“Artificial impairment” as a means for cramming down a chapter 11 plan on a recalcitrant secured creditor is a theory that does not hold water in the Sixth Circuit when very little unsecured debt takes a haircut, even in the face of an explicit bankruptcy court finding that the plan was proposed in good faith as the result of economic necessity.
The Sixth Circuit’s opinion on Jan. 27 is arguably at odds with a 2013 case from the Fifth Circuit.
The debtor owed $8.6 million on a mortgage securing an apartment building worth $5.4 million. Aside from the lender, the only creditors were the debtor’s accountant and lawyer, whose unsecured claims totaled $2,400.
To create an impaired class of accepting creditors, the plan proposed paying the unsecured claims in full over 60 days. The bankruptcy court’s confirmation order was reversed by the district judge, who set aside findings of fact as clearly erroneous.
The opinion by Circuit Judge Raymond M. Kethledge on Jan. 27 upheld the district court and could be interpreted as a broad rejection of the notion of artificial impairment in the Sixth Circuit.
To uphold rejection of the plan, Judge Kethledge first held that a good faith requirement is not engrafted onto Section 1129(a)(10), which requires acceptance by one impaired class. He said that contrived impairment is “immaterial” because Section 1124(1) only asks whether creditors’ interests are altered, not “whether the debtor had bad motives.”
Invoking the Fifth Circuit’s 2013 Camp Bowie decision, Judge Kethledge next held that the debtor’s motives instead are the province of Section 1129(a)(3), which requires that plans be proposed in good faith.
At that juncture, Judge Kethledge ran into a potential roadblock because the bankruptcy judge had found that the plan was filed in good faith as a result of economic necessity. The circuit court determined that the finding of fact was clearly erroneous because the lender had offered to pay unsecured creditors in full immediately.
The appeals court also said that the debtor’s close alliance with the unsecured creditors compounded the appearance that impairment “had more to do with circumventing” Section 1129(a)(10) than with “rationing dollars.”
Although Judge Kethledge cited Camp Bowie, his opinion may be at odds with the Fifth Circuit’s holding. In Camp Bowie, the circuit court held that the Bankruptcy Code makes no distinction between adverse effects on claim holders that result from economic necessity and those arising from the bankrupt’s discretion.
Like the Sixth Circuit, the Fifth held in Camp Bowie that a bankrupt company’s ability to pay claims in full remains an issue on the question of whether the plan is proposed in good faith. In the Fifth Circuit case, now-retired Bankruptcy Judge Michael Lynn found good faith.
So why were the results different in the two circuits? Does the Sixth Circuit have a lower standard for reversing findings of fact?
The difference might be attributed to the relative amount of unsecured debt. In Camp Bowie, the impaired unsecured debt was 0.2% of the secured debt. In the Sixth Circuit case, impaired unsecured debt was only 0.03% of secured debt. Is that reason enough for a different result? Can a lender defeat a finding of good faith by offering to pay unsecured claims in full?
The two cases may have other important factual distinctions, because the lender in Camp Bowie agreed that the owner could remain current on the revised mortgage and that the property was worth more than the debt. In the Sixth Circuit case, the property was worth a fraction of the mortgage debt and would be paid down little during the life of the plan.
Other factual differences may be important, too. In Camp Bowie, the bankruptcy judge required the owners to contribute $1.5 million in new equity and precluded them from taking money out until the lenders were fully paid. Nonetheless, the Fifth Circuit said that the plan fit within the “plain meaning of Sections 1124 and 1129(a)(10)” of the Bankruptcy Code.
There can be debate as to whether the two cases are at odds or merely reflect different underlying facts. While there may be no bright-line test to determine when a small amount of impairment is too little, the Sixth Circuit may be quicker to find artificial impairment, at least when the lender is taking a haircut and the debtor’s owners are injecting no new capital.
In any event, it does not appear that the two cases are sufficiently inconsistent to warrant Supreme Court review because the two courts’ pronounced legal principles are not far apart.