Cramdown Doesn’t Require Strict Enforcement of Subordination, Third Circuit Says

The Third Circuit ruled “that subordination agreements need not be strictly enforced for a court to confirm a cramdown plan.”

The Third Circuit upheld rulings by the bankruptcy court and the district court in the mammoth reorganization of publisher Tribune Co. Senior noteholders, whose class voted against the chapter 11 plan, wanted the Third Circuit to enforce their contractual subordination rights to the letter.

The appeals court declined the invitation. In his August 27 opinion, Circuit Judge Thomas L. Ambro said that the “unfair discrimination” provision in Section 1129(b)(1) is “rough justice.” It replaces “stringent requirements with more flexible tests that increase the likelihood that a plan can be negotiated and confirmed.”

Judge Ambro wrote a “masterful opinion,” according to Bruce A. Markell, Professor of Bankruptcy Law and Practice at the Northwestern Univ. Pritzker School of Law. Judge Ambro is someone “with lots of bankruptcy experience and good horse sense,” Prof. Markell told ABI.

Prior Appeals and Procedural History                             

Bankruptcy Judge Kevin J. Carey confirmed the Tribune plan in July 2012. Two groups of bondholders appealed. In August 2015, the Third Circuit upheld dismissal of the appeal by one group of bondholders, ruling that the appeal was equitably moot.

However, the Third Circuit reversed the district court by holding that a separate appeal by senior noteholders was not equitably moot because it would not be unfair if the class that received an extra $30 million were forced to pay it back. In In re Tribune Media Co., 799 F.3d 272 (3d Cir. 2015).

On remand, the senior noteholders argued that the plan discriminated unfairly against them and thus violated Section 1129(b)(1), because some of the recovery they would have received from subordinated debt holders was directed to other creditors.

Confirmation Upheld on Remand

As the plan was written and confirmed, the district court determined on remand that the dissenting bondholders would receive a recovery of 33.6%. If subordination were strictly enforced, the bondholders’ recovery would have risen to 35.9%, a difference of 2.3 percentage points. In other words, the recovery would have been about 7% larger if subordination had been fully enforced.

Analyzing Sections 510(a) and 1129(b)(1) on remand, the district court rejected the bondholders’ contention that the plan discriminated unfairly because the plan did not strictly enforce the subordination agreement.

The district court held that “[m]inor or immaterial differences . . . do not rise to the level of unfair discrimination.” The plan did not unfairly discriminate, the court said, because the dissenting class would receive “a percentage recovery that was, at most, 2.3 percentage points lower than the recovery to which they claim they were entitled.”

“While the actual amount of money at issue is large,” the district court said that “the percentage difference is not significant or material,” meaning there was no presumption of unfair discrimination.

The district court upheld confirmation and ruled against the senior noteholders. In re Tribune Media Co., 587 B.R. 606 (D. Del. 2018). To read ABI’s report about the decision on remand, click here.

The senior bondholders appealed but lost in the opinion by Judge Ambro that tracks and amplifies the decision by the bankruptcy and district courts.

‘Notwithstanding’ Nixes Section 510(a)

The appeal turned on Sections 510(a) and 1129(b)(1). Section 510(a) says that a “subordination agreement is enforceable [in bankruptcy] to the same extent that such agreement is enforceable under applicable nonbankruptcy law.”

Section 1129(b)(1) is one of the so-called cramdown provisions that permits confirmation of a chapter 11 plan over a dissenting class. “Notwithstanding section 510(a),” it provides that the court “shall confirm the plan” despite rejection by the dissenting class “if the plan does not discriminate unfairly, and is fair and equitable. . . .”

The Third Circuit, Judge Ambro said, has written often about the “fair and equitable” requirement, also known as the absolute priority rule. On the other hand, “the unfair-discrimination standard has received little analysis.”

Judge Ambro quickly concluded that “§ 1129(b)(1) overrides § 510(a) because that is the plain meaning of ‘[n]otwithstanding.’” The purpose of the section, he said, is to provide “flexibility to negotiate a confirmable plan even when decades of accumulated debt and private ordering of payment priority have led to a complex web of intercreditor rights.” It ensures that plans will “not have carte blanche to disregard pre-bankruptcy contractual arrangements, while leaving play in the joints.”

Judge Ambro therefore held “that subordination agreement need not be strictly enforced for a court to confirm a cramdown plan.”

How Much Is Too Much?

Next, Judge Ambro was tasked with deciding whether the deprivation of $30 million represented “unfair discrimination.” He began by noting how the plan gave the dissenting class a recovery of 33.6%. Were the subordination agreement enforced, the dissenting bondholders would have recovered 34.5%. To the bankruptcy court, the difference of 0.9% was not material and therefore did not amount to unfair discrimination.

Courts have come up with four tests to determine when discrimination is too much. The parties agreed that Prof. Markell wrote the test in A New Perspective on Unfair Discrimination in Chapter 11, 72 Am. Bankr. L.J. 227, 227–28 (1998). Given the parties agreement, Judge Ambro applied the Markell test but did not say that it is the proper test.

The Markell test establishes a rebuttable presumption of unfair discrimination. Applicable to the case on appeal, the presumption arises if the failure to enforce subordination results in “a materially lower percentage recovery.” The presumption can be overcome, Judge Markell said, if the “lower recovery for the dissenting class is consistent with the results that would obtain outside of bankruptcy, or that a greater recovery for the other class is offset by contributions from that class to the reorganization.”

Applying the test, Judge Ambro said that there must be a “materially lower percentage recovery” for the presumption to arise. By approving a plan where the recovery was 0.9% lower, he said that the bankruptcy court “did not necessarily err.” He went on hold that the difference was “not material.”

Judge Ambro said that a “typical” reorganization has “a need for flexibility over precision.” Although the Tribune plan did discriminate, he said it was not “presumptively unfair” because “a cramdown plan may reallocate some of the subordinated sums.”

Judge Ambro did not lay down a rule saying how much discrimination is too much. He did say that 0.9% “is, without a doubt, not material.” He therefore upheld the “pragmatic approach” taken by the bankruptcy and district courts.