Steps a Secured Lender Should Consider in a Chapter 11 and the Role of a Proposed Plan of Reorganization at Each Step

October 13, 2008

The plan of reorganization is one of the most critical documents in a Chapter 11 bankruptcy proceeding. Even before declaring a default under a mortgage or deed of trust, a secured lender needs to plan ahead by considering, among other things (a) what remedies the lender has at each step of a bankruptcy proceeding; and (b) whether the borrower/debtor can, at each such step, propose a sufficient-enough plan of reorganization to prevent the lender from realizing upon those remedies. Such planning will also help the lender predict how long the bankruptcy proceeding is likely to take, what it is likely to cost, and what the lender’s risks of adverse consequences, such as a cramdown, are. If nothing else, such planning will help the lender to determine what terms it should offer in workout negotiations.

As a Chapter 11 bankruptcy proceeding progresses, a secured lender will want to consider seeking in the following order in light to thedebtor’s ability to then propose a sufficient-enough plan of reorganization: (a) a lift Stay, (b) a conversion or dismissal, and (c) counting the classifications and the votes to avoid a cramdown.

{Unless otherwise noted, all Section references herein are to 11 U.S.C. Underlining indicates emphasis added for the purposes of this discussion; brackets “[]” indicate language deleted by BAPCPA; and italics indicates language added by BAPCPA.}
I. Seeking a Lift Stay under Section 362(d).

The debtor’s proposed plan of reorganization is likely to come up early. Section 362(d), states, in relevant part:

“(d) On request of a party in interest and after notice and a hearing, the court shall grant relief from the stay provided under subsection (a) of this section, such as by terminating, annulling, modifying, or conditioning such stay–
(1) for cause, including the lack of adequate protection of an interest in property of such party in interest;
(2) with respect to a stay of an act against property under subsection (a) of this section, if–
(A) the debtor does not have an equity in such property; and
(B) such property is not necessary to an effective reorganization; [or]
(3) with respect to a stay of an act against single asset real estate under subsection (a), by a creditor whose claim is secured by an interest in such real estate, unless, not later than the date that is 90 days after the entry of the order for relief (or such later date as the court may determine for cause by order entered within that 90-day period) or 30 days after the court determines that the debtor is subject to this paragraph, whichever is later–
(A) the debtor has filed a plan of reorganization that has a reasonable possibility of being confirmed within a reasonable time; or
(B) the debtor has commenced monthly payments that–
(i) may, in the debtor’s sole discretion, notwithstanding section 363(c)(2) [11 USCS § 363(c)(2)], be made from rents or other income generated before, on, or after the date of the commencement of the case by or from the property to each creditor whose claim is secured by such real estate (other than a claim secured by a judgment lien or by an unmatured statutory lien) [, which payments]; and
(ii) are in an amount equal to interest at [a current fair market rate] the then applicable nondefault contract rate of interest on the value of the creditor’s interest in the real estate [.] ; or . . .”

A. Section 362(d)(1).

In denying the creditor a lift stay under Section 362(d)(1), in In re: CGE Shattuck, LLC; Banc of America Commercial Finance Corporation v. CGE Shattouck, LLC, 1999 BNH 46, 1999 Bankr. LEXIS 1880 (Bankr. D.N.H., 1999), the Court held that, in order to obtain a lift stay under Section 362(d)(1), the moving creditor has “to present sufficient evidence to make an initial showing that the value of its collateral has deteriorated since the petition date.”

B. Section 362(d)(2).

In also denying a secured creditor a lift stay under Section 363(d)(2), but granting that creditor certain protections instead, the Court in CGE Shattuck, supra, the Court stated:

“The Supreme Court has adopted the view that to avoid triggering the second prong of § 362(d)(2), a debtor must show that there is “a reasonable possibility of a successful reorganization within a reasonable time,” and that the relevant property is necessary to such a reorganization. See Timbers, 484 U.S. at 376. See also 3 King et al., Collier on Bankruptcy P 362.07[4][b] (15th rev. ed. 1997). Although a debtor need not show that its proposed plan satisfies all of the confirmation requirements as provided by § 1129, it must prove that confirmation is feasible or, in other words, that there is reasonable possibility of confirmation within a reasonable time. See Marder v. Turner (In re Turner), 161 B.R. 1, 4 (Bankr. D. Me. 1993) (the debtor must show that the planned reorganization is feasible); In re Bldg. 62 Ltd. Partnership, 132 B.R. 219, 223 (Bankr. D. Mass. 1991) (“The Debtor . . . is not required to presently demonstrate that the plan will meet all of the confirmation requirements set out in § 1129.”); In re Pelham St. Assocs., 131 B.R. 260, 262-63 (Bankr. D.R.I. 1991) (“§ 362(d)(2)(B) requires only that there be a reasonable possibility of confirmation, within a reasonable time”). The Debtor filed a plan of reorganization on November 22, 1999 (the “Plan”). For the purposes of determining if the Debtor has a reasonable possibility of confirming a plan within a reasonable time in the context of a stay relief motion under § 362(d)(2), the Court need not conduct a full dress rehearsal of a confirmation hearing, but the Court must determine that the Debtor has a basis for proposing a confirmable plan within a reasonable period of time. The Movant has argued that the Plan is not confirmable on its face and, therefore, the Debtor does not have a reasonable possibility of confirming a plan within a reasonable time.”

The Court then proceeded to analyze the classification of claims in the manner set forth below with respect to Section 1129. In doing so, the Court stated the preliminary nature of the analysis at this stage as follows:

“However, the loan agreement between the Debtor and the Movant is complex and the Debtor has alleged several pre-petition breaches by the Movant which may warrant a legal distinction between the Movant’s claim and the general trade creditors or a reduction in the Movant’s claim. Based upon the summary nature of the hearing on the motion for relief and the state of the record, the Court is unable to find that separate classification is either necessary or cannot be justified.”

C. Section 362(d)3).

Section 362(d)(3) related to only “single asset real estate” cases. Section 101 defines “single asset real estate” as:

“(51B) The term “single asset real estate” means real property constituting a single property or project, other than residential real property with fewer than 4 residential units, which generates substantially all of the gross income of a debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental [thereto having aggregate noncontingent, liquidated secured debts in an amount no more than $4,000,000;] .”

Note, however, that Section 362(d)(3) gives the debtor at least a 90-day “breathing space” In re: National/Northway Limited Partnership, 279 B.R. 17, Bankr. LEXIS 616, 39 Bankr. Ct. Dec. 191 (Bankr. D. Mass, 2002) (“National I”) with no express limit upon the length of an extension the Court may grant. Furthermore, it appears that the creditor must file a motion, early, to get a Bankruptcy Court ruling that the subject case is in fact a single asset real estate case.

Moreover, as in the case of Section 362(d)(2), another handicap to the mortgagee is, at this point, the Bankruptcy Court’s depth of review, of the debtor’s possible plan of reorganization, is limited, giving the debtor the benefit of the doubt. As stated in National I, supra:

“[The mortgagee's] request for dismissal requires the Court to examine the confirmability of the plan. Just as a bankruptcy court must determine that a proposed plan is not facially unconfirmable without undertaking a full confirmation hearing when deciding a motion for relief under section 362(d)(2), 449 W. Warren Street Associates, Ltd., 151 B.R. 307, 310 [*23] (Bankr. N.D.N.Y. 1992) (citations omitted), a court should address the question of unconfirmablity in analyzing a request to dismiss. See 11 U.S.C. § 1112(b)(2).”

II. Seeking Conversion or Dismissal under Section 1112.

The secured creditor may also seek conversion or dismissal under Section 1112 based upon the debtor’s “inability to effectuate substantial consummation of a confirmed plan”. Specifically, that Section states, in relevant part:

Ҥ 1112. Conversion or dismissal
(b) (1) Except as provided in paragraph (2) of this subsection, subsection (c) of this section, and section 1104(a)(3) [11 USCS § 1104(a)(3)], on request of a party in interest [or the United States trustee or bankruptcy administrator], and after notice and a hearing, [the court may] absent unusual circumstances specifically identified by the court that establish that the requested conversion or dismissal is not in the best interests of creditors and the estate, the court shall convert a case under this chapter [11 USCS §§ 1101 et seq.] to a case under chapter 7 [of this title] [11 USCS §§ 701 et seq.] or [may] dismiss a case under this chapter [11 USCS §§ 1101 et seq.], whichever is in the best [interest] interests of creditors and the estate, [for] if the movant establishes cause. [ , including --
(1) continuing loss to or diminution of the estate and absence of a reasonable likelihood of rehabilitation;
(2) inability to effectuate a plan;
(3) unreasonable delay by the debtor that is prejudicial to creditors;]
(2) The relief provided in paragraph (1) shall not be granted absent unusual circumstances specifically identified by the court that establish that such relief is not in the best interests of creditors and the estate, if the debtor or another party in interest objects and establishes that–
(A) there is a reasonable likelihood that a plan will be confirmed within the timeframes established in sections 1121(e) and 1129(e) of this title [11 USCS §§ 1121(e) and 1129(e)], or if such sections do not apply, within a reasonable period of time; and
(B) the grounds for granting such relief include an act or omission of the debtor other than under paragraph (4)(A)–
(i) for which there exists a reasonable justification for the act or omission; and
(ii) that will be cured within a reasonable period of time fixed by the court.

(3) The court shall commence the hearing on a motion under this subsection not later than 30 days after filing of the motion, and shall decide the motion not later than 15 days after commencement of such hearing, unless the movant expressly consents to a continuance for a specific period of time or compelling circumstances prevent the court from meeting the time limits established by this paragraph.

(4) For purposes of this subsection, the term “cause” includes–
(A) substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation;
(F) unexcused failure to satisfy timely any filing or reporting requirement established by this title or by any rule applicable to a case under this chapter [11 USCS §§ 1101 et seq.];
[(7)] (M) inability to effectuate substantial consummation of a confirmed plan; . . .”

Thus, the analysis under Section 1112 is the same as that under Section 1129. However, the timeframe under Section 1112(b)(3)is much shorter than those under Section 362(b) and 1129. National I, supra.

Nevertheless, the depth of review, by the Bankruptcy Court, of a possible plan of reorganization proposed by the debtor is also limited. In National I, supra, in substantially granting the motion of the secured creditor, LaSalle Bank, under Section 1112(b), the Court held:

“Unlike a confirmation hearing where the Debtor would bear the burden of demonstrating confirmability, here LaSalle must demonstrate objective futility attempting to confirm a plan. In re Cadwell’s Corners Partnership, 174 B.R. 744, 759 (Bankr. N.D. Ill. 1994), although in other cases courts have concluded that the burden is on the debtor, at least in the context of avoiding relief from stay, to prove a “reasonable probability of effectively reorganizing.” See, e.g., In re Kent Terminal Corp., 166 B.R. 555, 560 (Bankr. S.D.N.Y. 1994). To the extent that the Debtor has a burden to bear, the Court agrees that the burden is judged against a “sliding scale” similar to the one employed by courts in analyzing whether a debtor has demonstrated a sufficient likelihood of a confirmed plan and thereby defeat a motion for relief.

A “sliding scale” is used to determine the extent to which the debtor must prove the possibility of an effective reorganization. In re Ashgrove Apts. of DeKalb County, Ltd., 121 B.R. 752, 756 (Bankr.S.D.Ohio 1990). The stage of the proceeding determines the meaning of “reasonable possibility within a reasonable time” and the extent of the burden of proof on the debtor. Id. At a minimum the debtor must show that (1) it is proceeding to propose a plan of reorganization, (2) the proposed or contemplated plan has a realistic chance of being confirmed and (3) the proposed or contemplated plan is not patently unconfirmable. (citations omitted)”

III. Seeking to Avoid a Cramdown under Section 1129.

A. The Usual Goal of the Major Secured Creditor: Avoiding a Separate Class of Impaired Unsecured Non-Insider Creditors That the Secured Creditor Does Not Control.

A “cramdown” is usually a plan of reorganization, approved by the Bankruptcy Court under Section 1129(b), that is supported by at least one class of non-insider impaired (and usually unsecured) claims or interests, and that is objected to by at least one class of creditors (usually a secured creditor whose loan terms are adversely affected by the plan of reorganization). The plan of reorganization is labeled as a cramdown with respect to that objecting creditor. Usually, in a single asset case, the secured creditor’s secured claims are by far the largest and most pressing claims and its claims for deficiencies are so large as to give it control of a class of unsecured creditors. Therefore, the debtor usually tries to structure the classes of claims of interests so as to buy-off, or otherwise have, at least one separate class of impaired unsecured non-insider creditors who will vote in favor of the debtor’s plan of reorganization, a process called gerrymandering. The usual issue in this conflict is over how the various claims are to be classified in forming the classes who can vote on the plan of reorganization. National I, supra.

Section 1129 establishes the minimum requirements of a plan of reorganization, and, in doing so, provides, in relevant part, as follows:

Ҥ 1129. Confirmation of plan
(a) The court shall confirm a plan only if all of the following requirements are met:

(3) The plan has been proposed in good faith and not by any means forbidden by law.

(7) With respect to each impaired class of claims or interests–
(A) each holder of a claim or interest of such class–
(i) has accepted the plan; or
(ii) will receive or retain under the plan on account of such claim or interest property of a value, as of the effective date of the plan, that is not less than the amount that such holder would so receive or retain if the debtor were liquidated under chapter 7 of this title [11 USCS §§ 701 et seq.] on such date; or
(B) if section 1111(b)(2) of this title [11 USCS § 111(b)(2)] applies to the claims of such class, each holder of a claim of such class will receive or retain under the plan an account of such claim property of a value, as of the effective date of the plan, that is not less than the value of such holder’s interest in the estate’s interest in the property that secures such claims.

(8) With respect to each class of claims or interests–
(A) such class has accepted the plan; or
(B) such class is not impaired under the plan.

(10) If a class of claims is impaired under the plan, at least one class of claims that is impaired under the plan has accepted the plan, determined without including any acceptance of the plan by any insider.

(11) Confirmation of the plan is not likely to be followed by the liquidation, or the need for further financial reorganization, of the debtor or any successor to the debtor under the plan, unless such liquidation or reorganization is proposed in the plan.

(b)(1) Notwithstanding section 510(a) of this title [11 USCS § 510(a)], if all of the applicable requirements of subsection (a) of this section other than paragraph (8) are met with respect to a plan, the court, on request of the proponent of the plan, shall confirm the plan notwithstanding the requirements of such paragraph if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.”

The governing provision, of the Bankruptcy Code, for determining classes, is Section 1122, which provides as follows:

“(a) Except as provided in subsection (b) of this section, 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.
(b) A plan may designate a separate class of claims consisting only of every unsecured claim that is less than or reduced to an amount that the court approves as reasonable and necessary for administrative convenience.”

Related thereto, is Section 1126(c), which governs the voting as to whether or not a class accepts the proposed plan, as follows:
“(c) A class of claims has accepted a plan if such plan has been accepted by creditors, other than any entity designated under subsection (e) of this section, that hold at least two-thirds in amount and more than one-half in number of the allowed claims of such class held by creditors, other than any entity designated under subsection (e) of this section, that have accepted or rejected such plan.”
B. The Strict Interpretation Approach to Classification.

In National I, supra, the Court rejected a debtor’s plan that contained the following 8 classes of claims or interests:

“class 1- taxes and municipal charges;
class 2- the secured claim of LaSalle [the objecting mortgagee];
class 3- the claim of C&W which the plan describes as the “C&W secured claim” [that collateral being real property not owned by the debtor"];
class 4- Lasalle’s general unsecured claim;
class 5-general unsecured claims;
class 6-convenience class consisting of general unsecured claims less than or voluntarily reduced to $ 2,500;
class 7- Affiliate loan claims; and
class 8- equity interests.”

After holding that classes 1 and 8 were unimpaired, the Bankruptcy Court dealt with the classification of the other creditors into classes separate from that of the deficiency claims of the objecting mortgagee, LaSalle Bank.

In holding that the various types of remaining unsecured claims (except the administrative convenience class, which the Court broke apart) really constituted a single class, the Court applied the following rules in determining classification of claims under Section 1122:

“The more difficult question is posed by the separate classifications of C&W’s and LaSalle’s unsecured claims. Except for the approval of convenience classes, section 1122 provides little guidance as to how claims are to be classified. It mandates that only “substantially similar” claims or interests may be grouped together. It does not indicate whether claims that are substantially similar must be classified together. In this circuit, however, the answer is that they must.

Granada Wines, Inc. v. New England Teamsters and Trucking Industry Pension Fund, 748 F.2d 42 (1st Cir. 1984), is the controlling case for classification of claims in this circuit.
The general rule regarding classification is that “‘all creditors of equal rank with claims against the same property should be placed in the same class.’” (citation omitted) In re Los Angeles Land and Investments, Ltd., 282 F. Supp. 448, 453 (1968), aff’d, 447 F.2d 1366 (9th Cir.1971) (quoting In re Scherk v. Newton, 152 F.2d 747 (10th Cir.1945)). Separate classifications for unsecured creditors are only justified “where the legal character of their claims is such as to accord them a status different from other unsecured creditors….” Id. at 454.

Granada Wines, 748 F.2d at 46. Therefore if LaSalle’s and C&W’s unsecured claims are of the same legal character as the other unsecured claims, they must be placed in class 5.

[The Court in National I, supra then quoted favorably as follows:] After reviewing the leading cases on classification of non-recourse deficiency claims, Judge Goodman adopted the approach set forth in Phoenix Mutual Life Ins. V. Greystone III Joint Venture (In the Matter of Greystone III Joint Venture), 948 F.2d 134 (5th Cir. 1991), vacated in part per curiam, reh’g en banc denied, 1992 WL 35878 (February 27, 1992). 14 In Greystone, the Fifth Circuit announced the often-quoted commandment for classification: “thou shalt not classify similar claims differently in order to gerrymander an affirmative vote on a reorganization plan.” Cantonwood, 138 B.R. at 653, quoting Greystone, 948 F.2d at 139. The Greystone court rejected separate classification of a non-recourse deficiency claim arising under section 1111(b).

[The Court in National I, supra then quoted favorably as follows:] It is well summarized in Collier on Bankruptcy, Vol. 6A, Section 9.13(1), Pg. 238, as follows: ‘The fact that (unsecured) claims may take various forms–as for example, notes, accounts, written contracts, torts or the like–would not ordinarily compel separate classification since an unsecured indebtedness or liability is the common denominator of all.’” (citation omitted)

Cases under the Bankruptcy Act, including In the Matter of Los Angeles Land and Investments, Ltd., cited with approval by the Granada Wines court, recognized that while generally “all creditors of equal rank with claims against the same property should be placed in the same class”, sometimes the legal character of some claims “is such as to accord them a status different from other unsecured creditors, i.e., claims within the ‘six-month rule’ or tax claims.” Los Angeles Land and Investment, 282 F. Supp. at 454. “It is well summarized in Collier on Bankruptcy, Vol. 6A, Section 9.13(1), Pg. 238, as follows: ‘The fact that (unsecured) claims may take various forms–as for example, notes, accounts, written contracts, torts or the like–would not ordinarily compel separate classification since an unsecured indebtedness or liability is the common denominator of all.’” (citation omitted)

Gerrymandering is still unacceptable, and in this circuit at least, because section 1122 remained unchanged, unsecured claims, whether trade or deficiency claims, must be classified together.”

In National I, supra, the court also held that a separate classification was not warranted for a creditor which is guaranteed by persons other than the debtor or secured by property not belonging to the debtor. Specifically, the Court held:

“Moreover, while the Debtor criticized LaSalle for ignoring Johnston, the Debtor ignores In re Thornwood, 161 B.R. 367 (Bankr. M.D.Pa.), aff’d., 162 B.R. 438 (M.D. Pa. 1993). In that case the court refused to separate classification of an unsecured claim which was also guaranteed by the debtor’s principal. “The focus of claim classification requirements should be upon the nature of the creditor’s claims ‘as it relates to the assets of the debtor.’ (citations omitted) Moreover, even Bjolmes, which the Debtor urges this Court to adopt with respect to Lasalle’s claim, stated that the presence of a personal guarantee is insufficient to meet the Granada Wines test. (citation omitted) If the existence of a personal guarantee, which provides the creditor a means to collecting payment not available to other unsecured creditors, does not affect the legal nature of the guaranteed claim, the existence of another means of collecting payment, albeit in the form of a mortgage, should also not affect the legal nature of the unsecured claim. As to the Debtor’s asset, C&W is unsecured.”

C. The Economic Differences Approach to Classification.

In CGE Shattuck, supra, the Court summarized the line of case law, outside the cases represented by National I, supra, in the U.S. First Circuit Court of Appeals, as follows:

“The Plan separately classifies the Movant’s unsecured deficiency claim from other unsecured claims. The Movant contends that separate classification of its deficiency claim from other general unsecured trade creditors is not permissible under § 1122(a). The First Circuit Court of Appeals has stated that “the general rule regarding classification is that ‘all creditors of equal rank with claims against the same property should be placed in the same class.’” Granada Wines, Inc. v. New England Teamsters and Trucking Ind. Pension Fund, 748 F.2d 42, 46 (1st Cir. 1984) (quoting In re Los Angeles Land and Invs., Ltd., 282 F. Supp. 448, 453 (1968)). Granada adopts the strict approach under pre-Code Chapter X cases which required that a plan must classify all legally similar claims together regardless of business or economic issues. See In re Barney & Carey Co., 170 B.R. 17, 24 (Bankr. D. Mass. 1994). However, no other Circuit Court of Appeals has followed the First Circuit’s strict approach. Courts of Appeals for the Second, Third, Fourth, Fifth, Eighth and Ninth Circuits have held that a debtor proposing a cramdown plan must show a reason for separately classifying unsecured claims other than the need to secure the vote of an impaired class of claims. (citations omitted) Those cases hold that separate classification of legally similar claims is not prohibited, but may only be undertaken for business or economic reasons independent of the debtor’s need to secure the acceptance of a plan by an impaired accepting class of creditors for purposes of confirmation of a cramdown plan of reorganization.”

IV. If Subject to a Cramdown, Seeking to Avoid Certain Provisions thereof under Section 1129.

The debtor National I, supra, revised its proposed plan of reorganization. The last such revision was designated as the “September 30 Plan” and was rejected by the Bankruptcy Court in In re National/Northway Limited Partnership, 2002 Bankr. LEXIS 1482, 50 Collier Bankr. Cas. 2d (MB) 1252 (Bankr. D. Mass., 2002) (“National II”). There, the Court analyzed the September 30 Plan and granted LaSalle the lift stay as follows:

“Importantly the September 30 Plan provides that the Debtor will use the escrowed rents, namely LaSalle’s own cash collateral (the “Cash Collateral”), which the Debtor has been collecting from Hi-Tech [the tenant], to pay the administrative expenses of the bankruptcy. The accompanying disclosure statement is clear: the Debtor does not have an alternative in the event it is denied use of those funds. Finally, the September 30 Plan calls for LaSalle’s claim to be amortized over 20 years with a balloon payment on the fifth anniversary of the effective date of the plan. The junior secured creditor, which agreed to a slightly reduced amount of its claim, and the unsecured creditors will all be paid in full within the first year of the plan term. The Cash Collateral will be used to help fund these payments.

In order to confirm the September 30 Plan, the Court must find that the Debtor has the ability to make the distributions called for under the plan. In the instant case, the Debtor cannot make such payments unless it is permitted to invade the escrowed funds. The Debtor does not dispute that the funds are LaSalle’s collateral. Instead it argues that it should be permitted to use them because LaSalle is getting the indubitable equivalent of its claim. It has not, or could it, argue that a surcharge of LaSalle’s collateral is permissible under 11 U.S.C. § 506(c). “It is the general rule that the unsecured creditors must assume the costs of administering the estate.” (citations omitted) (“The general rule is that post-petition administrative expenses and the general costs of reorganization ordinarily may not be charged to or against secured collateral.”); (citation omitted) (“Payment of administration expenses traditionally has been the responsibility of the debtor’s estate, not its secured creditors.”). Consistent with this rule and the Code’s priority scheme, the claim of an attorney rendering services to an estate is not entitled to priority over the claim [*36] of a secured creditor to its collateral. (citation omitted)
Because the Debtor may not use the Cash Collateral to pay its professional fees, the Plan does not satisfy section 1129(a)(1). Therefore the Court need not address the Debtor’s proposal to pay other creditors using LaSalle’s collateral.”