Interplay Between Subordination Agreements and Chapter 11 Cramdown Plans
The Bankruptcy Code provides that subordination agreements are enforceable in bankruptcy to the same extent that such agreements are enforceable under non-bankruptcy law. 11 U.S.C. § 510(a). However, Section 1129(b)(1) of the Bankruptcy Code permits a Chapter 11 plan to be confirmed subject to certain requirements “notwithstanding” Section 510(a).
Until recently, there was no Circuit-level guidance on whether bankruptcy courts had authority to disregard a valid subordination agreement in the context of a non-consensual “cramdown” plan when enforcement of the subordination agreement would jeopardize a plan proponent’s ability to confirm an otherwise enforceable Chapter 11 plan.
In re Tribune Co., 972 F.3d 228 (3d Cir. 2020)
In a case of first impression, the Third Circuit Court of Appeals in In re Tribune Co., 972 F.3d 228 (3d Cir. 2020) affirmed the Bankruptcy Court’s order confirming Tribune Company’s Chapter 11 plan over the objections of certain creditors who sought to enforce a subordination agreement entered into prior to the bankruptcy filing. The Third Circuit found that the Bankruptcy Code’s cramdown provision set forth in Section 1129(b)(1) “supplants strict enforcement of subordination agreements” and held that “when cramdown plans play with subordinated sums, the comparison of similarly situated creditors is tested through a more flexible unfair-discrimination standard.” The Third Circuit determined that the plain meaning of the word, “notwithstanding,” as used in Section 1129(b)(1) means that despite the rights conferred by Section 510(a) to subordination agreements, bankruptcy courts must confirm the plan over the objection of a non-consenting class of creditors if all of the applicable requirements of Section 1129(a) are satisfied so long as the plan does not discriminate unfairly, and is fair and equitable, for each impaired class that does not accept the plan.
Eight-Factor Test to Determine Unfair Discrimination
The Third Circuit established eight “principles” to assess unfair discrimination in this context: (1) subordination agreements need not be strictly enforced in the case of a cramdown, and creditors holding claims with the same priority can be treated differently so long as such discrimination is not unfair. “There is, as is typical in reorganizations, a need for flexibility over precision. The test becomes one of reason circumscribed so as not to run rampant over creditors’ rights.”; (2) unfair discrimination applies only to classes of dissenting creditors rather than individual creditors; (3) unfair discrimination is determined from the perspective of the dissenting class; (4) classes must be aligned correctly to enable bankruptcy courts to assess whether a cramdown plan discriminates unfairly; (5) bankruptcy courts should resolve how a plan proposes to pay each creditor’s recovery measured in terms of the net present value of all payments or the allocation of materially greater risk in connection with its proposed distribution; (6) bankruptcy courts should first determine the pro rata baseline for the recovery of creditors sharing the same priority and then compare such baseline against the percentage distribution that claimants in the dissenting class would have otherwise been entitled to receive under full enforcement of their subordination agreements under Section 510(a), but did not get under the plan; (7) there is a presumption of unfair discrimination where there is a materially lower percentage recovery for the dissenting class or a materially greater risk to the dissenting class in connection with the proposed distribution; and (8) the presumption of unfair discrimination may be rebutted (as determined by the bankruptcy courts in the first instance).
Pragmatic Approach to Assessing Unfair Discrimination
Applying the above principles, the Third Circuit agreed with the Bankruptcy Court’s finding that the difference between the senior noteholder’s desired and actual recovery is not material. The subordinated sums allocated to the retirees and trade creditors comprised 11.7% toward their 33.6% recovery, but only reduced the senior noteholders recovery by less than 1%.
According to the Third Circuit, its interpretation and application of Section 1129(b)(1) to override Section 510(a) supports the Bankruptcy Code’s purpose to allow confirmation of a cramdown plan provided that it protects the interests of the dissenting class of creditors. As the Third Circuit noted:
Both § 510(a) and the cramdown provision’s unfair-discrimination test are concerned with distributions among creditors. The first is by agreement, while the second tests, among other things, whether involuntary reallocations of subordinated sums under a plan unfairly discriminate against the dissenting class. Only one can supersede, and that is the cramdown provision. It provides the flexibility to negotiate a confirmable plan even when decades of accumulated debt and private ordering of payment priority have led to a complex web of intercreditor rights. It also attempts to ensure that debtors and courts do not have carte blanche to disregard pre- bankruptcy contractual arrangements, while leaving play in the joints.
In the alternative, the Third Circuit held that the allocation of the subordinated amounts to the class of non-consenting claimants did not result in unfair discrimination. The Third Circuit noted that the prohibition against unfair discrimination “ensures that a dissenting class will receive relative value equal to the value given to all other similarly situated classes.” In determining a plan’s differing treatment, the Third Circuit found that the best approach requires bankruptcy courts to compare the recovery of the preferred class and the dissenting class. However, where a class-to-class comparison is difficult, such as in Tribune where the “Swap claims” were entitled to benefit from the subordination of various notes while the trade creditors and retirees were not, “a court may opt to be pragmatic and look to the discrepancy between the dissenting class’s desired and actual recovery to gauge the degree of its different treatment.” Although this approach “is not the preferred way to test whether the allocation of subordinated amounts under a plan to initially non-benefitted creditors unfairly discriminates, . . . [t]here is, as is typical in reorganizations, a need for flexibility over precision.” Due to the perceived importance of flexibility over precision, the Third Circuit upheld the Bankruptcy Court’s unfair discrimination analysis which compared the Senior Noteholders’ recovery under the Plan to its recovery if strict enforcement of the Subordination Agreements were enforced, and found that a 0.9% loss in recovery was immaterial.
Unfair Discrimination Test Only Applies to Classes of Creditors, Not Individual Creditors
In a recent unpublished decision, the Third Circuit expanded its holding in Tribune to dismiss an appeal of a Chapter 11 plan confirmation order as equitably moot, holding that the unfair discrimination test only applied to classes of dissenting creditors rather than individual creditors. See In re Nuverra Envt’l Sol., Inc., 834 Fed.Appx. 729, 2021 WL 50160 (3d Cir. Jan. 6, 2021), amended, Feb. 2, 2021 (unpublished). In Nuverra, a creditor objected to the debtor’s plan of reorganization on the basis that the plan unfairly discriminated between classes of creditors. The District Court dismissed the appeal as equitably moot, which was subsequently appealed to the Third Circuit. The Third Circuit affirmed the dismissal, noting “’that unfair discrimination applies only to classes of creditors (not the individual creditors that comprise them), and then only to classes that dissent. Thus, a disapproving creditor within a class that approves a plan cannot claim unfair discrimination, and the standard does not ‘apply directly with respect to other classes unless they too have dissented.”” Id. at *4 (quoting Tribune, 972 F.3d at 242). Although the Third Circuit held that the creditor was free to object to the plan on unfair discrimination grounds, he could “propose that the appropriate remedy is to pay only him and no one else in his class. He never asked for individualized relief before the Bankruptcy Court. Nor could he have at the confirmation hearing, because § 1123(a)(4) bars individualized treatment. . . .” Id. Because the only way to give the objecting creditor redress was to give all creditors in the same class a 100% refund on their unsecured notes in the amount of $40.4 million “which would fatally scramble the Plan and significantly harm third parties,” the Third Circuit found that his appeal was properly dismissed as equitably moot. Id. Therefore, creditors who challenge a plan based on unfair discrimination can only seek relief on behalf of the class. Although this decision is not precedential, the Third Circuit’s rationale is instructive.
Takeaways from Tribune
Tribune provides valuable guidance regarding the interplay between subordination agreements and non-consensual cramdown plans. Courts and parties will need to grapple with the competing policies of freedom of contract to negotiate subordination agreements which are recognized under Section 510(a) and the hammer granted by Congress to plan proponents under Section 1129(b)(1) to cram down a plan over the objection of non-consenting creditors. Notably, Tribune’s flexible “unfair-discrimination” standard enables bankruptcy courts to disregard the rigid enforcement of subordination provisions when courts determine that it would be inequitable to do so by denying confirmation of an otherwise equitable plan of reorganization.