Gerrymandering votes in bankruptcy? The classification of an undersecured claim

Confirmation of a Chapter 11 plan generally requires the consent of each impaired class of creditors. A debtor can “cramdown” a plan over creditor dissent, however, as long as at least one class of impaired claims accepts the plan. This can be difficult when a dissenting secured creditor’s unsecured deficiency claim is large enough to act as a “blocking position.” To prevent a dissenting secured creditor from vetoing acceptance by the unsecured creditors class, and thus confirmation, debtors routinely attempt to classify the dissenting secured creditor’s unsecured deficiency claim separately from the class of general unsecured creditors. In these cases, secured creditors routinely oppose confirmation and argue that the debtor gerrymandered the acceptance of the unsecured class by separately classifying the deficiency claim in a class of its own. Depending on the circumstances, such objections enjoy a varying degree of success. Rather than following this pattern, Tara Retail Group attempted something else—it simply did not bifurcate the secured creditor’s claim into secured and undersecured portions—instead it kept the entire claim in its own class. Can this work?  

Background

In Tara Retail Group, LLC, the Debtor owned and operated The Crossings Mall—a multi-tenant commercial property. Public access to the property was originally limited to a single bridge that spanned over a creek. In June 2016, significant rainfall caused debris and water to accumulate at the bridge and the creek overflowed its banks and flooded bordering properties before washing away the bridge. After the flood, the Debtor’s tenants were unable to operate, and rents eventually stopped. When the Debtor was unable to service its debt, its principal creditor and mortgagee Comm2013 filed a civil action against the Debtor and sought to appoint a receiver. This lawsuit precipitated the Debtor’s bankruptcy filing.  

The tension between Debtor and Comm2013 continued in the bankruptcy case and the parties proposed competing Chapter 11 plans—the Debtor’s plan sought to reorganize its financial affairs while the Comm2013 plan sought to liquidate the Debtor’s property. Both plans gained acceptance by the voting creditors, but Comm2013 objected to the Debtor’s plan arguing that the plan improperly classified its entire (under)secured claim as one class and thus separated its deficiency claim from the general unsecured class. Comm2013 argued that the Debtor’s plan was therefore unconfirmable as a matter of bankruptcy law because it gerrymandered classes of unsecured claims to obtain at least one consenting, impaired class.   

Discussion 

Bankruptcy Code Section 506(a) provides that an undersecured creditor’s claim is bifurcated into a secured claim in an amount equal to the value of the collateral and an unsecured deficiency claim for the balance of the debt. The deficiency claim is typically placed in the general unsecured class. However, because acceptance of a plan requires the affirmative vote of the holders of two-thirds of the dollar amount of claims, a dissenting creditor with a large enough claim may have a veto power preventing the unsecured class from accepting the plan. Without an accepting impaired class, there can be no cramdown and a plan cannot be confirmed.  

In Tara, had the Debtor bifurcated Comm2013’s undersecured claim and classified the deficiency claim with the other unsecured claims, Comm2013’s rejection of the plan would have prevented confirmation.  

Rather than separately classifying Comm2013’s deficiency claim, the Debtor put Comm2013’s claim in its entirety, both the secured and unsecured portions, in one class. Thus, although Comm2013 voted to reject the plan, the acceptance by the unsecured class was used to cramdown the plan on Comm2013. 

The court rejected Comm2013’s gerrymandering objection to the Debtor’s plan. Since the Debtor did not propose to bifurcate the claim, the court did not see any issue preventing confirmation. While the court agreed with Comm2013 that Section 506(a) involves the determination of a creditor’s secured interest, it found that it has no bearing on proposed plan treatment, classification, or confirmation. The court further held that there is no requirement in the Bankruptcy Code that a plan proponent treat an undersecured creditor in a bifurcated fashion.  

Conclusion 

While the Bankruptcy Code provides a debtor with some flexibility in classifying claims, it requires that substantially similar claims be treated alike. Courts generally ask whether a separately classified unsecured claim is substantially similar to other unsecured claims. If it is, the claim cannot be separately classified unless there is a legitimate business or economic justification. While some courts have allowed debtors to separate classes of unsecured claims, efforts to gerrymander votes to gain acceptance of a plan have been generally unsuccessful. The court’s opinion in Tara raises the question, however, whether a debtor can skip bifurcation and confine a dissenting undersecured creditor’s claim to one class, containing both the secured and deficiency portions of its claim, to reach the same result. Comm2013 appealed the bankruptcy opinion. Secured creditors should follow further developments with interest.

Read the opinion >>