution of the payments provided under the Debtor’s plan of reorganization and to overseeing the Chapter 13 process.

Who can be a debtor?
Chapter 13 is available only to individuals with regular income who have noncontingent, liquidated unsecured debts of less than $307,675 and secured debts of less than $922,975. An individual and a spouse may file a joint Chapter 13 petition only if their combined financial picture meets these requirements. Individuals who do not meet these tests (i.e. unemployed people) must file under Chapter 7 or Chapter 11. There is no solvency requirement for filing under Chapter 13.

Chapter 9

What is it?
Chapter 9 provides an opportunity for troubled municipalities to restructure their debts. There is no automatic appointment of a trustee in a Chapter 9 case; accordingly, the municipality continues its governmental and business affairs in the same fashion as it did prior to the bankruptcy. Chapter 9 is also geared toward the development of a plan of reorganization.

Who can be a debtor?
Only municipalities may file under Chapter 9. Municipalities are generally any governmental or quasi-governmental body whose revenues are derived from taxes or assessments (cities, counties, school districts, water districts, etc.). The Bankruptcy Code prohibits a municipality from filing a petition under Chapter 9 unless it is “specifically authorized” to do so under state law. In other words, the Bankruptcy Code allows states to determine the conditions under which their municipalities may file bankruptcy. Many states have required their municipalities to go through state-mandated debt restructuring programs before they may file a Chapter 9 petition. Chapter 9 also requires that the municipality be “insolvent” which, in this case, means that the municipality is not paying its debts as they become due.

Chapter 12

What is it?
Chapter 12 is designed to provide “family farmers” who want to continue in the farming business with a means for financially restructuring their debts without selling their farm. A trustee is appointed in a Chapter 12 case, but her role is generally limited to the oversight of payments under the Debtor’s plan of reorganization. Absent extension, a Chapter 12 Debtor is required to file a plan of reorganization within 90 days of the filing of the bankruptcy case. The plan of reorganization will generally provide for the repayment of the farmer’s debts from the farmer’s future income.

Who can be a debtor?
Chapter 12 is only available to family farmers with regular income. Family farmers are individuals and their spouses whose debts do not exceed $1,500,000. Eighty percent of their debt and 50% of their income must come from farming operations (e.g., farming, ranching, or livestock production). A family farmer can also be a corporation, if more than 50% of the stock is held by one family and that family’s relatives (and if the stock is not publicly traded).

Employment of Counsel and Other Professionals
Any attorney or other professional (e.g., accountants, financial advisors, and consultants) retained by the Debtor, a trustee, or the Committee may only be retained with permission of the bankruptcy court. In order to be retained, the proposed professional must be “disinterested” (with certain limited exceptions). This generally means that the professional cannot have any conflicts of interest. The professional must disclose any potentially conflicting representation to the bankruptcy court and to all of the Debtor’s creditors, as well as why that representation would not impair the professional’s dedication to the proposed client. Professionals can only be paid after applying to the bankruptcy court for approval of their fees. In the application, the professional must fully describe every task performed and the amount of time spent on each task. The Court can then decide if the proposed fee is reasonable.

The Trustee’s Role in Bankruptcy Case Management
Any case involving a trustee (which can be under any Chapter of the Bankruptcy Code) adds a new player to the game. The trustee is typically an attorney well-versed in bankruptcy law and practice. In a Chapter 7 liquidation case, the trustee is mainly interested in liquidating the Debtor’s assets as quickly as possible for the greatest amount of money available. The trustee is also charged with the responsibility of investigating avoidable transfers, such as preferences and fraudulent conveyances, and then filing lawsuits to recoup those funds. As the trustee is impartial, she is a good resource for investigating any possible misdeeds of management which occurred before her appointment.

Exemptions

In a Chapter 7 case, the Bankruptcy Code essentially takes all of the Debtor’s property and sells it to satisfy as much of the Debtor’s obligations as possible. Since the creditors usually get less than they are owed, the Bankruptcy Code does not permit the Debtor to keep anything of value.

However, the Bankruptcy Code acknowledges that the Debtor should be permitted to keep certain assets, such that the Debtor may get back on her feet, or because those assets may have more sentimental value to the Debtor than monetary value to the creditors.

Most states’ laws provide for the “exemption” of certain types of property from creditors. The Bankruptcy Code provides that a debtor may choose to take advantage of the state law which applies, or may instead choose the exemptions provided by the Bankruptcy Code. The Bankruptcy Code also provides that state law may prohibit a debtor from electing the exemptions provided under the Bankruptcy Code, and restrict exemptions to those provided under state law.

Illinois has opted out of the Bankruptcy Code’s exemptions, and has instead provided its own exemptions. The exemptions provided under Illinois law generally include:

Up to $15,000 of value of residential real estate, whether vacant land, house, or condominium;
Necessary wearing apparel, bible, school books, and family pictures of the Debtor and dependents;
Up to $4,000 in other property;
Up to $2,400 in a motor vehicle;
Up to $1,500 in tools of the trade;
Insurance policies on the life of the Debtor and any equity therein;
Health aids;
Rights to receive social security, veterans’, disability, illness, or unemployment benefits;
Rights to receive alimony to the extent necessary for support of the Debtor and dependents;
Rights to receive crime victim reparations, but only within 2 years of the accrual of rights;
Payments on account of the wrongful death of one upon whom the Debtor was dependent to the extent necessary for the support of the Debtor and dependents, but only within two years of the payment;
Up to $15,000 for personal injury, but only within 2 years of the payment.

In Illinois, exempt property that is purchased with non-exempt property with the intent to defraud creditors is not exempt. Property purchased within 6 months prior to the bankruptcy filing is presumed to have been purchased with such a fraudulent intent.

AUTOMATIC STAY LITIGATION

The Extent of the Protections of the Automatic Stay Under Bankruptcy Code Section 362(a)
1. The filing of a petition under the Bankruptcy Code acts as an automatic stay against almost anything a creditor can do against the Debtor or its property. Absent approval from the bankruptcy court, creditors cannot file lawsuits, repossess collateral, enforce judgments, perfect liens, or set off debts. This prohibition generally even includes such minutiae as sending a collection letter to the Debtor.
2. Violations of the automatic stay are considered contempt of court, and can be punished by severe civil penalties. Anyone connected to a violation of the stay is subject to these penalties, including attorneys and individual employees of creditors.
Exceptions to the Automatic Stay Provision Under Section 362(b)
Stay Litigation
1. Creditors with an interest in particular property of the Debtor’s estate are entitled to seek relief from the automatic stay from the bankruptcy court if they can make the proper showing. As described below, there are two available avenues for obtaining relief from the automatic stay.
  1. First, the creditor can show “cause, including the lack of adequate protection” of that creditor’s interest in the property.
    1. Generally, this means that the value of the creditor’s collateral will diminish during the bankruptcy case. Since security interests are property interests protected by the United States Constitution, the Bankruptcy Code cannot prohibit a secured creditor from realizing the value of its collateral. (2)
    2. In order to avoid losing the protection of the automatic stay, therefore, the Debtor must show that the creditor’s interests are “adequately protected.” This means that the Debtor must show that the creditor will eventually end up with the same value as the property was worth on the date of the bankruptcy filing.
      1. If the property will diminish in value during the bankruptcy case, the Debtor must show that it is making periodic payments equal to the diminution in value, or the Debtor may provide additional liens on unencumbered property to secure the debt.
      2. If the property is not diminishing in value (i.e., real estate), the Debtor must only show that it is maintaining the property (i.e., insuring the property and paying property taxes).
    3. Other than a lack of adequate protection, the creditor may show other “cause” for relief from the automatic stay. “Cause” is not defined in the Bankruptcy Code, but may include situations where the Debtor is not properly utilizing the property or is otherwise jeopardizing the creditor’s likelihood of receiving the value of the property.
  2. Second, the creditor can show that the Debtor has no equity in the property, and that the property is not necessary for an effective reorganization.
    1. The first half of this test simply means that the property is worth less than the secured debt.
    2. The second half of the test means that the Debtor cannot demonstrate that a reasonably confirmable plan of reorganization, to which the property is essential, is likely to be filed in a reasonable period of time.
      1. Secured creditors have sometimes won on this issue by showing that they do not intend to vote in favor of any plan of reorganization proposed by the Debtor, and the Debtor cannot therefore propose a confirmable plan.
Section 362 Motions in All Cases — the “Compelling Circumstances” Test
1. Creditors who wish to pursue non-bankruptcy litigation against a Debtor (i.e., tort creditors who are trying to reach insurance policy proceeds) cannot obtain relief from the automatic stay unless they can show “compelling circumstances.” Implementation of this test helps prevent the Debtor from being distracted by litigation occurring outside of the bankruptcy case.
2. In order to show “compelling circumstances,” a creditor must show that it is suffering irreparable injury by the delay resulting from the automatic stay, and that pursuit of the litigation will cause the Debtor no great inconvenience.

CHAPTER 11 CONFIRMATION ISSUES

IV. CHAPTER 11 CONFIRMATION ISSUES

Disclosure Statement
1. Generally
  1. The proponent of a plan of reorganization solicits acceptance of its plan from creditors with a bankruptcy court approved disclosure statement.
2. Requirements for Court Approval
  1. Before soliciting votes on a plan, the proposed disclosure statement must be approved by the bankruptcy court as containing “adequate information.”
  2. Section 1125(a) of the Bankruptcy Code defines “adequate information” as “information of a kind, and in sufficient detail, as far as is reasonably practicable in light of the nature and the history of the debtor and the condition of the debtor’s books and records, that would enable a hypothetical reasonable investor typical of holders of claims or interests of the relevant class to make an informed judgment about the plan.”
  3. Although courts differ regarding individual items which must be included, at a minimum, a disclosure statement should contain:
    1. a description of the debtor’s business;
    2. a synopsis of the debtor’s pre-bankruptcy history;
    3. information regarding the debtor’s operations;
    4. a description of the plan and how it is to be executed;
    5. a liquidation analysis;
    6. a listing of management to be retained and such management’s compensation;
    7. cash flow projections of operations;
    8. a discussion of pending litigation and transactions with insiders; and
    9. an analysis of the tax consequences of the plan.
  4. When soliciting acceptances of the plan, a copy of the proposed plan is included with the court-approved disclosure statement.
    1. For a “small business debtor” (which is defined by the Bankruptcy Code as a person engaged in business whose debts do not exceed $2 million), the court may “conditionally” approve a disclosure statement for solicitation to creditors, and may reserve final approval of the disclosure statement for a combined hearing on plan confirmation.
3. The Exclusivity Period
  1. “Exclusivity” refers to the debtor’s initial right to propose, and then solicit votes in favor of, a plan of reorganization.
  2. During the first 120 days of a Chapter 11 case, the debtor has the exclusive right to file a plan of reorganization, and (if a plan is filed within that time) an additional 60 days to solicit acceptances of its plan.
  3. Upon notice and hearing, this period may be extended or shortened by the bankruptcy court for cause.
  4. The appointment of a trustee in a Chapter 11 case terminates the exclusivity period
  5. If the debtor is a “small business,” the exclusivity period is shortened from 120 to 100 days, and may only be extended if the debtor meets a higher standard (by showing that the need for the extension is due to circumstances beyond its control).
  6. Once the exclusivity period is terminated, any party in interest may propose a plan of reorganization. For example, a creditor may file a plan proposing to eliminate equity holders’ interests, provide for the sale of the debtor’s assets, or provide for the transfer of all of the debtor’s property to its creditors in satisfaction of debt.
Confirmation Standards Under Bankruptcy Code Section 1129
1. Section 1129(a) lists thirteen separate findings which a bankruptcy court must make in order to confirm a plan of reorganization.
2. Of these, some of the more typically contested criteria are:
  1. The plan must comply with the applicable provisions of the Bankruptcy Code (among other things, this incorporates the Bankruptcy Code’s requirements regarding claims classification);
  2. The proponent of the plan must have complied with applicable provisions of the Bankruptcy Code (for example, the plan proponent may not improperly have solicited acceptances of the plan);
  3. The plan must have been proposed in good faith and not by any means forbidden by law; vThe plan must contain required disclosures regarding the identity of management and insiders to be employed by the reorganized debtor;
  4. Each impaired class must have either accepted the plan, or must receive or retain under the plan as much as it would receive in a Chapter 7 liquidation proceeding (this requirement is often referred to as the “best interests” test);
  5. If a class of claims is impaired, at least one impaired class (excluding insiders, as defined in section 101(31) of the Bankruptcy Code) must have accepted the plan; and
  6. Confirmation of the plan is not likely to be followed by liquidation or the need for further financial reorganization of the debtor (this requirement is often referred to as the “feasibility” test).
3. Even absent objection, the bankruptcy court has an independent obligation to determine whether all of the requirements of section 1129(a) have been met.
4. The plan’s proponent bears the burden of proof as to each of these statutory requirements.
5. Many standards for confirmation of a plan concern “impaired” classes of parties in interest.
  1. Under section 1124 of the Bankruptcy Code, a class of claims or interests is impaired unless:
    1. the plan leaves unaltered the legal, equitable, and contractual rights to which such claim or interest entitles the holder of such claim or interest; or
    2. notwithstanding any contractual provision or applicable law that entitles the holder of such claim or interest to demand or receive accelerated payment of such claim or interest after the occurrence of a default, the plan:
      1. cures any such default that occurred before or after the commencement of the bankruptcy;
      2. reinstates the maturity of such claim or interest as such maturity existed before such default;
      3. compensates the holder of such claim or interest for any damages incurred as a result of any reasonable reliance by such holder on such contractual provision or such applicable law; and
      4. does not otherwise alter the legal, equitable, or contractual rights to which such claim or interest entitles the holder of such claim or interest.
  2. For example, a class of unsecured creditors proposed to be paid in full, but without interest and over time, is impaired because its legal rights are not unaltered.
6. Acceptance of a plan is governed by section 1126 of the Bankruptcy Code.
  1. Only holders of claims or interests allowed under section 502 of the Bankruptcy Code may vote to accept or reject the plan.
  2. For a class to accept a plan:
    1. more than one-half in number of holders of allowed claims in such class must vote in favor of the plan; and
    2. holders of at least two-thirds in amount of allowed claims in such class must vote in favor of the plan
  3. Thus, a creditor or group of creditors having allowed claims accounting for at least one-third of the total debt in a class may (absent “cram-down,” discussed below) exercise “veto power” over a plan./li>
7. To satisfy the “best interests” test, the creditor must receive more then it would in a Chapter 7 liquidation proceeding.
  1. If this issue is disputed, evidence must be offered on, among other things, the present value of any deferred payments under the plan, the liquidation value of the debtor’s assets, and the effect of expenses of administering a Chapter 7 liquidation.
8. To satisfy the “feasibility” requirement, the plan proponent must establish that the plan has a reasonable assurance of success.
  1. Bankruptcy courts consider a multitude of factors for assessing the chances of a plan’s success, such as:
    1. the capital structure of the reorganized debtor (for example, whether the reorganized debtor is overleveraged);
    2. the reorganized debtor’s financial projections; and
    3. the qualifications of the reorganized debtor’s proposed management team and business plan.
“Cramdown” and the Absolute Priority Rule
1. Even if all of the impaired classes do not accept a plan, the plan may nevertheless be confirmed under the section 1129(b) – the “cramdown” provision of the Bankruptcy Code.
2. Under the cramdown standard, the bankruptcy court may confirm the plan over the objection of a dissenting impaired class if the plan does not “discriminate unfairly” against, and is “fair and equitable” with respect to, each class that is impaired under, but has not accepted, the plan.
3. In addition, other than the requirements contained in section 1129(a)(8), the plan must still meet all of section 1129(a)’s remaining tests. Thus, at least one non-insider, impaired class must accept the plan as a precondition to cramming-down the remaining non-accepting classes.
4. The Bankruptcy Code does not define “unfair discrimination.”
  1. The first of three approaches to determining the issue of unfair discrimination adopted by bankruptcy courts is a mechanical approach, under which all unsecured creditors must be paid the same percentages of their claims, even if claims are properly placed in more than one class.
  2. A second approach used by courts determines whether discrimination is fair with reference to whether a subordination agreement exists.
  3. The third approach adopts a four-part test, in which the bankruptcy court:
    1. determines whether the discrimination is supported by a reasonable basis;
    2. determines whether a plan may be confirmed and consummated without discrimination;
    3. determines whether the discrimination is proposed in good faith; and
    4. considers the treatment of the classes discriminated against.
5. The determination of whether the treatment proposed to holders of claims in an impaired, non-accepting class is “fair and equitable” is governed by section 1129(b)(2) of the Bankruptcy Code.
  1. Treatment of secured creditors is fair and equitable if:
  2. Thus, under the first prong of this test, in addition to retaining its lien on its collateral to the extent of the allowed amount of such claim (i.e., the secured component of the debt), a secured creditor must receive deferred cash payments totaling the allowed amount of its claim and having a value, as of the effective date of the plan, at least equal to the value of the collateral securing its claim.
    1. Therefore, if a secured creditor is owed two dollars, but its collateral is only valued at one dollar, and the creditor has made a section 1111
    2. election to have its claim treated as a single secured claim (in contrast to bifurcating the claim into a one dollar secured claim and a one dollar unsecured claim), the plan must pay the secured creditor a stream of cash payments of not less than two dollars, which stream of payments must have a present day value of at least one dollar.
  3. In contrast, if the secured creditor does not make the section 1111(b) election, and therefore opts to bifurcate the claim into separate secured and unsecured claims of one dollar each, then it must be paid a total of one dollar on behalf of its secured claim, on a basis such that the stream of payments have a present day value of at least one dollar. c) The proposed interest rate plays a key role in this analysis.
    1. Traditionally, there have been four competing approaches – the formula rate, the coerced loan rate, the presumptive contract rate, and the cost of funds rate – to determining the correct and appropriate interest rate. Although there have been numerous conflicting decisions as to the appropriate rate, the Supreme Court recently ruled that that the so-called formula approach (the prime rate plus a calculated risk factor) best meets the intent of Congress and the objectives of the Bankruptcy Code.
      1. The formula rate incorporates a “national prime rate” with an evidentiary hearing where the parties may present evidence about the “appropriate risk adjustment.” Because the approach is already familiar in the financial community, it minimizes the need for expensive evidentiary proceedings. one dollar.
    2. In selecting the formula rate, the Supreme Court also recognized that the cram down provision requires an objective rather than a subjective standard.one dollar.
  4. The bankruptcy court’s finding that the debtor’s plan proposed appropriate interest rate does not, in and of itself, mean the court will find the plan to be “fair and equitable.”
    1. Section 1129(b)(2) of the Bankruptcy Code sets minimum standards plans must meet.
    2. Although section 1129 does not prohibit long term payouts, the proposed payment term must be a reasonable period.
  5. Treatment of unsecured creditors is “fair and equitable” if:
    1. the plan provides that each holder of a claim of such class receive or retain an account of such claim property of a value, as of the effective date of the plan, equal to the allowed amount of such claim; or
    2. the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property.
  6. Thus, to satisfy this test, an unsecured creditor must receive payment of the full amount of its claim, or no junior creditor or holder of equity interests may receive or retain any property under the plan.
  7. This second requirement is known as the “absolute priority rule.”
6. To satisfy the absolute priority rule, junior claims and interests may not receive any payment or retain any value under a plan of reorganization unless all senior claims either consent or have been paid in full.
  1. Thus, equity holders may not retain their interests unless all creditors have been entirely paid.
7. Courts have concluded that an exception to the absolute priority rule exists. Under this “new value exception,” holders of the debtor’s equity interests may receive property (such as stock in the reorganized debtor) under a plan where the distribution is made in consideration of a new, post-bankruptcy contribution of money (or money’s worth) reasonably equivalent to the value of the property received.
  1. This distribution must be on account of the new value contributed, and may not be on account of old interests.
Practical Considerations of Confirming a Plan, Including Votes
1. Contents of the Plan
  1. Section 1123(a) of the Bankruptcy Code lists the things a plan must do (in addition to satisfying the confirmation standards of section 1129).
  2. Among other things, a plan must:
    1. designate classes of claims and classes of interest;
    2. specify any class of claim or interest that is not impaired under the plan;
    3. specify the treatment of any class of claim or interest that is impaired under the plan;
    4. provide for the same treatment of claims or interests of a particular class, unless a holder agrees to a less favorable treatment; and
    5. provide adequate means for implementation of the plan (such as retention by the debtor of all or part of the property of the estate, transfer of all or part of the estate to one or more entities, merger or consolidation of the debtor with one or more persons, sale of all or part of the property of the estate, satisfaction or modification of any lien, cancellation or modification of any indenture, curing or waiving of any default, extension of a maturity date or change in an interest rate, amendment of the debtor’s charter, or issuance of securities of the debtor for cash, for property, for existing securities, or in exchange for claims or interests).
  3. Of these requirements, the proposed classification of claims may be the most controversial requirement, as a claim’s classification dictates the treatment of such claim. Placement in a particular class may determine the amount and timing of payment, and the ability to control that class’s acceptance or rejection of the plan.
  4. As previously discussed, section 1129(a)(10) of the Bankruptcy Code requires that at least one non-insider, impaired class must accept the plan and a class acceptance must be by more than half of the creditors in the class who hold claims equal to at least two-thirds of the total claims in the class. As a “deficiency” claimant (that is, a secured claimant holding a claim which has been bifurcated into secured and unsecured portions) holding more than one-third of the unsecured debt could veto acceptance, debtors frequently attempt to separately classify a deficiency claimant from other unsecured creditors.
  5. The ability to include or exclude creditors from a class is governed by section 1122 of the Bankruptcy Code.
    1. Section 1122(a) provides that, except for a class of claims created for administrative convenience under section 1122(b), a plan may place a claim or an interest in a particular class only if such claim or interest is substantially similar to the other claims or interests of such class.
    2. Some courts have stated that this section does not prohibit separate classification of similar claims, but rather merely proscribes the placement of dissimilar claims in the same class.
    3. Courts have taken various approaches to adjudicating the propriety of classification.
      1. Some courts have construed section 1122 strictly, concluding that separate classification of unsecured claims violates section 1122(a), and that Congress intended all unsecured claims be grouped in one class.
      2. Other courts have adopted a more flexible approach to claim classification, concluding that statute’s “substantially similar” language does not require that all similar claims be placed in one class. Instead, these courts simply require that any class so created be homogenous. These courts accept separate classification of similar claims as long as the separate classification is based on legal or factual distinctions, and is not for the purposes of “gerrymandering” the voting process.
      3. Courts disagree as to whether an undersecured creditor’s deficiency claim is legally distinct from other unsecured claims.
  6. Even if a bankruptcy court permits separate classification, the plan proponent may nevertheless have to overcome the unfair discrimination and absolute priority rule issues hurdles with respect to such creditors.

Bankruptcy Guide (Ch. 7 and 13)

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