Due-on-Sale Clause Not Mandatory in Cramdown Chapter 11 Plan, and Plan Acceptance Requirement Applies on "Per Plan" Basis
In Grasslawn Lodging, LLC v. Transwest Resort Properties Inc. (In re Transwest Resort Properties, Inc.), 881 F.3d 724 (9th Cir. 2018), the U.S. Court of Appeals for the Ninth Circuit considered, in connection with a "cramdown" chapter 11 plan, whether an undersecured creditor's election to be treated as fully secured under section 1111(b)(2) of the Bankruptcy Code means that the plan must include a due-on-sale clause and whether the section 1129(a)(10) impaired class acceptance requirement applies on a "per plan" or a "per debtor" basis. The Ninth Circuit affirmed a district court decision concluding that section 1111(b)(2) does not mandate inclusion of a due-on-sale clause in such a plan and, as a matter of first impression among the circuit courts of appeals, that section 1129(a)(10) applies on a "per plan" basis. The section 1129(a)(10) ruling reignites a debate on this issue that has been smoldering for many years.
Election of Fully Secured Status Under Section 1111(b)(2)
In situations where a secured creditor's claim is not fully secured by the value of its collateral, section 506 of the Bankruptcy Code provides that the undersecured creditor's claim is bifurcated into: (a) a secured claim up to the value of the collateral; and (b) an unsecured deficiency claim for the remainder. This means that the undersecured creditor is entitled to the inherent protections afforded to secured creditors with respect to its secured claim, while it also is given the right to vote on any chapter 11 plan which does not leave its unsecured claim unimpaired. This presents strategic advantages in cases where the amount of the unsecured claim provides the creditor with leverage at the plan bargaining table because its unsecured deficiency claim may be large enough to block confirmation.
An undersecured creditor may bypass the effects of section 506 by making an election to have its entire claim treated as secured under section 1111(b)(2) of the Bankruptcy Code. By making this election, the undersecured creditor relinquishes the possibility of recovering on the unsecured deficiency claim as well as its right to vote on the plan as an unsecured creditor. See In re Weinstein, 227 B.R. 284, 293, n.10 (B.A.P. 9th Cir. 1998).
However, a section 1111(b)(2) election can be beneficial. If the debtor or other plan proponent attempts to seek confirmation of a chapter 11 plan over the objection of an electing secured creditor, section 1129(b)(2)(A) of the Bankruptcy Code contains three options for treatment of its secured claim. One (and the most commonly used) of those—specified in section 1129(b)(2)(A)(i)—mandates that the electing creditor retain its lien on the collateral and receive deferred cash payments equal to the present value of the collateral, while the sum of the payments must equal the total amount of the creditor's allowed secured claim as of the plan's effective date. These requirements typically are met by a balloon payment for the remaining balance of the claim at the end of the term or a note bearing a below-market rate of interest.
Thus, by having its claim treated as fully secured, an electing undersecured creditor typically will hold a discounted note after confirmation of a chapter 11 plan, but it can share in the upside if its collateral increases in value and the debtor either sells the property and repays the note or defaults on the loan post-bankruptcy.
"Per Debtor" Versus "Per Plan" Impaired Creditor Acceptance
Section 1129(a)(10) of the Bankruptcy Code provides that, if a creditor class is impaired under a chapter 11 plan, at least one impaired class must vote in favor of the plan, excluding any acceptance of the plan by an insider. This provision, which has been called the "statutory gatekeeper" to cramdown, must also be satisfied for a chapter 11 plan to be confirmed under the nonconsensual plan confirmation requirements set forth in section 1129(b). See In re 266 Washington Assocs., 141 B.R. 275, 287 (Bankr. E.D.N.Y.), aff'd, 147 B.R. 827 (E.D.N.Y. 1992). Thus, a cramdown chapter 11 plan cannot be confirmed in the absence of an accepting impaired class.
Determining whether a plan satisfies section 1129(a)(10) is relatively easy in cases involving a single debtor and its classes of creditors (although even simple cases present the prospect of "artificial impairment" or "gerrymandering" to create an accepting impaired class). Complex chapter 11 cases, however, commonly involve multiple debtors and joint chapter 11 plans.
In such cases, courts have been divided as to whether section 1129(a)(10) applies on a "per debtor" or "per plan" basis. If the requirement applies on a "per debtor" basis, at least one impaired class of creditors for each debtor would have to accept the plan for it to be confirmed. By contrast, the "per plan" approach requires only that at least one impaired class of creditors votes to accept the plan, irrespective of whether the creditors in the class hold claims against one, some, or all of the debtors.
Another common aspect of chapter 11 cases involving multiple affiliated debtors is "substantive consolidation." Under this remedy, all assets and liabilities of multiple debtors are grouped together to form a single estate to satisfy the claims of all creditors and interest holders. Substantive consolidation is typically granted under circumstances where creditors dealt with affiliated debtors as a "single economic unit" or when the debtors' affairs "are so entangled that consolidation will benefit all creditors." In re Bonham, 229 F.3d 750 (9th Cir. 2000). When multiple debtors in a complex chapter 11 case have been substantively consolidated, the section 1129(a)(10) voting requirement is straightforward because the substantively consolidated entities are treated as a single debtor.
Substantive consolidation is to be distinguished from "joint administration," where the bankruptcy cases of affiliated debtors are jointly administered for administrative convenience, while the debtors' estates and creditors remain separate. See Fed. Bankr. P. 1015(b).
In multidebtor chapter 11 cases, judges in the U.S. Bankruptcy Court for the District of Delaware have adopted the "per debtor" approach when applying section 1129(a)(10). See In re Tribune Co., 464 B.R. 126, 182–83 (Bankr. D. Del. 2011); In re JER/Jameson Mezz Borrower II, LLC, 461 B.R. 293, 303 (Bankr. D. Del. 2011). In these cases, the bankruptcy courts reasoned that, if the debtors' estates have not been substantively consolidated, the joint plan is effectively a separate plan for each debtor.
Bankruptcy judges in the Southern District of New York and the Middle District of Pennsylvania have embraced the opposite view, ruling that the plain meaning of section 1129(a)(10) requires a "per plan" approach. See JPMorgan Chase Bank, N.A. v. Charter Commc'ns Operating, LLC (In re Charter Commc'ns), 419 B.R. 221 (Bankr. S.D.N.Y. 2009); In re Enron Corp., 2004 Bankr. LEXIS 2549 (Bankr. S.D.N.Y. July 15, 2004); In re SPGA Inc., 2001 Bankr. LEXIS 2291 (Bankr. M.D. Pa. Sept. 28, 2001).
Transwest
Transwest involved five affiliated debtor entities that acquired two resort hotels several years prior to filing for bankruptcy. The hotel acquisitions were financed by loans secured by the resort properties and one debtor's ownership interests in two of the operating debtors. The five debtors filed for chapter 11 in 2010 in the District of Arizona, and the cases were jointly administered but not substantively consolidated.
The lender was undersecured—it was owed $247 million, but the hotels were valued at no more than $92 million—and elected under section 1111(b)(2) to have its entire claim treated as secured. The debtors' joint chapter 11 plan proposed to give the lender a new secured note calling for monthly interest-only payments and then a balloon payment of the outstanding principal at the end of a 21-year term.
Under the plan, the new loan would also include a due-on-sale clause requiring the debtors to pay the lender's claim in full if the hotels were sold, but the due-on-sale clause would not apply if the hotels were sold between Years 5 and 15.
The lender was the only voting creditor for two of the five debtors and voted to reject the plan. The lender also objected to confirmation of the plan. In its objection, the lender argued that: (i) the 10-year window in which the due-on-sale clause did not apply "partially negate[d] the benefit of the Lender's section 1111(b)(2) election"; and (ii) the joint plan could not be confirmed because section 1129(a)(10) applies on a "per debtor" basis, and certain of the debtors had no accepting impaired class. The bankruptcy court overruled the objection on both counts and confirmed the plan.
The district court affirmed on appeal, and the lender appealed to the Ninth Circuit.
The Ninth Circuit's Ruling
A three-judge panel of the Ninth Circuit affirmed.
Looking to the plain language of section 1111(b)(2), the panel concluded that the provision does not explicitly or implicitly mandate that a due-on-sale clause be part of a plan. In addition, the Ninth Circuit panel explained that section 1123, which lists the required contents of a chapter 11 plan, does not include any reference to a due-on-sale clause. Rather, the court noted, section 1123 provides that a plan may "modify the rights of holders of secured claims," which, at most, suggests that the inclusion of a due-on-sale clause is entirely discretionary.
In addition, the court explained that section 1129(b)(2)(A)(i)(I) requires that the holder of a secured claim retain the lien securing that claim, even when "the property subject to such liens is … transferred to another entity." Thus, the Ninth Circuit panel reasoned, that provision expressly allows a debtor to sell the collateral to another entity so long as the creditor retains the lien securing its claim, yet the provision does not mention any due-on-sale requirement, "further undermining the Lender's position that a due-on-sale clause must be included in the Plan." Citing In re Airadigm Commc'ns, Inc., 519 F.3d 640 (7th Cir. 2008), the court adopted the Seventh Circuit's reasoning that a due-on-sale clause is not a lien that must be preserved to confirm a plan. Rather, the Ninth Circuit panel held that "a due-on-sale clause is a mechanism regarding the terms of a payment of debt, not a substantive right of creditors making an election pursuant to section 1111(b)(2)."
The Ninth Circuit also examined the plain language of section 1129(a)(10) to determine whether the provision should apply on a "per plan" basis. The court reasoned that the provision "makes no distinction concerning or reference to the creditors of different debtors under 'the plan,' nor does it distinguish between single-debtor and multi-debtor plans." Rather, the court concluded, the section 1129(a)(10) cramdown threshold for a joint plan is satisfied where "a single impaired class accepts a plan."
Finally, the Ninth Circuit panel rejected the lender's argument that the joint administration of the chapter 11 cases was tantamount to substantive consolidation of the debtors. The court also dismissed the lender's argument that the "per plan" approach had the effect of substantively consolidating the debtors and therefore would wreak havoc on mezzanine lenders who rely on debtors' separate existence for purposes of preserving their collateral. According to the court, "[S]uch hypothetical concerns are policy considerations best left for Congress to resolve."
In a concurring opinion, circuit judge Friedland wrote that, because the chapter 11 plan effectively merged the debtors without any assessment of whether substantive consolidation was appropriate, the lender's argument that it was unfairly deprived of the ability to object effectively to confirmation had some foundation. Even so, he noted, the lender failed to raise that objection in the bankruptcy court, choosing instead to rely on its objections under section 1129(a)(10).
Moving Forward
The Ninth Circuit panel's approach to section 1111(b)(2) in Transwest is unwelcome news for secured creditors, which have viewed the election as an important protection against depressed collateral value in bankruptcy. This protection is diminished somewhat by the panel's ruling that a cramdown plan need not include a due-on-sale clause for an undersecured creditor electing treatment under section 1111(b)(2) of the Bankruptcy Code.
The principal significance of Transwest is that, by embracing the "per plan" approach to section 1129(a)(10), the ruling gives debtors in multidebtor chapter 11 cases an easier road to cramdown confirmation of a joint chapter 11 plan, regardless of whether the debtors have been substantively consolidated. Although this is welcome news for debtors, it reignites the debate on the issue and creates additional uncertainty for debtors and creditors in jurisdictions where the courts have not addressed it. The ruling may also encourage debtors that face this issue and have a choice of bankruptcy venue to file for bankruptcy in the Ninth Circuit, the Southern District of New York, or the Middle District of Pennsylvania.
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