Chapter 11 Bankruptcy
Unsecured Creditors: Risk and Cramdown Rates (Part I of II)
This is the first of a two-part article. In October 2017, the Second Circuit Court of Appeals handed down its decision on cramdown interest rates in the matter In re: MPM Silicones, LLC. This decision has already stirred a great deal of discussion regarding cramdown interest rates to be paid secured creditors in Chapter 11 bankruptcy matters. Numerous articles have appeared on-line discussing the impact of this decision. These articles follow in a long line of literature on cramdown hearings and secured creditors.
Conversely, little has been written about impaired unsecured creditors, their contested claims, and the interest rate to be paid on deferred cash payments to be made to satisfy those claims. This article reviews the portion of the U.S. Bankruptcy Code relating to the standards for the court to confirm a reorganization plan over the objection of an impaired class, the status of unsecured creditors, varying categorizations for unsecured creditors, and factors to consider when reviewing the repayment plan offered by the debtor. Ultimately, an argument will be made for the interest rate to be offered on deferred cash payments made to unsecured creditors.
In October 2017, the Second Circuit Court of Appeals handed down its decision on cramdown interest rates in the matter In re: MPM Silicones, LLC.¬† This decision has already stirred a great deal of discussion regarding cramdown interest rates to be paid secured creditors in Chapter 11 bankruptcy matters.¬† Numerous articles have appeared on-line discussing the impact of this decision.¬† These articles follow in a long line of literature on cramdown hearings and secured creditors.
Conversely, little has been written about impaired unsecured creditors, their contested claims, and the interest rate to be paid on deferred cash payments to be made to satisfy those claims.¬† This article reviews the portion of the U.S. Bankruptcy Code relating to the standards for the court to confirm a reorganization plan over the objection of an impaired class, the status of unsecured creditors, varying categorizations for unsecured creditors, and factors to consider when reviewing the repayment plan offered by the debtor.¬† Ultimately, an argument will be made for the interest rate to be offered on deferred cash payments made to unsecured creditors.
In October, the Second Circuit Court of Appeals handed down its decision on cramdown interest rates in the matter In re: MPM Silicones, LLC. ¬†This decision has already stirred a great deal of discussion regarding cramdown interest rates to be paid secured creditors in Chapter 11 bankruptcy matters.¬† Numerous articles have appeared on-line discussing the impact of this decision.¬† These articles follow in a long line of literature on cramdown hearings and secured creditors.
During the first part of this century, much has been written about impaired secured creditors, their claims, and confirming a Chapter 11 reorganization plan over their objections.¬† More specifically, numerous cases and articles have discussed determining the interest rate(s) allowing for the payment of the present value of a secured creditor‚Äôs claim over a period of time.
Conversely, little has been written about impaired unsecured creditors, their contested claims, and the interest rate to be paid on deferred cash payments to be made to satisfy those claims.¬† Part of this is because it is seldom unsecured creditors are offered interest on payments satisfying these claims.¬† Another is that court decisions have not provided clear direction on how the interest rate is to be determined.
This two-part article reviews the portion of the U.S. Bankruptcy Code relating to the standards for the court to confirm a reorganization plan over the objection of an impaired class, the status of unsecured creditors, varying categorizations for unsecured creditors, and factors to consider when reviewing the repayment plan offered by the debtor.¬† Ultimately, an argument will be made for the interest rate to be offered on deferred cash payments made to unsecured creditors.
Confirmation and the U.S. Bankruptcy Code
The United States Bankruptcy Code allows for the court to confirm a reorganization plan if 16 different potential requirements are met. ¬†The eighth requirement states, ‚ÄúWith respect to each class of claims or interests‚ÄĒ(A) such class has accepted the plan; or (B) such class is not impaired under the plan.‚ÄĚ ¬†Under this format, a business‚Äô bankruptcy reorganization is confirmed because the various creditors making claims against the bankrupt estate or those with other interests have either (1) not had their pre-bankruptcy terms changed or (2) have found acceptable the offered payment for their claims and have, therefore, not contested the reorganization plan.
Of course, not all reorganization plans are met with open arms by the various classes of creditors and equity holders.¬† Some plans create what are called impaired classes.¬† These are classes or interests that have had their legal, equitable, or contractual rights altered by the reorganization plan.¬† This may include payments totaling less than the full amount of the claim.
In some cases, the impaired classes, after negotiations, accept the reorganization plan.¬† In others, the debtor and creditor(s) or interests cannot come to an agreed solution.¬† Should that situation arise, the code allows for the court to confirm the proposed plan so long as it ‚Äúdoes 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.‚ÄĚ
The hearings to confirm or deny a plan contested by an impaired class or classes of creditors has come to be called a ‚Äúcramdown‚ÄĚ hearing.¬† This is because the debtor is requesting the court to cramdown the terms of the proposed plan on the contesting, impaired class, their rejection of the plan notwithstanding.
For these contested hearings, the Bankruptcy Code provides the following language to assist the court in determining what is fair and equitable with respect to each class.
‚ÄúWith respect to a class of secured claims, the plan provides:
(i)(I) that the holders of such claims retain the liens securing such claims, whether the property subject to such liens is retained by the debtor or transferred to another entity, to the extent of the amount allowed of such claims, and
(II) that each holder of a claim of such class receive on account of such claim deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder‚Äôs interest in the estate‚Äôs interest in such property;
(ii) for the sale, subject to section 363(k) of this title, of any property that is subject to the liens securing such claims, free and clear of such liens on proceeds under the clause (i) or (iii) of this subparagraph; or
(iii) for the realization by such holders of the indubitable equivalent of such claims.
(B) With respect to a class of unsecured claims:
(i) the plan provides that each holder of a claim of such class receive or retain on account of such claim property value, as of the effective date of the plan, equal to the allowed amount of such claim; or
(ii) the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property, except that in a case of which the debtor is an individual, the debtor may retain property included in the estate under section 1115, subject to the requirements of subsection (a)(14) of this section.
(C) With respect to a class of interests:
(i) the plan provides that each holder of an interest of such a class receive or retain on account of such interest property of a value, as of the effective date of the plan, equal to the greatest of the allowed amount of any fixed liquidation preference to which such holder is entitled, any fixed redemption price to which such holder is entitled, or the value of such interest; or
(ii) the holder of any interest that is junior to the interests of such class will not receive or retain under the plan on account of such junior interest any property.‚ÄĚ
The claims of unsecured creditors are treated according to the priority of distribution granted under this framework.¬† This prioritization scheme is based on language found in section 507 of the Bankruptcy Code.
‚ÄúIn general, creditors whose claims are secured by assets of the estate (a.k.a., secured creditors) are in a superior position (and such claims are outside of the gambit of section 507 entirely).¬† Should a chapter 11 debtor fail in its attempt to reorganize, a secured creditor may generally look to the liquidation of its collateral for payment of its claim (subject to many caveats, which we will not discuss here).
Conversely, all other creditors are dependent on unencumbered assets of an estate for payment.¬† The priority for payment of these claims is generally as follows: first, costs of administration (including professional fees and expenses and post-petition expenses of operating the debtor‚Äôs business), followed by a host of unsecured claims that Congress has determined deserve special priority‚Ä¶and finally, general unsecured creditors might be viewed as having the most to lose should a chapter 11 debtor‚Äôs reorganization fail.‚ÄĚ 
Claims filed by unsecured creditors range from small to large dollar amounts.¬† In single asset real estate (SARE) matters, there may be many unsecured creditors; however, seldom will the individual claims be of a large dollar amount. ¬†This is because the SARE does not buy or consume large amounts of goods and services.¬† A corporate bankruptcy involving manufacturing or oil and gas service companies may also produce many unsecured creditors.¬† In this situation, a few of the unsecured creditors may hold a significant portion of the claims.¬† This is because these types of businesses may purchase a large amount of goods and services.
In some bankruptcies, a pool of unsecured creditors with similar claims may total a large amount.¬† As an example, the pool of unsecured creditors holding unused gift cards in the Radio Shack bankruptcy totaled approximately $43 million. ¬†With large corporate bankruptcies, the pool of unsecured creditors may also include various groups of unsecured bond holders.
In general, unsecured creditors fall into three groups, providers of goods and services, deficiency claimants, and successful litigants.¬† The first group is the most common and is comprised of firms or individuals who provided goods and/or services to the debtor and have not been paid in full.¬† The goods and services could range from office supplies to building materials to lawn service or office cleaning.¬† The second group is comprised of secured creditors whose claim is greater than the value of their securing collateral.¬† Setting aside an 1111(b) filing, the secured claim may only be up to the value of the collateral.¬† The difference between the value of the claim and the security is called a deficiency claim.¬† This deficiency makes the secured creditor an unsecured creditor as well.¬† The third group consists of individuals or businesses who have successfully won a monetary award through litigation against the bankrupt firm.¬† The award may have been from a class action suit or individual litigation.¬† If the litigation was not tied specifically to an asset of the debtor (e.g., a truck or equipment), the creditor owning a judgement against the bankrupt firm becomes an unsecured creditor.¬† For large corporate bankruptcies, a fourth category comprised of bond holders.¬† They were to be paid out of the business cash flow with no underlying collateral included in the bond offering.¬† Therefore, they are unsecured creditors as well.
Unsecured Creditors Class
The Bankruptcy Code generally contemplates placing general unsecured creditors, who are entitled to a priority of distribution, in a single class.¬† However, the Bankruptcy Code does expressly allow for the creation of a convenience class which is created for economic and practical reasons. ¬†This process allows the unsecured creditors with smaller dollar amounts to be pooled.¬† Generally, the convenience creditors are paid in full on or very soon after the effective date of the reorganization plan.¬† There are exceptions to this and debtors may attempt to carve up the general unsecured creditors into multiple classes to gerrymander accepting classes.
The courts have wrestled with the language of Section 1122 regarding classification of general unsecured claims to create multiple classes.¬† The language of that section states, ‚Äúa plan may place a claim or an interest in a particular class only if such claim or interest is substantially like the other claims or interests in such class.‚ÄĚ ¬†One particularly fertile source of controversy has been attempts to separately classify the deficiency claims of unsecured creditors into separate classes.¬† The courts have often been reluctant to allow deficiency claims to be placed in separate classes.¬† However, this has been interpreted to mean that certain unsecured deficiency claims from under collateralized loans should be placed in a different class because of their unique nature. ¬†The 7th Circuit Court of Appeals has noted, ‚Äú[T]he legal rights of a [section] 1111(b) claimant are substantially different from those of a general unsecured claimant.‚ÄĚ ¬†The appellant court went on to say 1111(b) and 1122(a) ‚Äúnot only permit but require separate classification‚ÄĚ for 1111(b) deficiency claims from the general unsecured creditors.
Payment of Unsecured Claims
While small unsecured creditors may be paid on or near the effective date of the plan, larger unsecured creditors may be offered a series of deferred cash payments.¬† Negotiations can lead to the unsecured creditors receiving different treatment based on what each is willing to accept.¬† As an example, some creditors could elect to receive a lesser amount on or near the effective date of the reorganization plan while others could negotiate a greater amount in a series of deferred payments.¬† Provided the secured and unsecured creditors consent to the plan, there is generally no need for a contested hearing.
If any impaired class chooses to not accept the reorganization plan, the plan becomes contested.¬† Under this scenario, the ‚Äúabsolute priority rule‚ÄĚ applies.¬† This means that the non-accepting class of creditors cannot be required to accept less than full payment for their claims while more junior creditors or equity holders receive any payment or retain equity interest under the reorganization plan. ¬†Generally, the application of the absolute priority rule relates to instances where the equity holders want to maintain their equity interests without paying the unsecured creditors in full.
‚ÄúThe provisions of 11 U.S.C. 1129(b)(2)(B) and (C) require that for a plan to be confirmed with respect to an impaired dissenting class of unsecured claims or interests, a Chapter 11 plan must provide that each holder of a claim must receive property of a value as of the effective date of the plan equal to the allowed amount of its claim or the holder of a claim or interest¬† that is junior to the claims of such a class will not receive or retain under the plan any property on account of such junior claim‚Ä¶ Commonly referred to as the absolute priority rule, the statute‚Äôs requirements prevent a lower class of unsecured creditors or equity interests from receiving money or property where senior classes and senior interests are not being paid in full.‚ÄĚ
However, should a reorganization plan be contested by an impaired class of unsecured creditors, the plan can be confirmed if the impaired class receives or retains ‚Äúunder 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 he debtor were liquidated under Chapter 7 of this title on such date.‚ÄĚ
So, if the debtor offers to pay less than 100% to holders of general unsecured claims, the plan may be confirmed so long as the unsecured creditors vote to accept the reorganization plan.¬† If the unsecured creditors vote to reject the offer, the equity holders of the bankrupt firm cannot retain their equity interests in the business under the proposed reorganization plan.¬† Their interests are cancelled on the effective date of the new plan.¬† The only way they can retain ownership is by investing new money, property or some equivalent into the business in exchange for the equity interests.¬† This has been called the ‚Äúnew value‚ÄĚ corollary.
 Momentive Performance Materials, Inc. v. BOKF, NA (In the Matter of: MPM Silicones, LLC, F3d 2017, WL 4700314, No.15-1682, (2nd Cir. Oct. 20, 2017).
 Needham, Allyn, Schroeder, Kristin, ‚ÄúCram Down Interest Rate Analysis in Chapter 11 Bankruptcy Matters: An Overview‚ÄĚ, The Earnings Analyst, Vol. 12, 2012, (Online Winter 2013), www.TheEarningsAnalyst.com
 U.S. Bankruptcy Code Section 1129 (a).
 U.S. Bankruptcy Code Section 1129 (a) (8).
 U.S. Bankruptcy Code Section 1129 (b) (1).
 Equity interests of stockholders, partners, or members are often referred to as ‚Äúinterests.‚ÄĚ
 U.S. Bankruptcy Code Section 1129(b)(2)(A), (B), (C).
 ‚ÄúWhat Every Unsecured Creditor Should Know About Chapter 11, ABI Journal reprint of June 2004.
 SARE is defined as a commercial real estate property that generates substantially all of the gross income of the debtor by the business of operating the real property and activities incidental to it. ¬†For further information about SARE see Needham, Allyn, Schroeder, Kristin, ‚ÄúCommercial Real Estate, Chapter 11 Bankruptcy & Cram Down Interest Rates‚ÄĚ, The Earnings Analyst, Vol. 13, 2013, (Online Fall 2014), www.TheEarningsAnalyst.com
 ‚ÄúTexas AG Sues RadioShack Over Unused Gift Cards,‚ÄĚ The Wall Street Journal, 6/18/2015.
 U.S. Bankruptcy Code Section 1122.
 U.S. Bankruptcy Code Section 1122(a).
 The secured lender has the option under 1111(b) of the Bankruptcy Code to treat the entire claim as an allowed secured claim. ¬†This provision is intended to protect unsecured creditors who believe that the collateral will substantially increase in value.
 In re: Woodbrook Associates, 19 F.3d 312, 319 (7th Cir. 1994).
 U.S. Bankruptcy Code Section 1129(a)(2)(b)(ii).
 In re: SW Boston Hotel Venture, LLC, 460 B.R. 38, 61 (2011).
 U.S. Bankruptcy Code Section 1129(a)(7)(A)(ii).
 Bank of America National Trust and Savings Association v 203 North LaSalle Street Partnership, 526 U.S. 434, 438 (1999).
I want to thank J. Robert Forshey of the law firm Forshey Prostok in Fort Worth Texas for his assistance with this article.¬† His knowledge and experience were greatly beneficial to my understanding of the bankruptcy code‚Äôs handling of unsecured creditors. ‚Äď Dr. Needham
Allyn Needham, PhD, CEA, is a partner at Shipp, Needham & Durham, LLC, a Fort Worth-based litigation support consulting expert services and economic research firm. Prior to joining Shipp, Needham, & Durham, he was in the banking, finance, and insurance industries for over twenty years. As an expert, he has testified on various matters relating to commercial damages, personal damages, business bankruptcy, and business valuation. Dr. Needham has published articles in the area of financial economics and forensic economics and provided continuing education presentations at professional economic, vocational rehabilitation and bar association meetings.
Dr. Needham can be reached at (817) 348-0213, or by e-mail to firstname.lastname@example.org.