Confirming the Plan: The Absolute Priority Rule Problem. Anne Lawton*

Transcription

1 Confirming the Plan: The Absolute Priority Rule Problem By Anne Lawton* On December 8, 2014, the American Bankruptcy Institute Commission to Study the Reform of Chapter 11 ( Commission ) released its Final Report and Recommendations ( Report ). 1 Part VII of the Report contains the Commission s recommendations for small or medium- sized enterprise cases ( SMEs ). In this Article, the third of several outlining the Commission s recommendations for SMEs, I discuss the Commission s proposals for amending the Code s current rules in cases involving unsecured creditor cramdown. Overview The Commission recommends several amendments to the Code s current provisions governing plan confirmation. 2 First, the Commission proposes a change to the numerosity requirement of 1126(c). 3 Second, the Commission recommends deleting the Code s current requirement that at least one class of impaired claims vote to accept the plan. 4 Third, in cases in which the SME debtor seeks confirmation of its plan under 1129(b)(2)(B) because a class of unsecured creditors has voted to reject the plan, the Commission proposes two alternative paths to confirmation the new value corollary and the SME equity retention plan. The Commission s goal is to improve confirmation rates for small business enterprises by offering alternative paths to confirmation that allow small business owners to retain their ownership interest in the reorganized firm, notwithstanding the absolute priority rule. 5 In order to demonstrate how the Commission s recommendations would work, consider the hypothetical chapter 11 filing of Poe, Inc. Poe is a family- run business in financial distress. It is not engaged in real property activities, and qualifies as an SME. Marie and Roger, a married couple, each own 50% of Poe s shares, which are not publicly traded. Marie and Roger also serve as the firm s President and Vice- *Professor, Michigan State University College of Law. American Bankruptcy Institute Resident Scholar, Spring Term See AMERICAN BANKRUPTCY INSTITUTE COMMISSION TO STUDY THE REFORM OF CHAPTER 11, FINAL REPORT AND RECOMMENDATIONS [hereinafter Commission Report]. 2 None of the proposed changes apply to individual chapter 11 debtors. See id. at 288 (stating that the Commission did not consider reform proposals for individual chapter 11 debtors ). 3 See id. at See id. 5 See id. at 299 (describing testimony from several witnesses arguing that the absolute priority rule and courts disparate treatment of the new value corollary doom many small business debtors plans ) (footnotes omitted). 1

2 President, respectively. Poe s unsecured liabilities total $150,000, which includes $30,000 in pre- petition loans that Roger made to the firm. When Poe files for relief under chapter 11, its Schedule F includes 15 entries. Three of those entries describe Roger s three pre- petition loans to the firm. 1. Section 1126(c) The Commission recommends replacing 1126(c) s numerosity requirement more than one- half in number of those voting with a one creditor, one vote approach. 6 The Commission makes no change to 1126(c) s requirement that creditors holding at least two- thirds in amount of allowed claims in the class vote to accept the plan. The Commission s proposal applies to SME and non- SME debtors alike. In order to demonstrate how the proposed revision to the numerosity requirement operates, assume that Poe proposes a plan of reorganization with a single class of unsecured creditors ( Class V ). Suppose Roger s three loans stem from three separate pre- petition transactions and that he files three proofs of claim. 7 Thus, Roger holds three claims in Class V, and he will vote all three claims in favor of the plan. Of the remaining 12 unsecured creditors in Class V, only 9 vote on the plan. Thus, creditors holding 12 of the 15 claims listed on Schedule F cast votes either in favor of or against Poe s plan of reorganization. Assume that of the creditors casting votes in favor of Poe s plan, 1126(c) s requirement that at least two- thirds in amount of those claims voted is satisfied. As a result, only 1126(c) s numerosity requirement is at issue. Currently under the Code, Roger s voting of his three claims counts toward the requirement in 1126(c) that more than one- half in number of the allowed claims voting cast votes in favor of Poe s plan. 8 If creditors holding 12 claims vote on the plan, then an affirmative vote for Poe s plan by 7 claimants means that Class V accepts the plan. Because Roger holds 3 of those 7 claims, however, only 4 other unsecured creditors holding claims in Class V must vote yes on the plan in order to satisfy the Code s current numerosity requirement. In cases in which the SME s owners hold multiple claims, the Commission s proposed change to the numerosity requirement may alter the ability of the SME debtor to obtain confirmation by consent. As Poe s hypothetical case demonstrates, the Commission s proposal may diminish the owners influence in the voting process. 6 See id. at See, e.g., In re Gilbert, 104 B.R. 206 (Bankr. W.D. Mo. 1989). In Gilbert, the bankruptcy court held that a creditor holding two claims in a class of unsecured creditors could vote both claims because [e]ach claim arose out of a separate transaction, evidencing separate obligations for which separate proofs of claim were filed. Id. at 211. The Gilbert court noted that the formula contained in Section 1126(c) speaks in terms of the number of claims, not the number of creditors, that actually vote for or against the plan. Id. (italics in original) (footnote omitted) (citations omitted) U.S.C. 1126(c) (2012). 2

3 In Poe s case, the Commission s proposed change increases by 1 the number of other unsecured creditors who must cast affirmative votes on Poe s plan in order for Class V to accept the plan. 9 While Roger holds 3 unsecured claims, his 3 votes count as 1 under the Commission s one creditor, one vote principle. That means that for purposes of the numerosity requirement, only 10 claimants voted, not In order to satisfy the revised more- than- one- half- in- number requirement, at least 6 creditors must vote in favor of Poe s plan. Roger casts one affirmative vote, which means that 5 other unsecured creditors must vote in favor in order for Class V to accept the plan. In this example, then, the Commission s recommendation would increase from 4 to 5 the number of non- owner votes required to approve the debtor s plan. It is important to realize, however, that the one creditor, one vote principle applies with equal force to all creditors, not simply to owner/creditors. Thus, a trade creditor with two claims also would count as one vote under the Commission s one creditor, one vote principle. Moreover, is it really a bad thing to require a debtor to obtain a potentially larger proportion of non- owner affirmative votes in order to confirm a plan as a consent plan under 1129(a)? 2. Section 1129(a)(10) Section 1129(a)(10) of the Code requires that if the debtor s plan impairs a class of claims, then at least one class of claims that is impaired under the plan must accept the plan, and that acceptance is determined without including any acceptance of the plan by any insider. 11 In other words, if Roger holds three unsecured claims in Class V, his three votes in favor of the plan do not count in determining whether Class V is an accepting class for purposes of 1129(a)(10). The Commission recommends deleting 1129(a)(10) for SME and non- SME cases alike. What happens if Congress adopts the Commission s recommended changes for 1126(c) and 1129(a)(10)? Suppose Poe s plan impairs only Class V, and a total of 12 claims vote on the plan, three of which are held by Roger. Assume that the vote satisfies 1126(c) s requirement that two- thirds in amount of claims vote to accept the plan. Roger s three votes count as one vote now for purposes of 1126(c) s numerosity requirement. If 5 other creditors vote in favor of the plan, then the bankruptcy 9 The Commission recognizes that if a creditor holds claims in different capacities (e.g., as an indenture trustee and as an individual creditor) [then it] should be able to vote once in each capacity. Commission Report, supra note 1, at If 12 creditors cast votes on the plan, either in favor or against, and Roger casts 3 of those 12 votes, then 2 of those votes are not counted in the denominator for purposes of the Commission s recommended change to 1126(c) s numerosity requirement U.S.C. 1129(a)(10) (2012). 3

4 court may confirm Poe s plan as a consent plan, so long as the plan satisfies the other requirements of 1129(a). 12 But, what if Roger and only 4 other claimants in Class V vote to accept Poe s plan? Only 10 claims voted, so 5 affirmative votes fails to satisfy 1126(c) s more- than- half- in- number requirement. Nonetheless, Poe may try to cramdown its plan because under the Commission s proposal it need not satisfy 1129(a)(10) s requirement of one accepting impaired class. 3. Section 1129(b)(2)(B) Assume that Class V is impaired under the terms of Poe s plan and votes to reject. The plan also provides that Marie and Roger will retain their ownership interests in the reorganized Poe. These facts present an absolute priority rule problem for the debtor. In its Report, the Commission proposes two alternative ways that an SME debtor may obtain plan confirmation in such circumstances. The first is the Commission s recommendation to codify the new value corollary for SME and non- SME debtors alike. The Commission explained that while the Supreme Court has acknowledged that the new value corollary might exist under certain circumstances, it [has] not resolve[d] the issue [and] [l]ower courts have adopted different approaches to assessing this potential exception. 13 Codifying the new value exception, according to the Commission, would provide further clarity and enhance the confirmation process in many cases. 14 At the same time, the Commission recognized that the application of what we call the absolute priority rule... and the so- called new value exception to it in small to mid- size Chapter 11 cases proves problematic. 15 As a result, the Commission recommends a second path for plan confirmation the SME equity retention plan. a. The New Value Corollary The Commission recommends codifying the new value corollary as an express exception to the absolute priority rule. 16 The proposal for a statutory new value corollary has three necessary components: 12 Unlike 1129(a)(10), nothing in the language of 1126(c) requires the bankruptcy court to subtract off insider votes, such as Roger s, in determining the number of votes accepting the plan. See In re Gilbert, 104 B.R. 206, 213 (Bankr. W.D. Mo. 1989) (stating that [n]owhere in Section 1126(c) is there any reference to an exclusion of insiders for purposes of determining whether a class is an accepting class ). 13 Commission Report, supra note 1, at 225 (footnote omitted). 14 Id. at Id. at 299 (footnote omitted). 16 Id. at

5 New money or money s worth; In an amount proportionate to the equity received or retained by prepetition equity security holders; and Subject to a reasonable market test. 17 The Commission s recommendation applies to both SME and non- SME debtors. What does this proposal mean for Poe, and Marie and Roger? It allows Marie and Roger to retain their equity interests in Poe, so long as they contribute money or money s worth equal to Poe s reasonable market value. As the Supreme Court held in Norwest Bank Worthington v. Ahlers, Marie s and Roger s sweat equity does not constitute money or money s worth. 18 The bankruptcy court must determine Poe s reasonable market value, but based on what market? There is no clear answer to that question. The Commission specifically declined to define an appropriate market test, instead leaving to bankruptcy courts the process of determining market value based on the facts of each individual case. 19 Determining market value requires expert evidence, which can be costly. The expense of a valuation hearing coupled with the cost of the investment needed to satisfy the new value corollary may simply be too much for many small businesses. Thus, the Commission recommends an alternative path to confirmation, specifically for SME debtors the SME equity retention plan. b. The SME Equity Retention Plan The Commission s goal in recommending creation of the SME equity retention plan is to create an equity retention structure that would appropriately align the interests of prepetition management and equity with the debtor s reorganization and protect the interests of unsecured creditors, despite noncompliance with the traditional absolute priority rule. 20 Thus, the reorganized firm benefits from having continuity of ownership and management, because the pre- petition owners, who possess the knowhow and relationships necessary to facilitate a successful restructuring of the business retain their interests in the reorganized firm. 21 At the same time, the Commission s proposal provides the class of unsecured creditors leverage because if the reorganized firm fails to pay the allowed claims of unsecured creditors in full over the course of four years from the plan s effective date, the unsecured creditors, as a group, take a majority ownership interest in the reorganized firm. 17 See id U.S. 197, 204 (1988) (stating that even if the new value exception to the absolute priority rule survived enactment of the Code, it does not include promises to contribute " labor, experience, and expertise to the reorganized enterprise ). 19 Commission Report, supra note 1, at Id. at Id. (footnote omitted). 5

6 In order to understand how the Commission s proposal works, let s return to our hypothetical chapter 11 debtor, Poe, Inc. Suppose Poe proposes a plan of reorganization that promises to pay less than the full amount of the allowed claims of unsecured creditors in Class V. Class V votes to reject the plan, and Marie and Roger have no cash to invest in Poe to satisfy the new value corollary. The Commission would allow Poe now to seek confirmation of an equity retention plan. The equity retention plan would differ from Poe s earlier proposed plan, which Class V rejected, in only one respect: its treatment of the class of unsecured creditors in Class V. In order for the bankruptcy court to confirm Poe s equity retention plan, Marie and Roger must remain involved, on a basis reasonably comparable to their prepetition involvement, in the ongoing operations of the reorganized [Poe]. 22 The reason for this requirement of continued participation by the pre- petition owners is to ensure less disruption in the operation of the business post- bankruptcy. In addition, the bankruptcy court may confirm Poe s equity retention plan only if the plan provides for the issuance to the unsecured creditors in Class V on the plan s effective date of 100 percent of a class of preferred stock, similar preferred interests, or payment obligations... (referred to as the creditors preferred interests ). 23 The creditors preferred interests must provide for two things: (1) pro rata voting rights on extraordinary transactions; and (2) entitlement to 85% of economic distributions by the reorganized Poe. 24 Extraordinary transactions include the sale of all or substantially all of Poe s assets, changes to Marie s or Roger s compensation from what the plan described, and changes to Poe s organizational documents to alter the rights of the holders of creditors preferred interests. 25 Economic distributions include dividends or proceeds received from liquidation or sale. 26 The plan also must provide that at least once per year for each of the three full fiscal years following the effective date of the chapter 11 plan, Poe must pay what the Commission labels as excess cash flow to the holders of the creditors preferred interests. 27 The amount of that payment is based on what is reasonable in relation to the company s operating cash flow for that fiscal year. 28 If Poe fails to redeem the creditors preferred interests by paying in cash the full face value of each creditor s unsecured claim no later than the fourth anniversary of the effective date of Poe s plan, the creditors preferred interests mature and convert into 85% of Poe s common stock See id. at Id. (bold in original). 24 See id. 25 See id. at See id. at Id. 28 Id. 29 Id. at

7 As a practical matter, what do these various requirements mean for Poe, and for Marie and Roger? i. Amending Organizational Documents If the bankruptcy court confirms Poe s equity retention plan, then Poe may have to amend its charter to provide for the creation of the creditors preferred interests. As outlined above, those interests entitle the holders to pro rata voting rights on extraordinary transactions, and 85% of any economic distributions made by the reorganized Poe. Suppose Acme holds 10% of the allowed claims in Class V. If Marie and Roger want to pay themselves a larger salary than described in Poe s plan an extraordinary transaction - then Acme has the right to vote on that request for increased compensation. Marie and Roger may only increase their compensation if more than 50% of all holders of the creditors preferred interests vote to approve the increase. 30 Therefore, if Acme is the only creditor that bothers to vote, even if it votes yes, Marie and Roger may not increase their compensation. Suppose Poe pays dividends of $100. Under the equity retention plan, holders of the creditors preferred interests receive $85 of that $100. Acme, as the holder of 10% of the allowed claims in Class V, would be entitled to $8.50 of the $85 in dividends. 31 Marie and Roger would receive $15. ii. Excess Cash Flow The holders of the creditors preferred interests are entitled to payment, at least annually, of Poe s excess cash flow for the three full fiscal years following the effective date of Poe s plan. The Commission does not define excess cash flow; instead, it merely says that the excess cash flow payment must be reasonable in relation to the firm s operating cash flow. The amount of the excess cash flow payments, however, should not be a total mystery to the unsecured creditors. Poe must include a budget with its plan and disclosure statement showing its projections for excess cash flow. While projections are just that projections disclosure does afford creditors some general idea of the amount they can expect to receive post confirmation. Moreover, the projections are necessary in order for the bankruptcy court to determine whether Poe s equity retention plan is feasible See id. at 298. The plan may provide for a greater- than- majority vote, but an absolute majority vote by the holders of the creditors preferred interests is required. See id. 31 The Commission does not specify how to allocate economic distributions among the unsecured creditors, but pro rata distribution makes sense. 32 See 11 U.S.C. 1129(a)(11) (2012). 7

8 While the Commission does not specify the method of distributing excess cash flow, it is likely that the debtor will distribute the payments on a pro rata basis. Suppose, then, that Poe has $10,000 in excess cash flow during its first full fiscal year after the plan s effective date. Acme, as the holder of 10% of the claims in Class V, would receive $1000 of the total $10,000 distributed. iii. Redemption Poe must redeem the creditors preferred interests no later than four years after the plan s effective date or those interests convert into 85% of Poe s common stock, thereby diluting Marie s and Roger s ownership interests in the firm. Redemption must be for cash and equal to the face amount of each unsecured creditor s claim, taking into account any payments already made to that creditor, either as an economic distribution or as payment of excess cash flow. The Commission s proposal does not contemplate the payment of interest to unsecured creditors. The following two examples show how plan confirmation affects the timing not only of the first payments of excess cash flow, but also of the redemption of the creditors preferred interests. The debtor concerned with having sufficient cash flow in the early days post- confirmation may try to time confirmation to push back the first payment of excess cash flow to unsecured creditors, as in Example #1. The debtor concerned with having the funds necessary to redeem the creditors preferred interests may prefer more time at the back end of the payment period, as in Example #2. Example #1 Suppose Poe s fiscal year runs from July 1 through June 30. On June 28, 2015, the bankruptcy court confirms Poe s equity retention plan, which has an effective date of August 1, Three full fiscal years means that the time period from August 1, 2015 through June 30, 2016 does not count for purposes of cash flow distributions, because it is not a full fiscal year. Therefore, Poe need make no payments to the unsecured creditors under the equity retention plan until June 30, 2017, which is the end of the first full fiscal year post- bankruptcy. Suppose Acme holds $15,000 of Poe s total $150,000 in unsecured claims. It receives $1,000 in excess cash flow on June 30, 2017, June 30, 2018, and June 30, 2019, which are the three full fiscal years following the effective date of Poe s plan. Poe makes no economic distributions during this same time frame. The creditors preferred interests, including Acme s, mature on the fourth anniversary of the effective date, which is August 1, The redemption trigger, then, occurs about one month after the final payment of excess cash flow on June 30, Poe must pay Acme $12,000 in cash on or before August 1, The $12,000 is the face amount of Acme s claim minus the three $1,000 payments of annual excess cash flow. If Poe fails to redeem, then Acme s preferred interest and the preferred interests of other unsecured creditors whose claims are not fully paid convert to 85% of Poe s common stock. In other words, Marie and Roger lose their 8

9 controlling ownership interest in Poe if Poe fails to redeem the creditors preferred interests on or before August 1, Example #2 Suppose Poe s fiscal year runs from July 1 through June 30. On April 25, 2015, the bankruptcy court confirms Poe s equity retention plan, and June 1, 2015 is the plan s effective date. Poe s unsecured creditors will receive their first payment of excess cash flow no later than June 30, 2016, the end of the first full fiscal year post- bankruptcy. Suppose Acme holds $15,000 of Poe s total $150,000 in unsecured claims. It receives $1,000 in excess cash flow on June 30, 2016, June 30, 2017, and June 30, 2018, which are the three full fiscal years following the effective date of Poe s plan. Poe makes no economic distributions during this same time frame. The creditors preferred interests, including Acme s, mature on the fourth anniversary of the effective date, which is June 1, The redemption trigger, then, does not occur for another eleven months from the final payment of excess cash flow on June 30, Poe must pay Acme $12,000 in cash on or before June 1, If Poe fails to do so, then Acme s preferred interest and the preferred interests of other unsecured creditors whose claims are not fully paid convert to 85% of Poe s common stock. Conclusion Small businesses typically have unified ownership and management. Owners seeking to reorganize the business want to retain their pre- petition ownership interests, because the business is not simply a business for them. The owners have a personal stake in seeing the business succeed. Chapter 11 s absolute priority rule, however, raises the prospect that small business owners may be unable to keep their ownership stake in the reorganized business. If a class of unsecured creditors rejects the plan and the firm cannot afford to pay those creditors allowed claims in full (with interest if paid out over time) 33 or satisfy the jurisdiction s new value exception, then the debtor s reorganization fails. In order to address this problem, the Commission recommends two significant amendments to the Code s rules on unsecured creditor cramdown. First, it proposes codifying the new value corollary, a recommendation applicable to SME and non- SME debtors, alike. According to the Commission, codification would provide much- needed clarity, thereby enhancing the plan confirmation process. 34 Second, for SME debtors without sufficient financial resources to use the new value corollary, the Commission recommends allowing SME debtors to confirm a plan, 33 See 11 U.S.C. 1129(b)(2)(B)(i) (2012). 34 See Commission Report, supra note 1, at

10 notwithstanding the absolute priority rule, if they pay the face amount of their unsecured creditors claims within four years of the plan s effective date. This alternative path to confirmation balances the interests of equity holders and creditors. The firm stays in business, owners keep their ownership interests, and unsecured creditors are paid in full over time, albeit without interest. 10