The New Gerrymandering Cross-classification of Claims in a Joint Reorganization Plan Prior to Substantive Consolidation

<p>When a corporate debtor files a bankruptcy petition, it often has subsidiaries, parents or other affiliates that
simultaneously file their own bankruptcy petitions. Indeed, corporate structure and debt guaranties often require the
co-filing of affiliated companies.

</p><p>When multiple debtors file bankruptcy, the only efficient means of administration is through joint administration.
Otherwise, multiple copies of the same pleading are filed and served, thereby increasing the cost to the bankruptcy
estates. Also, considering the average size of plan and disclosure statements, requiring the filing and service of a separate plan and
disclosure statement for each debtor can result in mass defoliation.

</p><p>Congress foresaw the benefits of jointly administered cases and provided for such procedural consolidation. <i>See</i> Fed.
R. Bankr. P. 1015. Congress did not, however, provide specific guidelines for the subsequent administration of
jointly administered cases. Nor did Congress address the application of other Bankruptcy Code provisions and/or
other Bankruptcy Rules to jointly administered bankruptcy estates.

</p><p>Nonetheless, in an effort to save additional time and expense, joint administration naturally leads to the filing of a
joint reorganization plan/liquidation, which is also not addressed in the jointly administered context. Without any
such guidance, joint-plan proponents often make assumptions regarding the proper means of classification and
balloting. Specifically, when jointly administered debtors, who are not substantively consolidated, file a joint plan,
an issue arises as to whether that joint plan may place the unsecured creditors of two or more joint debtors into one
class, without any subclasses, and then solicit votes for that class, as if the jointly administered debtors were
previously substantively consolidated. When this occurs, the joint debtors have "cross-classified" claims, as one
might cross-collateralize a loan outside of bankruptcy.

</p><p>These procedures have received little attention from the judiciary, at least in published form, but can have
tremendous impact on the success or failure of a joint debtors' reorganization efforts. Without much precedence,
joint-plan proponents are left guessing as to the propriety of "cross-classification."

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This new form of gerrymandering can harm the substantive rights of cross-classified creditors because separate classification and balloting could prevent the confirmation of at least one debtor in a joint-debtor case.
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<h4>Classification and Substantive Consolidation</h4>

<p>A plan may place a claim or an interest in a particular class only if such claim or interest is substantially similar to
the other claims or interests of such class. <i>See</i> 11 U.S.C. §1122(a). Section 1122, however, does not address the
classification of claims against different debtors in a joint plan. Yet such a classification is frequently used in joint
plans that contemplate substantive consolidation of joint debtors upon confirmation. When that occurs, creditors of
debtor A vote equally to accept the plan on behalf of debtor A, debtor B and debtor C, even though they are not
creditors of debtors B and C.

</p><p>The problem is that a creditor of one debtor cannot vote to accept the plan of another debtor because it does not have
a claim against that separate debtor. <i>See</i> 11 U.S.C. §502. In addition, the Code expressly provides that "[t]he holder
of a claim or interest allowed under §502 of this title may accept or reject a plan." <i>See</i> 11 U.S.C. §1126(a). Thus,
pursuant to §§502 and 1126(a), a creditor of debtor A cannot vote to accept the plan of debtor B, unless debtors A
and B have substantively consolidated their bankruptcy estates, or the creditor otherwise has a claim against debtor
B.

</p><p>In fact, quite often, joint debtors file a joint plan that contemplates substantive consolidation for purposes of voting
and distributions. However, such provisions have no binding effect until the court enters an order that substantively
consolidates the debtors' bankruptcy estates. Until such an order is entered, joint debtors are not substantively
consolidated, particularly not for voting purposes. <i>See In re N.S. Garrott &amp; Sons,</i> 48 B.R. 13, 17 (Bankr. E.D.
Ark. 1984). In fact, a court has an obligation to make an independent inquiry into the necessity and desirability of
substantive consolidation, which prevents substantive consolidation via mere suggestion. <i>See Id.</i> at 18; <i>see, also,</i>
Fed. R. Bankr. P. 1015(a). Clearly, joint debtors that wish to file a joint plan without classifying creditors by class
and bankruptcy estate must seek an order on substantive consolidation before filing such a joint plan.

</p><p>In addition, a court must also consider that a benefit/detriment analysis similar to the substantive consolidation
analysis, as a joint plan that pools assets of different bankruptcy estates, may very well run afoul of 11 U.S.C.
§1129(a)'s confirmation requirements. Specifically, §1129(a)(7)(A) requires that, with respect to an impaired class of
claims or interests, each holder has accepted the plan, or will receive or retain property of a value that is not less
than the amount that such holder would receive or retain <i>if the debtor were liquidated under chapter 7.</i> In contrast
to §1122, which references "debtor" and "debtors," §1129(a) (7)(A)(ii) makes clear that the liquidation analysis is
particular for both creditor and debtor. And, regardless of the asserted benefits of the proposed plan, a debtor cannot
cram down a §1129(a)(7)(A)(ii) objection, only a §1129(a)(8) objection. <i>See</i> 11 U.S.C. §1129(b)(1).

</p><p>Thus, the obvious objection to cross-classification is where one debtor has substantial assets, while another debtor
has few assets. In certain circumstances, such as a liquidating plan, the classification of creditors of joint debtors
into one class is of benefit to the insolvent debtor's bankruptcy estate, but improperly dilutes the value of the
solvent debtor's bankruptcy estate.

</p><p>Granted, if joint debtors guaranteed and/or cross-collateralized their obligations, such cross-classification has no
impact. But when one considers the various exits from bankruptcy that a plan may propose, a real issue exists as to
the propriety of classifying creditors of more than one bankruptcy estate into one class, as if there were only one
bankruptcy estate, because a chapter 11 confirmation order discharges a debtor's obligations, except as provided in
the plan, on the effective date of the plan. <i>See</i> 11 U.S.C. §1141. Thus, even a cross-classifying joint plan that
proposes payment of 100 percent of general unsecured claims puts creditors' interests at risk because of the potential
for a subsequent default. Such a default could result in a liquidation of assets, which implicates the aforementioned
liquidation analysis. The liquidation analysis objection is in addition to a more familiar objection: gerrymandering.

</p><h4>Gerrymandering via Cross-classification</h4>

<p>Even if a cross-classifying joint plan is not detrimental due to differing liquidation values, an objection to such
cross-classification still exists. Specifically, joint debtors might seek to cross-classify creditors to gerrymander
classes for voting purposes. For example, where debtor A has numerous unsecured creditors that will vote to accept
the plan, whereas debtor B has only a few unsecured creditors and/or a very large unsecured creditor that will rule
that class and will vote to reject the plan, such cross-classification is the equivalent of improper gerrymandering.

</p><p>This new form of gerrymandering can harm the substantive rights of cross-classified creditors because separate
classification and balloting could prevent the confirmation of at least one debtor in a joint-debtor case. Though two
of three joint debtors may fulfill §1129(a)(8)'s provisions, thereby confirming the joint plan as to their bankruptcy
estates, the inability to confirm the third joint debtor could prove catastrophic. Indeed, depending on corporate
structure and cross-collateralization, the inability of the third debtor to confirm the joint plan as to its bankruptcy
estate could effectively undermine and render moot confirmation of the joint plan as to the other two debtor's
bankruptcy estates. These considerations are fact-specific and occasionally will not matter.

</p><p>On the other hand, such considerations will occasionally matter and create havoc in an otherwise seemingly
confirmable joint plan. Conversely, the court may require the joint debtors to amend their joint plan and/or
formulate separate plans along with the corresponding disclosure and dissemination requirements. Indeed, such
objections were asserted in both the <i>WorldCom</i> and <i>Daisytek</i> bankruptcy cases. Although in both cases the debtors
confirmed their joint plans, or a version thereof, these cases demonstrate the potential for serious issues arising from
cross-classification.

</p><h4>Conclusion</h4>

<p>Neither the Bankruptcy Code nor case law provides much guidance on the cross-classification of creditors and
claims in a joint plan, yet joint plans are commonplace in today's bankruptcy cases. Perhaps the lack of guidance
from case law stems from the realities of many bankruptcy cases, which is that often unsecured creditors face a
dismal liquidation value and distribution potential regardless of classification. Indeed, in many bankruptcy cases,
the above analysis simply does not matter because the bankruptcy estates are all insolvent, and either sufficient
votes exist for each debtor to confirm its own plan, or §1129(b) would allow confirmation over any objecting
creditors.

</p><p>However, a few cases have and will occur where there is a substantial difference in liquidation values and the effects
of such cross-classification gerrymandering are of consequence. In such cases, albeit inconvenient, joint debtors are
wise to seek substantive consolidation prior to plan dissemination and/or formulate separate plans and prepare for
separate confirmation results.

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