Cram-Down Chapter 11 Plan Need Not Strictly Enforce Subordination Agreement
In the latest chapter of more than a decade of contentious litigation surrounding the 2007 leveraged buyout ("LBO") and ensuing bankruptcy of media conglomerate Tribune Co. ("Tribune"), the U.S. Court of Appeals for the Third Circuit affirmed lower court rulings that Tribune's 2012 chapter 11 plan did not unfairly discriminate against senior noteholders who contended that their distributions were reduced because the plan improperly failed to strictly enforce pre-bankruptcy subordination agreements. In In re Tribune Co., 972 F.3d 228 (3d Cir. 2020), the Third Circuit held that, according to a plain reading of the relevant provisions of the Bankruptcy Code, a nonconsensual chapter 11 plan that does not strictly enforce a subordination agreement does not necessarily discriminate unfairly against a class of creditors that would otherwise benefit from subordination. In this case, the Third Circuit agreed with the lower courts that the "immaterial" reduction in the senior noteholders' recovery did not rise to the level of unfair discrimination. In reaching this conclusion, the Third Circuit appears to have become the first court of appeals in a published ruling to adopt the "Markell test" for assessing unfair discrimination.
Cramdown Confirmation of a Chapter 11 Plan
Section 1129(a)(8) of the Bankruptcy Code requires that, for a chapter 11 plan to be confirmable, each class of claims or interests must either accept the plan or not be "impaired." However, "cramdown" confirmation is possible in the absence of plan acceptance by impaired classes under section 1129(b)(1), which provides as follows:
Notwithstanding section 510(a) of this title, if all of the applicable requirements of subsection (a) of this section other than paragraph (8) are met with respect to a plan, the court, on request of the proponent under the plan, shall confirm the plan notwithstanding the requirements of such paragraph if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.
11 U.S.C. § 1129(b)(1) (emphasis added).
The Bankruptcy Code does not define "unfair discrimination." As noted by a leading commentator, "Courts have struggled to give the unfair discrimination test an objective standard." Collier on Bankruptcy ("Collier") at ¶ 1129.03[a] (16th ed. 2020). Nevertheless, most courts agree that the purpose underlying the requirement is "to ensure that a dissenting class will receive relative value equal to the value given to all other similarly situated classes." In re LightSquared Inc., 513 B.R. 56, 99 (Bankr. S.D.N.Y. 2014); accord In re SunEdison, Inc.,575 B.R. 220 (Bankr. S.D.N.Y. 2017); In re 20 Bayard Views, LLC, 445 B.R. 83 (Bankr. E.D.N.Y. 2011); In re Johns-Manville Corp., 68 B.R. 618, 636 (Bankr. S.D.N.Y. 1986), aff'd, 78 B.R. 407 (S.D.N.Y. 1987), aff'd, 843 F.2d 636 (2d Cir. 1988).
Courts historically have relied on a number of tests to determine whether a plan discriminates unfairly. These include: (i) the "mechanical" test, which prohibits all discrimination and requires that the recoveries of similarly situated creditors be identical; (ii) the "restrictive" approach, which narrowly defines unfair discrimination to mean that, absent subordination, disparate treatment of similarly situated creditors is not permitted; and (iii) the "broad" approach, which considers whether (1) a reasonable basis for discrimination exists, (2) the debtor can consummate a plan without discrimination, (3) the discrimination is proposed in good faith, and (4) the extent of discrimination is directly proportional to its rationale. See generally Denise R. Polivy, Unfair Discrimination in Chapter 11: A Comprehensive Compilation of Current Case Law, 72 Am. Bankr. L.J. 191, 196-208 (1998) (discussing cases applying the various tests).
Several courts have adopted some form of the unfair discrimination test (the "Markell test") articulated by Bruce A. Markell in his article A New Perspective on Unfair Discrimination in Chapter 11, 72 Am. Bankr. L.J. 227, 249 (1998). See, e.g., In re Armstrong World Indus., Inc., 348 B.R. 111 (D. Del. 2006); In re Quay Corp., Inc., 372 B.R. 378 (Bankr. N.D. Ill. 2007); In re Exide Techs., 303 B.R. 48 (Bankr. D. Del. 2003). The Markell test was first applied by a bankruptcy court in In re Dow Corning Corp., 244 B.R. 705 (Bankr. E.D. Mich. 1999), aff'd in relevant part, 255 B.R. 445 (E.D. Mich. 2000), aff'd in part and remanded, 280 F.3d 648 (6th Cir. 2002). Under the Markell test, a rebuttable presumption that a plan unfairly discriminates will arise when the following elements exist:
(1) a dissenting class; (2) another class of the same priority; and (3) a difference in the plan's treatment of the two classes that results in either (a) a materially lower percentage recovery for the dissenting class (measured in terms of the net present value of all payments), or (b) regardless of percentage recovery, an allocation under the plan of materially greater risk to the dissenting class in connection with its proposed distribution.
Id. at 710. The burden then lies with the plan proponent to rebut the presumption by demonstrating that "outside of bankruptcy, the dissenting class would similarly receive less than the class receiving a greater recovery, or that the alleged preferred class had infused new value into the reorganization which offset its gain." Id.
Enforceability of Subordination Agreements in Bankruptcy
As noted previously, even if not all classes vote to accept a plan, section 1129(b)(1) states that it can be confirmed "notwithstanding section 510(a)" of the Bankruptcy Code, provided the plan complies with all of the other confirmation requirements, does not discriminate unfairly, and is fair and equitable with respect to impaired dissenting classes. Section 510(a) deals with contractual subordination agreements. It provides that, if the claims of one creditor or group of creditors are subordinated in accordance with the provisions of a valid and enforceable agreement, the subordination agreement is enforceable in a bankruptcy case "to the same extent that such agreement is enforceable under applicable nonbankruptcy law."
Thus, in construing the enforceability of a subordination agreement in bankruptcy, section 510(a) directs the bankruptcy court to look to applicable nonbankruptcy law—generally state law—as well as the terms of the agreement itself. See Collier at ¶ 510.03. If there is ambiguity in the agreement concerning the terms or extent of the subordination, a bankruptcy court may refuse to enforce it. See In re Bank of New England Corp., 364 F.3d 355, 367 (1st Cir. 2004) (remanding case to bankruptcy court to determine under New York law whether subordination agreement actually provided for payment of postpetition interest on senior debt prior to any payment on junior debt), on remand, 404 B.R. 17 (Bankr. D. Mass. 2009) (finding that parties did not intend to subordinate claims for postpetition interest), aff'd, 426 B.R. 1 (D. Mass. 2010), aff'd, 646 F.3d 90 (1st Cir. 2011).
However, because section 1129(b)(1) would appear to remove section 510(a) from the playing field when determining whether a chapter 11 plan can be confirmed over the objection of a dissenting impaired class, it is unclear whether a chapter 11 plan must give effect to the explicit terms of a subordination agreement in providing for the treatment of creditor claims. This was the thorny question addressed by the Third Circuit in Tribune.
Tribune
In 2007, Tribune was the target of an LBO that paid its shareholders more than $8 billion in exchange for their shares in the company and saddled Tribune with nearly $13 billion in debt. Shortly after the LBO was completed in December 2007, Tribune experienced financial difficulties due to declining advertising revenues and its failure to meet projections. The company filed for chapter 11 protection in December 2008 in the District of Delaware.
At the time of the bankruptcy filing, Tribune's complex capital structure included, among other obligations: (i) approximately $1.28 billion in senior unsecured notes ("senior notes"); (ii) approximately $759 million in unsecured debentures ("sub debentures"); and (iii) $225 million in unsecured notes ("sub notes"). The sub debentures and the sub notes were contractually subordinated to the senior notes in their respective indentures, which limited repayment of the instruments until all "Senior Obligations" were paid in full. Tribune's other debts included an unsecured $150.9 million claim under an interest rate swap agreement ("swap claim"), $105 million in unsecured retiree claims ("retiree claims"), and $8.8 million in unsecured trade claims ("trade claims").
Under Tribune' proposed chapter 11 plan, creditors in the class comprising the swap claim, the retiree claims, and the trade claims—Class 1F—and creditors in the separate class comprising the senior notes—Class 1E—would each receive 33.6% of their outstanding claims. These payments included distributions that would otherwise have been made in respect of the contractually subordinated sub debentures and sub notes.
The senior noteholders objected to the plan, arguing that it violated section 510(a) because it allocated more than $30 million to which they said they were entitled under the contractual subordination provisions to Class 1F, which did not contain claims qualifying as "Senior Obligations." In the alternative, the senior noteholders argued that the plan unfairly discriminated against their class (Class 1E).
The bankruptcy court ruled that section 1129(b)(1) does not require that a subordination agreement be strictly enforced for a plan to be confirmed. The court also rejected the senior noteholders' unfair discrimination argument, even though the court assumed (without deciding) that, except for the swap claim, none of the claims in Class 1F were Senior Obligations entitled to the benefit of the subordination provisions. By eliminating the swap claim from the calculus of the senior noteholders' $30 million complaint, the court found that only $13 million was in dispute, compared to the senior noteholders' $1.28 billion claim. Thus, the court reasoned that, if it ruled in the senior noteholders' favor, their recovery would increase by only 0.9% (from 33.6% to 34.5%). Applying the Markell test, the bankruptcy court concluded that "[t]he discriminatory effect on the dissenting class is immaterial and, therefore, no rebuttable presumption of unfair discrimination arises here." In re Tribune Co., 472 B.R. 223, 244 (Bankr. D. Del. 2012), aff'd in part, vacated in part, 2014 WL 2797042 (D. Del. June 18, 2014), aff'd in part, rev'd in part, 799 F.3d 272 (3d Cir. 2015), aff'd after remand, 587 B.R. 606 (D. Del. 2018), aff'd, 972 F.3d 228 (3d Cir. 2020). The bankruptcy court accordingly confirmed Tribune's chapter 11 plan in July 2012.
The senior noteholders appealed the confirmation order to the district court, which dismissed their appeal as being "equitably moot" because Tribune's plan had been substantially consummated. According to the district court, it could not "practically or equitably" order disgorgement from Class 1F creditors because the class consisted of more than 700 members, the majority of which were individuals and small-business trade creditors. Also, disgorgement would be "difficult to implement uniformly," as only 16% of the class creditors received cash distributions, while the remaining creditors received part of their distributions from interests in a litigation trust.
The Third Circuit reversed on appeal and remanded the case to the district court. It ruled that forcing Class 1F creditors to repay the distributions they received under the plan would not "unravel" the plan, noting that "the dispute is about whether one of two classes of creditors is entitled to $30 million in the context of a $7.5 billion reorganization."
On remand, the district court upheld the plan confirmation order. It rejected the senior noteholders' contention that the plan discriminated unfairly because it did not strictly enforce the subordination provisions. Among other things, the district court found that the bankruptcy court did not err in concluding that the swap claims were Senior Obligations. According to the district court, "[m]inor or immaterial differences … do not rise to the level of unfair discrimination." The plan did not unfairly discriminate, it explained, because the dissenting class (Class 1E) would receive "a percentage recovery that was, at most, 2.3 percentage points lower than the recovery to which they claim they were entitled," meaning there was no presumption of unfair discrimination under the Markell test.
The senior noteholders appealed to the Third Circuit.
The Third Circuit's Ruling
A three-judge panel of the Third Circuit affirmed. Writing for the panel, Circuit Judge Thomas L. Ambro held at the outset that "§ 1129(b)(1) overrides § 510(a) because that is the plain meaning of '[n]otwithstanding.'" According to Judge Ambro, the purpose and the legislative history of section 1129(b)(1) support this interpretation, as does the only published court ruling that has directly addressed the question. See In re TCI 2 Holdings, 428 B.R. 117, 141 (Bankr. D.N.J. 2010).
He explained that both section 510(b) and section 1129(b)(1)'s unfair discrimination test are concerned with distributions among creditors—the former, by agreement, and the latter, as a gauge of "whether involuntary reallocations of subordinated sums under a plan unfairly discriminate against the dissenting class." However, Judge Ambro noted, "Only one can supersede, and that is the cramdown provision," which "provides the 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." At the same time, he wrote, section 1129(b)(1) "attempts to ensure that debtors and courts do not have carte blanche to disregard pre-bankruptcy contractual arrangements, while leaving play in the joints."
Next, Judge Ambro noted that, by mentioning only cases involving the relative treatment of like-kind creditors affected by subordination agreements, the scant and sometimes confusing legislative history of section 1129(b)(1) suggests that lawmakers intended to "rely on that discrimination principle, and not on § 510(a), to enforce subordination agreements" in a cramdown chapter 11 plan. See H.R. Rep. No. 95-595, at 416-17 (1977).
He rejected the noteholders' argument that lawmakers' intent to favor section 510(a) can be inferred from a 1995 recommendation that removal of the reference to section 510(a) in section 1129(b)(1) was warranted to "prevent the anomalous result of overriding § 510(a) and eliminating the enforcement of subordination agreements in cases in which the class rejects the plan." See Kenneth N. Klee, Adjusting Chapter 11: Fine Tuning the Plan Process, 69 Am. Bankr. L.J. 551, 561 (1995). According to Judge Ambro, that recommendation is not evidence of legislative intent and Congress never amended the provision to reflect it.
Finally, the Third Circuit ruled that the plan's allocation of a small portion of subordinated sums to the Class 1F creditors did not unfairly discriminate against the senior noteholder class even if the Class 1F creditors were not entitled to them under the subordination agreement. In doing so, it "distill[ed]" several principles from various unfair-discrimination analyses. These included, among other things:
- A "pure pro rata division of plan distributions among like-priority creditors … runs counter to the text" of section 1129(b)(1). Thus, a subordination agreement need not be "enforced to the letter" in the case of a cramdown, and subordinated amounts may be allocated to other classes not entitled to benefit from subordination outside of bankruptcy.
- Although one approach in assessing unfair discrimination is to compare the proposed plan distributions to the allegedly preferred class and the dissenting class, a court may instead consider—as in this case—the difference between the amount to which the dissenting class argues it is entitled and what it actually received under the plan.
- To presume unfair discrimination, there must be either a materially lower percentage recovery for the dissenting class or a materially greater risk to the dissenting class in connection with its proposed distribution. The definition of "material," however, must be left to the courts on a case-by-case basis. The presumption can be rebutted, but the determination of what qualifies as an adequate rebuttal must be left to the courts.
Applying these principles, the Third Circuit affirmed the lower courts' ruling that there was no unfair discrimination. It stated that the bankruptcy court "did not necessarily err" by comparing the senior noteholders' desired recovery (34.5%) with their actual recovery under Tribune's plan (33.6%) because the comparison was "an appropriate metric (or cross-check)" under the circumstances. Judge Ambro explained that, because the claims of the retirees and trade creditors were substantially smaller than the senior noteholder claims ($114 million compared to $1.28 billion), "the increases in the recovery percentage for the [retirees and the trade creditors] from reallocated subordinated amounts results in only a minimal reduction of the recovery percentage for the Senior Noteholders." He therefore agreed with the lower courts' decision to apply a "pragmatic approach" in concluding that the 0.9% difference was "not material." "Although the Plan discriminates," Judge Ambro wrote, "it is not presumptively unfair when understood … that a cramdown plan may reallocate some of the subordinated sums."
Outlook
The Third Circuit's ruling in Tribune is notable for at least two reasons. First, although many lower courts (within and outside of the Third Circuit) have adopted the Markell test in examining whether a plan unfairly discriminates against a dissenting class, the Third Circuit appears to be the first circuit court of appeals to endorse that approach in a published opinion. In doing so, it acknowledged that chapter 11 balances competing interests with the goal of achieving an outcome that is fair (albeit imperfectly) to all stakeholders. Discrimination between similarly situated classes is permitted under a chapter 11 plan, as long as it not unfair and is supported by a reasonable justification. What constitutes unfair discrimination will depend on the circumstances of each case. However, the Third Circuit clarified in Tribune that immaterial disparities in recoveries do not qualify, writing that "[w]hat constitutes a material difference in recovery when analyzing the effect of a plan on the dissenting class is a distinct and context-specific inquiry." The court cautioned that it did not "address the outer boundary of that inquiry here."
Second, Tribune is important because the Third Circuit, construing the plain language of section 1129(b)(1), held that a chapter 11 plan that does not strictly enforce a contractual subordination agreement does not necessarily discriminate unfairly against classes that would otherwise benefit from subordination.
______________________________
Jones Day represented Tribune Co. in the litigation before the Third Circuit.
A version of this article was previously published by Lexis Practice Advisor. It has been reprinted here with permission.
