Reverse Cramdown Another Option in the Secured Creditors Playbook

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Sep 2004

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If you haven't done so already, it may be time to add the term "reverse cramdown"
to your list of clever and distinctive chapter 11 parlance—right
alongside such familiar expressions as "artificial
impairment," "negative amortization" and the "new
value corollary." Boiled down to its essentials, the term
"reverse cramdown" refers to a reorganization strategy in which
a chapter 11 debtor's secured lenders—holding liens on all of
the debtor's assets yet still substantially undersecured—join
with the debtor's existing equity and/or management and effectively
agree to divide up among themselves the equity in the reorganized debtor
while distributing little or nothing to those unsecured creditors who are
considered nonessential to the reorganized debtor's post-confirmation
operations.

<h4>Overview</h4>

To illustrate a reverse cramdown in operation, assume
that ABC Company—a chapter 11 debtor in the business of manufacturing
and distributing "widgets"—has the following debt
structure at the time that it files for chapter 11 relief:

<table cellpadding="1" width="300"><tbody><tr><th>Creditor Group</th>
<th>Amount Outstanding</th></tr>

<tr><td>Secured Bank Facility</td>
<td>$100 million</td></tr>

<tr><td>Unsecured Bondholders</td>
<td>$30 million</td></tr>

<tr><td>Unsecured Trade Creditors</td>
<td>$10 million</td></tr></tbody></table>

Further assume that while the lenders participating in
the Secured Bank Facility (the secured lenders) have a wall-to-wall lien on
all of ABC's assets, the value of these assets—even on a
going-concern basis—is somewhere south of $70 million (i.e., at least $30 million
less than what it is owed by the debtor to the secured lenders). Certainly,
the secured lenders are less than enthusiastic about finding themselves
grossly undersecured at the commencement of ABC's bankruptcy
proceedings. Nevertheless, they believe that in the long-term, ABC has some
real upside growth potential. Accordingly, they pragmatically conclude that
the best way for them to maximize their ultimate recovery is to have ABC
reorganize with its existing management in place and to take an equity
position in "Reorganized ABC." To insure that existing equity
and management remain properly incentivized with respect to the long-term
success of Reorganized ABC, the secured lenders are willing to allow the
existing management and equity to retain a minority equity position in
Reorganized ABC. Moreover, in order to insure that Reorganized ABC has
sufficient support from its vendors, the secured creditors are also
prepared to allow the debtor's unsecured trade creditors to be paid
in full. For obvious reasons, however, the secured lenders have no interest
in taking care of ABC's unsecured bondholders and/or allowing these
bondholders to participate in any potential upside in the event
Reorganized ABC ultimately succeeds.

With the foregoing objectives in mind, the secured
lenders get together with ABC's existing management and equity and
devise a chapter 11 plan under which (1) ABC will reorganize and emerge out
of bankruptcy as "Reorganized ABC;" (2) the secured
lenders' secured debt will be reduced down and re-amortized to a
level that Reorganized ABC can realistically manage; (3) the unsecured
trade creditors will get paid in full; (3) the senior lenders will receive
an 85 percent equity stake in Reorganized ABC; (4) most, if not all, of the
remaining equity in Reorganized ABC will go to ABC's existing equity;
and (5) the unsecured bondholders will receive nothing or some form of
nominal consideration such as warrants (with an out-of-the-money strike
price) in Reorganized ABC.

Of course, the unsecured bondholders will vote
against such a chapter 11 plan. Consequently, the secured lenders and the
other supporters of the plan will have to seek confirmation under the
"cramdown provisions" set forth in Bankruptcy Code
§1129(b). In response, the unsecured bondholder will undoubtedly
contend that "cramdown" is not permissible because (1) the plan
violates §1129(b)'s prohibition against "unfair
discrimination" by providing for unsecured trade creditors to be paid
in full while the bondholders—who, under applicable non-bankruptcy
law, occupy the same priority as the unsecured trade creditors—are to
receive little or nothing, and (2) the plan fails to meet the absolute
priority rule embodied in §1129(b)'s "fair and
equitable" requirement because it provides for the existing equity to
obtain an equity interest in Reorganized ABC even though the (higher
priority) unsecured bondholders will not be paid or otherwise satisfied in
full.

In light of the forgoing objections, it would appear
that the proposed plan cannot be confirmed—but not so fast! A growing
number of cases suggest that the secured lenders in the above hypothetical
may be able to overcome the bondholders' objections pursuant to a
rationale that first appeared to gain ground (at least, under the modern
Code<a href="#1" name="1a">1</a>) in the First Circuit Court of Appeals's decision in In re SPM Manufacturing Corp., 984
F.2d 1305 (1st Cir. 1993).

The SPM Manufacturing case involved an unsuccessful attempt by a family-owned
business to reorganize in a chapter 11 proceeding that was eventually
converted to a chapter 7 proceeding. Prior to conversion, the
debtor's secured lender entered into an agreement with the unsecured
creditors' committee appointed in the case under which the secured
lender agreed to share a portion of its recovery with the debtor's
general, unsecured creditors in exchange for the committee's
commitment to, among other things, cooperate with the secured
lender's efforts to maximize the value of its collateral through a
sale of the collateral under Code §363(f). Id. at 1308.

Although the §363 sale was consummated during
the chapter 11 proceedings, the proceeds from the sale remained in the
custody of the bankruptcy estate at the time of conversion. Following
conversion, the committee and the secured lender petitioned the bankruptcy
court to direct the recently appointed chapter 7 trustee to distribute the
sale proceeds to the secured lender, whereupon the secured lender would
pay-over the portion of the proceeds owing to the debtor's general
unsecured creditors in accordance with the secured lender's
pre-conversion agreement with the committee. At the time, however, there
were a number of outstanding unsecured, priority claims pending against the
bankruptcy estate—including a claim for more than $750,000 in unpaid
withholding taxes allegedly owing to the Internal Revenue Service (IRS). Id. at 1308. Consequently,
several parties objected to the proposed pay-out requested by the secured
lender and the committee, arguing that it constituted a circumvention of
the Code's priority scheme.

Agreeing with the latter parties, the bankruptcy
court authorized the chapter 7 trustee to distribute the sale proceeds to
the secured lender, but expressly required the secured lender to pay back
to the chapter 7 trustee the portion of the proceeds that the secured
creditor had previously agreed to relinquish to the debtor's general
unsecured creditors. Specifically, the bankruptcy court held that the
latter funds had to be distributed by the chapter 7 trustee to both
priority and non-priority unsecured creditors in accordance with the
Code's priority scheme (which, as a practical matter, would mean that
all of the funds would be paid to unsecured, priority claimants, and the
debtor's general unsecured creditors would receive nothing). Id. at 1310-1.

The committee appealed the bankruptcy court's
decision all the way up to the First Circuit Court of Appeals, which found
that the bankruptcy court had erred as a matter of law in requiring the
secured lender to pay over to the chapter 7 trustee the portion of the sale
proceeds that the secured lender had previously agreed to make available to
the general unsecured creditors. Id. at 1318. In so ruling, the First Circuit flatly rejected
the contention that the secured lender's agreement with the committee
somehow undermines the Code's priority scheme. As the court observed,
absent any agreement with the committee, the secured lender would have been
entitled to recover and retain all of the sale proceeds at issue,
"leaving nothing for the estate to distribute to other creditors,
including the IRS." Id. at 1312. Thus, the court found "it hard to see how the
priority creditors lost anything given the fact there would have been
nothing left for [them...anyway] after the [sale proceeds...were]
distributed to [the secured lender]." Id.

Moreover, the First Circuit noted, "the
bankruptcy court has no authority to control how [a secured creditor]
disposes of the proceeds [of its collateral] once it receives them. There
is nothing in the Code forbidding [a secured creditor...from] voluntarily
[paying] part of these monies to some or all of the general, unsecured
creditors after the bankruptcy proceedings are finished." Id. at 1313. Accordingly, the
First Circuit remanded the case to the bankruptcy court so that the sale
proceeds could be distributed in accordance with the secured lender's
original agreement with the committee.<a href="#2" name="2a">2</a>

Picking up on the First Circuit's apparent
endorsement of the proposition that a secured creditor should remain free
to divvy up the value of its collateral however it so pleases, a number of
parties have recently invoked the SPM
Manufacturing decision to successfully
defeat "unfair discrimination" and "fair and
equitable" objections raised by parties in a position essentially
equivalent to the unsecured bondholders in the hypothetical described
above.

Thus, for instance, in In
re Genesis Health Ventures Inc., 266 B.R. 591
(Bankr. D. Del. 2001), appeal dismissed, 280 B.R. 339 (D. Del. 2002), certain unsecured creditors of
a group of bankrupt health care and related service providers opposed the
debtors' chapter 11 reorganization plan under which the
debtors' senior secured creditors—together with the
debtors' existing management—would receive most of the equity
in the reorganized debtor, while the objecting parties would receive little
or no distribution on certain of their claims. Like the unsecured
bondholders in the hypothetical above, the objecting parties in Genesis Health asserted
that the proposed reorganization plan discriminated unfairly against them
because it provided greater distribution to other unsecured creditors, and
was not fair and equitable because it provided for debtors' existing
management to receive equity in the reorganized debtor while the objecting
parties' claims were not being repaid in full.

Expressly relying on the SPM
Manufacturing decision, the bankruptcy court
in Genesis Health
rejected both of the foregoing objections and ruled that the debtors'
reorganization plan should be confirmed. Specifically, the court determined
that the total enterprise value of the debtors was around $1.33 billion,
whereas the outstanding indebtedness owing to the debtor's senior
secured creditors was approximately $1.46 billion. Id. at 616. Based on this
determination, the court concluded that even if the senior secured
creditors "receive all of the debt and equity distributed under the
debtors' plan, [their] claims...would not be satisfied in
full." Id. at
616. Accordingly, the bankruptcy court believed that the entire enterprise
value of the debtors was properly allocable to the senior secured
creditors. Under such circumstances, the objecting parties could not
rightfully complain that they were receiving less under the proposed
chapter 11 plan than other similarly situated unsecured creditors,
since—but for the grace of the senior secured creditors—none of
the unsecured creditors would receive anything. Thus, like the elder son in
the parable of the prodigal son, the objecting parties should have rejoiced
in being permitted to partake in any portion of the fatted calf and not
concerned themselves with the fact that their brethren were receiving a
significantly larger cut.<a href="#3" name="3a">3</a>

Employing essentially identical reasoning, the Genesis Health court was also
able to easily dispense with the objecting parties' fair and
equitable objection. As the court explained, "the issuance of stock
and warrants to management represents an allocation of the enterprise value
otherwise distributable to the senior lenders, which the senior lenders
have agreed to offer to the top executives as further incentive to them to
remain and effectuate the debtors' reorganization. The senior lenders
are free to allocate such value without violating the 'fair and
equitable' requirement." Id. at 618.<a href="#4" name="4a">4</a>

<h4>Comparison with Secured Creditor's State Law Rights</h4>

At first blush, the results achieved through a
reverse cramdown might not seem that remarkable given that under state law,
a secured lender has the ability to foreclose upon its collateral and,
thereby, put the collateral outside the reach of its borrower's
unsecured creditors. Thus, it is certainly conceivable that outside of
bankruptcy, a secured creditor could achieve the same results as those
obtained under a reverse cramdown by engaging in a "friendly
foreclosure" in which the assets of an existing borrower are
foreclosed upon and sold to a "new company" formed by the
original borrower's equity-holders and management. In fact, a number
of state statutory schemes contain special safeguards that would protect
such a transaction from an attack or challenge otherwise available under
such statutes. Thus, for instance, the Uniform Fraudulent Transfer Act
(UFTA) expressly exempts from avoidance under the UFTA's constructive
fraud provisions any transfer that occurs pursuant to the
"enforcement of a security interest in compliance with Article 9 of
the Uniform Commercial Code."<a href="#5" name="5a">5</a> Similarly, most (if not all) bulk
transfer statutes still remaining on the books contain a special carve-out
for transfers that occur by way of foreclosure.<a href="#6" name="6a">6</a>

Nevertheless, it would be a mistake to conclude that
there are not substantial risks for a secured creditor that attempts to
cleanse or "whitewash" a borrower's business of its
unsecured debt by engaging in a friendly foreclosure outside of bankruptcy
in which the assets of the business are transferred to a new company formed
in conjunction with the existing borrower's management and equity.
The case law reporters are replete with decisions involving such
circumstances, wherein unsecured creditors of the original borrower are
permitted to pursue their claims against the new company.<a href="#7" name="7a">7</a> Indeed, this is
true not only with respect to unsecured creditors with product liability
claims, but also those with contract and statutory causes of action.<a href="#8" name="8a">8</a>

Of course, under a successful reverse cramdown
strategy, the risks of such successor liability claims should be
eliminated.

<h4>Analysis and Conclusion</h4>

In the final analysis, the reverse cramdown
strategy—at least, to the extent that it is looked to as a mechanism
for overcoming the absolute priority rule—seems to rest on a flawed
and mistaken foundation. While the Code requires that secured creditors
receive the full value of their collateral as of the effective date of a
chapter 11 plan,<a href="#9" name="9a">9</a> this value does not include the potential appreciation in
the enterprise value that the reorganized debtor as a whole might
experience post-confirmation (i.e., such appreciation does not constitute a
"proceed" or "product" of the secured
creditor's collateral).<a href="#10" name="10a">10</a> Instead, such potential appreciation would
seem to fall outside a secured creditor's package of collateral and,
as such, would be something to which undercollateralized secured creditors
would only be entitled to participate in their capacity as and to the
extent they are unsecured creditors, in which case they should be required
to share such potential appreciation on a pro
rata basis along with all of the
debtor's other unsecured creditors (rather than being deemed the sole
and exclusive beneficiary of all such potential appreciation with the
unbridled discretion to parcel out shares of such potential appreciation to
whomever they so choose).

Moreover, the notion that "reverse
cramdown" plans are a permissible method of defeating possible
absolute priority objections by intervening creditors or interest-holders
is directly contradicted by the legislative history to the current
Bankruptcy Code. Indeed, the bankruptcy reform bill originally passed by
the Senate contemplated a reverse cramdown provision that "would
permit a senior creditor to adjust his participation for the benefit of
stockholders," in which case "junior creditors, who have not
been satisfied in full, may not object if, absent the 'give
up,' they are receiving all that a fair and equitable plan would give
them."<a href="#11" name="11a">11</a> Ultimately, however, this approach was abandoned in favor of
the current statutory language that the drafters expressly believed would
prohibit the confirmation of reverse cramdown plans.<a href="#12" name="12a">12</a>

Apparently, however, such academic fine points
didn't slow down the secured creditor parties in cases such as Genesis Health from coming away
with the desired victory.<a href="#13" name="13a">13</a> So for those of you out there calling the
plays on behalf of undercollateralized secured lenders, you may want to
give some serious consideration to having your team attempt a reverse
cramdown.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> See Klee, K.,
"Barbarians at the Trough: Riposte in Defense of the Warrant
Carve-out Proposal," 82 Cornell L. Rev. 1466, 1481 (September 1997)
(referencing reverse cramdown-like practices that occurred in equity
receivership cases of the early 20th Century). <a href="#1a">Return to article</a>

<a name="2">2</a> For a case
apparently reaching a similar result, see In
re Shoe Corp. of America Inc., Case No.
99-55400 (Bankr. S.D. Ohio) (wherein the bankruptcy court approved a
"distribution agreement" under which secured creditors agreed
to allow a portion of their collateral proceeds to be paid to general
unsecured creditors notwithstanding outstanding priority claims), described
in Indyke, J. and Weisberg, B., "Committee Issues: Carve-outs;
Liquidations for Benefit of Banks; Liability; Inconvenient Delaware Issues;
Liquidations for the Benefit of Secured Creditors: An Unsecured
Creditor's Committee Perspective," 041802 ABI-CLE 223 (20th
Annual Spring Meeting, April 18-21, 2002). <a href="#2a">Return to article</a>

<a name="3">3</a> See, also, Matter of Union Financial Services Group Inc., 303 B.R. 390, 424 (Bankr. E.D. Mo. 2003) (wherein the
court—citing to the SPM Manufacturing decision—found that a chapter 11 plan was not
unfairly discriminatory for purposes of Code §1129(b), even though it
provided for payment in full of the unsecured claims of certain necessary
trade vendors and utilities while the debtor's unsecured noteholders
only received a very small equity stake in the reorganized debtor); In re MCorp Financial Inc.,
160 B.R. 941, 960 (S.D. Tex. 1993) (chapter 11 plan did not unfairly
discriminate against class of junior noteholders as larger share of
distribution to be paid to another class of arguably equal rank represented
a reallocation of funds otherwise payable to the class of senior
noteholders); but, see In re Sentry Operating
Co. of Texas Inc., 264 B.R. 850, 864
(Bankr. S.D. Tex. 2001) (categorically rejecting the notion that a chapter
11 plan may discriminate among junior creditors under a reverse cramdown
rationale). <a href="#3a">Return to article</a>

<a href="#4" name="4a">4</a> Cf. In re Exide Technologies, 303
B.R. 48, 77 (Bankr. D. Del. 2003) (wherein the court appeared to
acknowledge the potential permissibility of a reverse cramdown plan but
found that the reverse cramdown rationale was not applicable in the case
before it because the debtor's secured lenders were oversecured). <a href="#4a">Return to article</a>

<a name="5">5</a> Uniform
Fraudulent Transfer Act, §8(e)(2). <a href="#5a">Return to article</a>

<a name="6">6</a> Uniform
Commercial Code, §6-103(3)(1989)(i.e., "Revised Article 6"); Uniform Commercial Code,
§6-103(3)(1962) (i.e., "Old Article 6"). <a href="#6a">Return to article</a>

<a name="7">7</a> See, e.g., Continental Insurance Co. v. Schneider, 810 A.2d 127, 133 (Pa. Super. 2002) (a foreclosure
"sale pursuant to §9504 of the UCC does not, as a matter of law,
preclude a creditor's claim against the purchaser based upon
successor liability;" Equal Employment
Opportunity Commission v. SWP Inc., 153 F.
Supp. 911 (N.D. Ind. 2001) (EEOC could seek to enforce sexual harassment
judgment against an entity that purchased assets of judgment debtor
pursuant to friendly foreclosure); Ed Peters
Jewelry Co. Inc. v. C & J Jewelry Co. Inc., 124 F.3d 252, 267 (1st Cir. 1997) ("existing case law
overwhelmingly confirms that an intervening foreclosure sale affords an
acquiring corporation no automatic exemption from successor
liability"); Glynwed v. Plastimatic
Inc., 869 F. Supp. 265, 274 (D. N.J.
1994) ("a corporation may held liable for the debts and liabilities
of a corporation whose assets it purchased at a UCC foreclosure
sale"). <a href="#7a">Return to article</a>

<a name="8">8</a> Id. <a href="#8a">Return to article</a>

<a name="9">9</a> See, generally, 11 U.S.C.
§1129(b)(2). <a href="#9a">Return to article</a>

<a name="10">10</a> See, e.g., Beal Bank S.S.B. v. Waters Edge Limited
Partnership, 248 B.R. 668, 679-680 (D.
Mass. 2000) (secured creditor's right to credit bid the full amount
of its secured claim pursuant to 11 U.S.C. §363(k) does not apply or
extend to auctions or sales of the equity in the reorganized debtor). <a href="#10a">Return to article</a>

<a name="11">11</a> Sen.
Report (Judiciary Committee) No. 95-598, p. 127, reprinted in 1978 U.S.C.C.A.N.
5913. The Senate Judiciary Committee Report goes on to provide an example
that is very similar to the hypothetical posed in this article. <a href="#11a">Return to article</a>

<a name="12">12</a> 124 Cong.
Rec. H. 11089 (Remarks of Rep. Edwards) (Sept. 28, 1978), reprinted in 1978
U.S.C.C.A.N. 6436, 6477 ("Contrary to the example contained in the
Senate report, a senior class will not be able to give up value to a junior
class over the dissent of an intervening class unless the intervening class
receives the full amount, as opposed to value, of its claims or
interests"); 124 Cong. Rec. S 11089 (Remarks of Sen. DeConcini) (Oct.
6, 1978), reprinted in 1978 U.S.C.C.A.N. 6505, 6546 (same); see, also, Klee, K., "All
You Ever Wanted to Know About Cramdown Under the New Bankruptcy
Code," 53 Am. Bankr. L. J. 133, 144 (Spring 1979) ("a
dissenting class of unsecured creditors that is not provided for in full
will be able to prevent confirmation of a plan in which a class of senior
claims proposes to give value to a class lower in priority to the
dissenting class—for example, a class of equity interests"). <a href="#12a">Return to article</a>

<a name="13">13</a> For
outside commentary suggesting that reverse cramdown plans are a permissible
method of defeating potential absolute priority objections, see Breach, R., "LaSalle, the
"Market Test" and "Competing Plans: Still in the
Fog," 21 Am. Bankr. Inst. J. 18, 50 (January 2003) ("The senior
classes are free to allocate their property as they wish without violating
the absolute priority rule."); Houser, B., "Disclosure
Statements, Confirmation and Cramdown of Chapter 11 Plans," SH054
ALI-ABA 337, 383 (May 2003) ("Similarly, the absolute priority rule
is not violated where the value being given to old equity comes from funds
which would otherwise be distributed to a senior class but is instead
distributed to old equity with the senior class's consent"). <a href="#13a">Return to article</a>

Journal Authors

David D. Farrell

Journal Date

Wednesday, September 1, 2004 - 12:00

Bankruptcy Rule

2004