Delaware Bankruptcy Court Issues Latest Decision Approving Plan with “Death Trap”

One of a plan proponent’s primary tasks in the confirmation process is seeking the acceptance of creditors whose claims would be impaired under the proposed plan. The Bankruptcy Code’s list of prerequisites for confirmation includes the requirement that each class of claims either “has accepted the plan” or “is not impaired under the plan.”[1] The Bankruptcy Code contains one exception to this requirement: The court may confirm a plan over the dissent of one or more impaired classes if the plan meets the cramdown requirements of § 1129(b). But even in a cramdown scenario, the Bankruptcy Code still requires that “at least one class of claims that is impaired under the plan has accepted the plan.”[2]

One method that plan proponents sometimes use to encourage impaired creditors to accept a plan is to include a so-called “death trap” provision in the plan’s treatment of the class of creditors in question, which is a provision that provides that the class will receive a more favorable treatment if it accepts the plan than it will if it rejects it. Although creditors sometimes argue that these provisions are unfairly coercive, courts generally uphold “death trap” provisions as important facilitators of the sort of compromise that leads to consensual plans.[3] As the U.S. Bankruptcy Court for the District of Delaware explained in confirming a plan with such a provision, “[I]f the class accepts, the Plan proponent is saved the expense and uncertainty of a cramdown fight. This is in keeping with the Bankruptcy Code’s overall policy of fostering consensual plans of reorganization....”[4] Similarly, in a recent opinion, the U.S. Bankruptcy Court for the Southern District of New York expressed the same view, stating that fostering consensus “is a clear rationale behind such provisions” and that “such provisions offer a choice to avoid the expense and, more importantly, the uncertainty of a contested cramdown hearing.”[5]

The Bankruptcy Code is silent on “death trap” provisions, neither explicitly forbidding nor allowing them. The Delaware and Southern District of New York bankruptcy courts have each stated in published opinions that they view the Code’s silence as “not forbidding” — rather than “not permitting” — such provisions.[6] These courts take the view that “death trap” provisions would only be impermissible if they have the effect of depriving a party of a legal right to which it is otherwise entitled. In other words, to be permissible, the provision must offer the affected creditors a “reward” to which they would not otherwise be entitled, rather than threaten to deprive them of a right to which they are already entitled.

As the Southern District of New York bankruptcy court explained in Adelphia Communications, “This ‘carrot and stick’ provision, by which a creditor is offered an inducement to vote on a plan of reorganization, is not inconsistent with any provision of the Code — though I’d prefer to qualify that general statement to make it applicable if (but only if) the inducement is to give a stakeholder more than it would be entitled to, rather than to threaten to take an existing right away.”[7] For example, in Adelphia Communications, the court upheld a “death trap” provision that would give a class of equity-holders certain consideration if the class voted to accept the plan, but nothing if the class voted to reject. The court explained, “[T]he Bankruptcy Code doesn’t require that any distribution be made to the holders of Equity Interests.... [T]he Plan offers [certain consideration] as an inducement to holders of Equity Interests to vote on the Plan where they would otherwise be receiving no distribution.”[8] The court reasoned that simply by giving them the choice to receive a distribution, “the Plan gives equity holders more than their legal entitlement.”[9]

Latest Decision: Approval of “Death Trap” Provision in In re Emerald Oil

The latest pronouncement on the subject of “death trap” provisions comes from the Delaware bankruptcy court, which recently confirmed a plan containing such a provision in the Emerald Oil cases.[10] The plan in those cases classified all general unsecured creditors together in class 4, and provided that any class members voting to accept the plan would receive their pro rata share of a $2 million cash fund to be provided by the debtors’ lenders specially for that purpose. On the other hand, class members either rejecting or abstaining would receive nothing.

Unlike some of the “death trap” provisions discussed in prior published opinions, the Emerald Oil plan proposed to reward only the individual class members who cast accepting votes, as opposed to rewarding the class as a whole for its acceptance. The U.S. Trustee objected and argued that the “death trap” provision violated 11 U.S.C. § 1123(a)(4)’s requirement that “a plan shall provide the same treatment for each claim or interest of a particular class....”[11] The rewarding of some class 4 creditors but not others amounted to “treat[ing] creditors in the same class differently,” the U.S. Trustee argued.[12]

The court disagreed. In a decision announced from the bench on March 22, 2017, the court held that the plan did not violate § 1123(a)(4), because all class members actually did receive the same treatment. The court explained that a “death trap” provision complies with § 1123(a)(4) as long as all class members have the same opportunity to receive equal treatment, even if some class members end up receiving nothing as a result of declining the opportunity.[13] Because the opportunity to receive the distribution was open to all members of class 4 equally, the court held that the Emerald Oil plan met § 1123(a)(4)’s requirement that it “provide the same treatment for each claim.”

In addition, the court found that the class 4 creditors had no existing entitlement to any distribution at all, meaning that the rejecting and abstaining creditors were not being stripped of any existing rights. In this regard, the court accepted the debtors’ liquidation analysis, which showed that the class 4 creditors would be entirely “out of the money” in a hypothetical chapter 7 liquidation, and were therefore entitled to no distribution at all under the “best interests” test of 11 U.S.C. § 1129(a)(7).[14] In accepting the debtors’ liquidation analysis, the court accepted the debtors’ assertion that the fund to be created for paying the class 4 distributions “is solely the result of the Plan, and such a recovery pool would not be available in a chapter 7 liquidation.”[15] Implicit in the court’s holding is the concept that funds proposed to be provided by third parties to fund “death trap” rewards may properly be excluded from the plan proponent’s liquidation analysis for purposes of § 1129(a)(7).

Accordingly, like the “death traps” approved in prior published opinions, the Emerald Oil plan only bestowed a “reward” on the accepting creditors and did not threaten a “punishment” on the rejecting or abstaining creditors. The latter simply received their legal entitlement under the Bankruptcy Code (which in this case was nothing).

Takeaway

Emerald Oil is the latest in an ever-increasing line of cases approving “death trap” provisions in plans. Although the case law is still relatively sparse, the Delaware and Southern District of New York bankruptcy courts each appear to view the Bankruptcy Code’s silence on the subject as permissive and appear untroubled by these provisions in and of themselves. The courts’ decisions can be distilled to the fundamental principle that “death traps” are permissible where the incentive is consideration beyond a creditor’s existing rights (i.e., a “reward”), but impermissible where the incentive is the threat of stripping existing rights (i.e., a “punishment”).

In addition, Emerald Oil stands for the principle that a “death trap” provision may offer to reward individual creditors within a class for their votes, as opposed to the class as a whole. This intra-class rewarding is permissible under the Emerald Oil court’s reasoning so long as each creditor in the class has equal opportunity to obtain the reward, even if the end result is that some class members receive distributions and others do not.

Creditors faced with a plan containing a “death trap” provision should keep these principles in mind. As long as the provision would not deprive creditors of any specific rights under the Bankruptcy Code, and, if applicable, offers all creditors in the affected class(es) the same opportunity, the provision is likely to be upheld under the current trend.