A deeply subordinated creditor may neither vote on a chapter 11 plan nor object to confirmation if the creditor has no chance of receiving a distribution in either chapter 11 or chapter 7, according to Chief Bankruptcy Judge Dale L. Somers of Topeka, Kan.
The opinion could be read broadly to mean that an underwater creditor is barred by the doctrine of prudential standing from voting on a plan. Other courts may view the holding as applicable only to creditors who are deeply subordinated by contract.
The Debtor’s Capital Structure
The corporate debtor’s principal creditor was a bank with a secured claim of $7.7 million. The subordinated creditor had a $5.3 million unsecured claim. Both the bank and the subordinated creditor filed claims for the $5.3 million.
In addition to providing that any recovery on the subordinated creditor’s claim would go to the bank, the subordination agreement allowed the bank to file and vote the subordinated creditor’s claim.
The chapter 11 plan evidently bifurcated the secured creditor’s claim into a $2.5 million secured claim and a $5.2 million unsecured claim. General unsecured creditors, including the bank, were to be paid 15% of their claims.
The subordinated creditor was in a separate class to be paid $120,000, but the payments would go to the bank.
The equity holders were to retain ownership after confirmation.
The subordinated creditor conceded that it would receive no distribution in either chapter 11 or chapter 7.
The debtor and the bank filed a motion to disallow the claim filed by the subordinated creditor and to declare that the bank could vote the subordinate claim.
In his March 31 opinion, Judge Somers ruled in favor of the subordinated creditor until the very end, but he then gave the prize to the bank and the debtor.
The Right to Vote and File a Claim
The bank argued that the subordination agreement allowed the bank to vote the subordinated claim in favor of the plan.
Judge Somers analyzed lower court cases coming down both ways. He adopted the analysis by former Bankruptcy Judge Eugene R. Wedoff of Chicago in Bank of America, Nat’l Ass’n v. N. LaSalle St. Ltd. P’ship (In re 203 N. LaSalle Street P’ship), 246 B.R. 325 (Bankr. N.D. Ill. 2000).
Judge Wedoff gave several reasons why a subordination agreement cannot divest the subordinated creditor of voting rights. Among other things, Judge Wedoff said that the right to vote is controlled by the Bankruptcy Code, not by an intercreditor agreement. He also said that Section 510(a), permitting the enforcement of subordination agreements, does not allow a waiver of voting rights because subordination affects the priority in payment of claims, not voting rights.
Like the caselaw, Judge Somers cited commentators who come down both ways. Ultimately, he quoted the ABI Commission to Study the Reform of Chapter 11 by saying that a subordination agreement should not be enforced to preclude a subordinated creditor from voting. American Bankruptcy Institute Commission to Study the Reform of Chapter 11: 2012-2014 Final Report and Recommendations, 23 Am. Bankr. Inst. L. Rev. 1, 284 (2015).
Judge Somers held “that the attempted modification of voting rights stated in the Subordination Agreements is not enforceable.”
Judge Somers also overruled the objection to the proof of claim filed by the subordinated creditor. He said that “subordination merely reorders priorities among creditors. Unlike the circumstance where a claim is assigned to another party, subordination does not involve transfer of the subordinated creditor’s legal interest.”
Prudential Standing
Judge Somers addressed three “distinct” standing doctrines: constitutional standing, statutory standing and prudential standing. Pertinent factually, he said there was “no circumstance under which the [subordinated creditor] has any financial stake in the outcome of the confirmation process.”
The subordinated creditor had statutory standing under Section 1109(b), which provides that a “party in interest, including . . . a creditor, . . . may raise and may appear and be heard on any issue in a case under this chapter.”
Constitutional standing under Article III deals with the required existence of a case or controversy. Judge Somers said he found no caselaw dealing with Article III standing principles applied to the right of subordinated creditors to participate in the confirmation process.
Because he was ruling next on prudential standing, Judge Somers found it unnecessary to rule on constitutional standing.
Prudential Standing
Prudential standing is a court-made doctrine. Judge Somers quoted the Supreme Court for saying that prudential standing encompasses “the general prohibition on a litigant’s raising of another person’s legal rights.” Lexmark Int’l, Inc. v. Static Control Components, Inc., 572 U.S. 118, 126 (2014).
Judge Somers said that the subordinated creditor “would be litigating issues affecting the rights of third parties, not itself,” because “there is no scenario under which the [subordinated creditor] will receive any direct financial benefit.”
Were there a plan amendment to improve the recovery for the subordinated creditor, Judge Somers predicted that “other unsecured creditors would likely receive less.”
Judge Somers surmised that the subordinated creditor aimed to vote against the plan and thereby invoke the absolute priority test under Section 1129(b). He said that other creditors had the “financial interest” in asserting the absolute priority rule and other cramdown requirements.
Absolute priority could have been an issue in cramdown were there an objecting class, because the plan allowed existing equity to retain ownership. If all creditor classes voted “yes,” absolute priority would not be an issue.
Judge Somers decided that “prudential standing principles preclude the [subordinated creditor] from participating in the disclosure statement and Plan confirmation process.”
Observations
The opinion confirms the subordinated creditor’s statutory standing under Section 1109(b), the right to file a claim, and the statutory right to vote on the plan, yet prudential standing deprived the creditor of rights granted by Congress. Other courts may limit the persuasive value of the opinion to cases involving creditors who are deeply subordinated by contract.
If it were followed by other courts, the opinion would have important implications for chapter 11 plan confirmation. By preventing underwater classes of creditors from voting, a debtor might confirm a plan without addressing the requirements of cramdown in Section 1129(b). Or, as Prof. Stephen J. Lubben told ABI, “By ignoring the vote of an out of the money creditor, equity does not even have to show it is paying ‘new value.’”
Prof. Lubben added, “Nobody but the lenders could object in many cases where everything is all liened up.” He is the Harvey Washington Wiley Chair in Corporate Governance & Business Ethics at the Seton Hall University School of Law.
Prof. Bruce A. Markell went the next step. He said that “the holders of equity interests in an insolvent company would not have standing.” He saw the opinion as confusing “the financial facts with the bankruptcy process: it is the plan that allocates rights, not the financial situation of creditors.”
On a practical level, Prof. Markell observed that “owners and out-of-the-money creditors participate all the time — usually to get a different plan which will allocate value differently.” Prof. Markell is the Professor of Bankruptcy Law and Practice at the Northwestern Univ. Pritzker School of Law.
Prof. Lubben believes that the “discussion about raising ‘other people’s rights’ is really off point, given that the creditor at issue was really just forcing compliance with Section 1129 — not somebody else’s rights.”
Prof. Markell said he agreed with the ruling about the transfer of voting rights.
A final note: If one subscribes to the idea that the subordination agreement validly transferred voting rights, then the outcome is correct in terms of voting on the plan, and perhaps also with regard to barring the subordinated creditor from objecting to confirmation.
A deeply subordinated creditor may neither vote on a chapter 11 plan nor object to confirmation if the creditor has no chance of receiving a distribution in either chapter 11 or chapter 7, according to Chief Bankruptcy Judge Dale L. Somers of Topeka, Kan.
The opinion could be read broadly to mean that an underwater creditor is barred by the doctrine of prudential standing from voting on a plan. Other courts may view the holding as applicable only to creditors who are deeply subordinated by contract.
The Debtor’s Capital Structure
The corporate debtor’s principal creditor was a bank with a secured claim of $7.7 million. The subordinated creditor had a $5.3 million unsecured claim. Both the bank and the subordinated creditor filed claims for the $5.3 million.
In addition to providing that any recovery on the subordinated creditor’s claim would go to the bank, the subordination agreement allowed the bank to file and vote the subordinated creditor’s claim.
The chapter 11 plan evidently bifurcated the secured creditor’s claim into a $2.5 million secured claim and a $5.2 million unsecured claim. General unsecured creditors, including the bank, were to be paid 15% of their claims.
The subordinated creditor was in a separate class to be paid $120,000, but the payments would go to the bank.
The equity holders were to retain ownership after confirmation.
The subordinated creditor conceded that it would receive no distribution in either chapter 11 or chapter 7.
The debtor and the bank filed a motion to disallow the claim filed by the subordinated creditor and to declare that the bank could vote the subordinate claim.
In his March 31 opinion, Judge Somers ruled in favor of the subordinated creditor until the very end, but he then gave the prize to the bank and the debtor.