Bankruptcy Court for the District of Arizona Holds Separate Classification of Undersecured Creditor's Deficiency May Be Required By § 1122(a)

Dale C. Schian

By Dale C. Schian and Trent S. Trueblood

This article was published in the February 2011 ABI Real Estate Committee Newsletter. The subject case for this article, In re Loop 76 LC, was argued before the Ninth Circuit Bankruptcy Appeals Panel (BAP) on January 19, 2012.

To confirm a Chapter 11 plan under the so-called "cramdown option," at least one impaired class of creditors must accept the proposed plan.[1] For a class to accept a plan, more than one half (in number) of the voting claimants in a class, representing at least two-thirds of the total dollar amount of voting claims in such class, must vote to accept.[2] In single-asset real estate cases,[3] the lienholder frequently holds a deficiency claim larger than one third of the total dollar amount owed to unsecured creditors,[4] giving it an effective veto on the plan unless the lienholder's deficiency claim is classified separately from the claims of other unsecured creditors.

Section 1122 of the Bankruptcy Code, Classification of Claims or Interests, does not restrict a debtor's ability to separately classify similar claims in a plan of reorganization.[5] However, nearly all courts place some restrictions on the debtor's freedom to classify claims separately.[6] The prevailing view follows the "one clear rule," that debtors may not "gerrymander" substantially similar claims into separate classes for the purposes of confirming a plan.[7] It requires that a debtor establish a credible business or economic justification to separately classify unsecured claims from the deficiency claims.[8]

I. In re Loop 76 LLC

In In re Loop 76 LLC, the United States Bankruptcy Court for the District of Arizona held that if a guaranty by a non-debtor provides the lienholder an alternative source of repayment for a deficiency claim, then the deficiency claim is not necessarily "substantially similar" to other unsecured claims. If the evidence presented at a confirmation hearing established that the guarantee was a significant factor in determining the creditor's vote (for example, by showing that the guarantee had value), § 1122 requires the "guaranteed" deficiency claim be classified separately from non-guaranteed unsecured claims.[9] Issues of "gerrymandering" would not arise because § 1122 precludes placing dissimilar claims in the same class.[10]

The court based its holding on In re Johnston.[11] Johnston had affirmed the separate classification of a deficiency claim where, unlike other unsecured creditors, the undersecured creditor (1) was partially secured by the collateral of a non-debtor; (2) was engaged in litigation with the debtor that might result in the reduction or elimination of its deficiency claim; and (3) might recover before any of the other unsecured creditors if it prevailed in the litigation.[12] The Loop 76 court observed that only the first factor provided a "basis on which to ascertain dissimilarity," [13] the starting point in applying § 1122. The court found that, like third-party collateralization in Johnston, the third-party guaranty provided the deficiency creditor with an alternative source of payment.[14] Thus, Johnston and Loop 76 hold that it is permissible for a bankruptcy court to find, as a matter of fact, that a non-debtor source of repayment may render a claim substantially dissimilar from other unsecured claims for purposes of § 1122, requiring that it be separately classified.[15]

The deficiency claimant in Loop 76 argued that Johnston was no longer controlling,[16] given the Ninth Circuit Court of Appeals’ decision in In re Bakarat, which rejected separate classification as a means to "gerrymander" an impaired accepting class absent a "legitimate business or economic reason to do so."[17] The Loop 76 decision observed that Bakarat had only addressed the legal limits on separately classifying claims that had already been determined to be substantially similar. It found that Bakarat did not analyze whether the claims were substantially similar in fact,[18] but that Bakarat had simply distinguished Johnston and could not have overruled it.[19] Therefore, the Loop 76 decision found Bakarat to be inapposite, leaving the court to determine whether the Johnston factors applied.

Based upon authority under chapter X of the Bankruptcy Act,[20] Loop 76's deficiency creditor further argued that the Code requires the common classification of "all creditors of equal rank with claims against the same property." The court also rejected this view. First, it observed that relying on jurisprudence under chapter X to interpret § 1122 was not appropriate and that chapter 11 of the Code more closely resembles chapter XI of the Bankruptcy Act rather than chapter X.[21] In chapter XI of the Act, the classification rule was intended to be flexible. Chapter XI of the Act did not permit courts to order reclassification from what the debtor had proposed.[22] Moreover, had the Code's drafters intended to forbid the separate classification of claims with the same priority, they could have easily substituted the term "priority" for "similarity" in § 1122, eliminating any ambiguity.[23]

The Loop 76 court further noted that the interpretation of § 1122 that the deficiency creditor proposed would contradict the purpose of classification. Under either chapter of the Act, separate classification was only important to determine how claims were treated and which claims were required to be treated alike.[24] Under the Code, classifying dissimilar claims in a single class became a concern because classes can waive the absolute priority rule, perhaps to the frustration of dissenting members within the class.[25] Therefore, it would be inappropriate to permit a class to waive the absolute priority rule to the detriment of a creditor whose claim did not belong in that class and that wished to receive the benefits of that rule.[26]

Separately classifying similar claims was not a concern until Congress enacted § 1129(a)(10), which requires at least one impaired consenting class for confirmation if any class is impaired.[27] However, the history of § 1129(a)(10) demonstrates that it was intended only to ensure "some indicia of creditor support" for the plan, not to require unanimity or to give veto power to any unsecured creditor simply because it held more than a third of the total amount of unsecured claims in an impaired class.[28] Thus, the classification rules under the Code now serve the additional function of determining whether there is some creditor support for the plan.[29] According to the Loop 76 court, it would defeat the purpose of § 1129(a)(10) “to allow a single creditor with an entirely unique interest, because it can be assured of payment from non-debtor sources, to prevent other creditors from demonstrating their approval of the plan and therefore its satisfaction of § 1129(a)(10)."[30]

II. Implications of the Loop 76 Decision

At its heart, the Loop 76 decision simply requires a comprehensive inquiry into whether claims are in fact "substantially similar," but in doing so it expands the scope of the inquiry far beyond mere superficial similarity. It is a treasure trove in considering whether particular claims may or must be separately classified under a proposed plan of reorganization. Relying on Johnston, which it describes as perhaps the only Circuit decision that has definitively considered the meaning of substantial similarity under the Code,[31] the Loop 76 decision considers whether claims of equal priority are factually dissimilar and therefore must be separately classified.[32] As in Johnston, the Loop 76 court concluded that a creditor who is able to recover all or part of its claim from non-debtor assets is factually dissimilar from creditors who may not recover beyond the assets of the bankruptcy estate.[33] Loop 76 noted that "[c]reditors may favor a plan because it provides future jobs in the community, because they will be able to do business with the reorganized debtor, or because the reorganized debtor will provide a useful product or service to the community," and stated "[i]t is entirely appropriate to define classification . . . with the creditors' various and conflicting interests in mind."[34]

Today, few courts have adopted the plain language of § 1122, which contains no prohibition upon separate classification, but rather only a prohibition of overinclusiveness.[35] Some courts have suggested that separate classification may be permissible if it is not done for an improper purpose such as gerrymandering. [36] Other courts have suggested that separate classification may be appropriate if supported by a sufficient business justification.[37] Finally, the Ninth Circuit decision in Johnston may be read for the proposition that differing treatment of claims otherwise having the same priority may justify separate classification.[38]

Although the Loop 76 decision acknowledged each of these lines of authority, its resolution of the dispute before it made reaching those arguments unnecessary. Instead, relying upon canons of statutory construction and the Ninth Circuit's Johnston decision, it concluded that an issue of fact existed as to whether the personal guarantees that supported the unsecured deficiency claim caused that claim to be factually dissimilar from the claims of other general unsecured creditors who lacked the benefit of personal guarantees. In so doing, Loop 76 appears to have rejected a narrow mechanical determination in favor of considering the broad range of factors that actually motivate the holders of superficially similar claims.