Automatic Stay Ruling Previews Court’s Take on Plan Classification

Contributed by Nelly Almeida
One of the “perks” of filing a petition for relief under chapter 11 of the Bankruptcy Code is the availability of the automatic stay under section 362(a) of the Bankruptcy Code, which provides that, at the moment of filing, certain actions by creditors to collect debts will be stayed.  The automatic stay acts as a temporary injunction, allowing debtors some “breathing room” while they prepare a plan of reorganization and determine creditors’ rights.  Although there are strong policy reasons for keeping the automatic stay in place until a plan is approved—such as to give a debtor the opportunity to propose a workable plan without creditor interference—a bankruptcy court may enter an order “terminating, annulling, modifying, or conditioning [the automatic] stay” for any of the reasons listed under section 362(d), if court finds cause to do so.
The fact that a debtor may have recently sought protection under the Bankruptcy Code and only just begun to take advantage of the breathing room provided by the automatic stay is not necessarily a bar to stay relief.  In fact, in a recent ruling in In re 4th Street East Investors, Inc. Judge Bason of the United States Bankruptcy Court of the Central District of California granted a motion for relief from the automatic stay even though the bankruptcy proceeding was in its early stages.  Judge Bason determined that the debtor had not met its burden to show there was a reasonable possibility that it could accomplish a successful reorganization within a reasonable time.  In making this determination, the court was required to prognosticate on the debtor’s reorganization proposal even in the early stages of the debtor’s case.  The ruling is significant not only because the court undertook a forward-looking analysis of the debtor’s reorganization prospects (which bankruptcy courts are sometimes forced to do when deciding motions for relief from stay) but also because it distinguished the facts before it from those of a recent decision, In re Loop 76, issued by the Ninth Circuit’s Bankruptcy Appellate Panel.
The debtor, 4th Street Investors, Inc., owned and operated a storage facility consisting of five buildings with 240 rentable storage units, an office, and a residence for an on-site manager.  The deterioration of the market over the past few years led 4th Street to file a voluntary chapter 11 petition on March 5, 2012.  4th Street’s largest creditor was Coastline RE Holdings Corp., which held between $200,000 and $450,000 in a general unsecured deficiency claim.  Operating under the belief that it would be better served “if the funds used for Debtor’s attorneys were paid directly” to the creditors, Coastline filed separate motions for relief from the automatic stay of section 362(a) and for conversion of the case from a chapter 11 to a chapter 7 under section 1112.
Coastline first alleged “bad faith” by the debtor and argued that this was sufficient cause for relief from the automatic stay and for conversion to chapter 7.  Coastline asserted that the reorganization was a baseless attempt by insiders—who were also creditors—to preserve an “upside” for themselves.  The bankruptcy court, however, found that it was not per se bad faith for a debtor’s insiders to attempt reorganization, and the court bolstered its conclusion on the fact that the case was in its early days and 4th Street, until that time, had been keeping up with its adequate protection payments.  Consequently, the court held that Coastline failed to show cause for conversion of the debtor’s case to a case under chapter 7.
Although the bankruptcy court did not give any credence to Coastline’s request to convert the debtor’s chapter 11 case, it did find that relief from the automatic stay was warranted under section 362(d)(2) of the Bankruptcy Code.  Under section 362(d)(2), a court must grant relief from stay of an act against property if it finds that the debtor lacks equity in the property and the property is not necessary for the debtor’s effective reorganization.  The United States Supreme Court has ruled that there must be “a reasonable possibility of a successful reorganization within a reasonable time.”  Judge Bason stated that although the debtor is not required to show “detailed plans for reorganizing,” it must, at least, outline how it would successfully reorganize.  The court held that 4th Street investors failed to show a possibility of successful reorganization for two reasons: (a) it did not show any financial prospects for reorganizing, and alternatively (b) it did not show that it would be able to meet the legal test to “cram down” a plan over Coastline’s objections.
The bankruptcy court found that 4th Street did not show financial prospects for reorganizing because its reorganization proposal relied entirely on the “hope of improved market conditions and reducing its payments to Coastline.”  4th Street had been reporting net losses as a result of the general market conditions and did not offer any evidence that it was taking actions to redress this issue.  Additionally, although 4th Street alleged that it would have positive cash flow after reducing Coastline’s claim, the court noted that Coastline’s claim had already been reduced and yet 4th Street still needed to borrow money to fund its ordinary expenses.  In light of these things, the bankruptcy court found that 4th Street failed to meet its “burden to show a reasonable possibility of a successful reorganization within a reasonable time.”
Judge Bason went on to find that, in the alternative, 4th Street also failed to show a reasonable possibility of being able to cram down a plan of reorganization over Coastline’s opposition — another way it could have shown prospects for an effective reorganization.  To effectuate cramdown, a debtor’s plan must (among other things) obtain a favorable vote by at least one impaired class, not counting insider votes.  In this case, because (excluding insider claims) general unsecured claims totaled less than $9,000, Coastline’s general unsecured deficiency claim could have out-voted any other general unsecured claims if all of the general unsecured claims were classified together (assuming that Coastline did not make the election under section 1111(b)).  As such, classification became the focal point of this portion of Judge Bason’s decision.
4th Street Investors argued that it could have separately classified Coastline’s unsecured deficiency claim of about $200,000 to $450,000 from the other non-insider general unsecured claims because Coastline held a guaranty, whereas the other creditors did not.  To support its claim, 4th Street cited to a recent decision of the Bankruptcy Appellate Panel, In re Loop 76, (Loop II) affirming a bankruptcy court’s confirmation of a plan that separately classified a deficiency claim (Loop I).  The basis for separate classification in In re Loop 76 was that the creditor had a non-debtor source of repayment, namely a guaranty.  Coastline’s response was that, in its situation, the guarantor was judgment proof, and there was no real chance of collection on the guaranty.  Although the bankruptcy court in Loop I had suggested that if the guarantor were insolvent or the creditor declined to pursue the guarantor, the existence of a guaranty might not be sufficient to render two ostensibly similar claims “dissimilar” purposes of plan classification, the Bankruptcy Appellate Panel seemed to reject this distinction in dicta, questioning whether collectability was a factor to consider.   Judge Bason was ultimately tasked to determine “whether the existence of a guarantee requires that claims be separately classified” and whether collectability matters.
Observing that “BAP decisions are not strictly binding,” the bankruptcy court rejected the analysis in both Loop I and Loop II, finding that the existence of a guarantee does not require that claims be separately classified.  The court further agreed with the bankruptcy court’s reasoning in Loop I, concluding that collectability does matter.
The court began its analysis by observing that, under section 1122(a) of the Bankruptcy Code, claims must be separately classified if they are not “substantially similar.”  If claims are substantially similar, a plan may nonetheless classify them separately if there is a “business or economic justification for doing so.”  The bankruptcy court observed that it was “not required to approve separate classification of Coastline’s unsecured deficiency claim as a matter of law.”  It cited two leading Ninth Circuit decisions on the issue: (a) In re Johnston, 21 F.3d 323 (9th Cir. 1994), where the bankruptcy court confirmed a plan that separately classified a deficiency claim on the basis of special circumstances and (b) In re Barakat, 99 F.3d 1520 (9th Cir. 1996), where the bankruptcy court denied confirmation of a plan that separately classified a deficiency claim on the basis that no “special circumstances” existed.  As Judge Bason understood it, the special circumstances in Johnston “went beyond the mere existence of a potential third party source of repayment such as a (possibly worthless) guaranty.  Those special circumstances involved the rare situation of (1) a deficiency claim that was secured by collateral, (2) pending litigation that could affect not only the dollar amount of the claims but also the creditor’s rights, and (3) collectability of the claim at issue from non-debtor sources.”  Finding that special circumstances, such as the ones in Johnston, were not present in 4th Street’s case, the court concluded that 4th Street’s case was more like Barakat in that, in the 4th Street case, there was no showing of any non-debtor collateral for the debt, no pending litigation that might establish rights of Coastline different from the rights of general unsecured creditors, and 4th Street had not shown that Coastline’s claim was meaningfully collectable from a non-debtor source.  (Judge Bason further determined that even if his decision to follow the Ninth Circuit cases were incorrect, Coastline had also shown sufficient evidence that “relative to the size of its deficiency claim the guarantor is pretty much judgment proof” and thus even under the logic of Loop I or Loop II, separate classification would likely not be required.)
The bankruptcy court next considered whether separate classification would have been permissible. If separate classification were permissible, cramdown on Coastline’s deficiency claim, theoretically, could be possible. Fortunately for Coastline, the court found that 4th Street had not provided any business or economic justification (other than wanting to confirm its plan) warranting separate classification of Coastline’s claim from other general unsecured claims. In light of this, the bankruptcy court found that 4th Street had not shown that cramdown would be possible and failed to meet its burden to show the likelihood of an effective reorganization.
Judge Bason concluded his decision with a short explanation of the policy considerations supporting his ruling.  He first noted that lower courts “should be wary of holding that claims of the same priority must be separately classified” because this mandatory classification can cut against both debtors and creditors.  Second, he asserted that one of the underlying policies of the Bankruptcy Code is that creditors that hold greater debt should have a greater voice in the reorganization process.  Finally, he noted that if existence of a possibly worthless guaranty “is enough to require that a claim be separately classified, simply because there is theoretical non-debtor source of payment, then how about other claims that may be more or less collectible for practical or legal reasons?”  Judge Bason thought this might lead to absurd results such as mandatory separate classification for, among others, important trade creditors, “unimportant” trade creditors, and personal injury creditors with or without insurance.
In the end, although Coastline was unable to prove there was bad faith by 4th Street, it was able to show that 4th Street lacked equity in the property and—in part by arguing against separate claim classification—that 4th Street had not shown a reasonable possibility of being able to “accomplish a successful reorganization within a reasonable time.”  As such, Coastline received relief from the automatic stay.  With this decision, Judge Bason made it abundantly clear that although the automatic stay might be intended to protect debtors, section 362(d), case law, and various policy considerations may require a court to delve deeper into a debtor’s reorganization prospects than the debtor might anticipate.  If the debtor’s longer-term reorganization prospects look grim, that may be cause for stay relief.