Restructuring

Contributed by Julio C. Gurdian
This month, our “Breaking the Code” super-random-topic-generator has selected the section you’ve all been waiting for — section 1122(b) of the Bankruptcy Code.  Well, even if you weren’t waiting for it, the generator picked it.  Section 1122(b) allows a debtor to classify certain unsecured claims into a single class for administrative convenience, but beware the pitfalls.
What is it?
To understand the implications of section 1122(b), it must be read together with section 1122(a) of the Bankruptcy Code, which states that “[e]xcept as provided in subsection (b) of this section, a plan may place a claim or an interest in a particular class only if such claim or interest is substantially similar to the other claims or interests of such class.” Section 1122(b), in turn, provides that “[a] plan may designate a separate class of claims consisting only of every unsecured claim that is less than or reduced to an amount that the court approves as reasonable and necessary for administrative convenience.”  So, although section 1122(a) requires a debtor to classify similar claims in the same class, section 1122(b) provides a narrow exception to that rule when it comes to what is known colloquially in bankruptcy circles as the debtor’s “convenience class.”
The class consists of unsecured claims below a certain threshold dollar amount, which,  as a result of their “convenience claim” status, may often (though not always) be paid quickly, in cash, in full – even though their larger-sized counterparts in other unsecured classes may receive an entirely different plan treatment.  Debtors use their convenience classes to ease the administrative burden that would be imposed on them were they forced to process many smaller claims in the same manner as larger ones.
Creating a convenience class is an art more than a science.
The express language of section 1122(b) does not specify a monetary threshold for convenience claims, instead leaving it up to the debtor and the bankruptcy court to work out what that threshold might be.  To add more nebulous language into the fray, section 1122(b) also requires that the separate classification of the convenience class claims be “reasonable and necessary for administrative convenience.”
Though the subjective nature of the section allows for each debtor to establish what is reasonable and necessary in its bankruptcy case, it also means that not all “convenience classes” will be upheld in the plan confirmation process.  Simply because a debtor has collected several small claims into a single class does not necessarily mean it will be able to meet the requirements of section 1122(b).
When the debtor touts its convenience class as is its sole impaired, accepting class, for example, bankruptcy courts tend to look skeptically at the proposed classification, questioning whether the convenience class is being used as a smokescreen for gerrymandering claims to gain approval of a plan.
This was the case in In re S&W Enterprises, 37 B.R. 153 (Bankr. N.D. Ill. 1984).  There, the debtor placed a secured creditor’s deficiency claim of over $454,000 in a different class as the other two remaining unsecured claims in the case, each in the amount of approximately $400.  The classification scheme was set up to win plan approval under section 1129 by having the convenience claims (i.e., the very small claims) make up the only impaired accepting class.  The court determined, however, that placing those claims in a separate class from the deficiency claim was neither reasonable nor necessary and concluded that the deficiency claims should be placed in the same class as other similarly situated unsecured claims (i.e., the very large deficiency claim).
First, the court found that “necessary” means something more than “just tending to ease the administrative burden” of the estate.  The court held that the debtor must demonstrate that classifying similar claims in the same class is “truly burdensome” before the court will allow separate classification in a convenience class.  It concluded that dealing with a total of three general unsecured claims hardly qualified as “burdensome” and determined that the classification scheme was not necessary.
Next, the court determined that the reasonableness test in section 1122(b) required balancing the administrative benefits of the classification scheme against the negative effects of the classification on creditors and the policies of the Bankruptcy Code.  In doing so, the court concluded that the classification used by the debtor fell short on reasonableness as well.  It noted that the debtor had created the convenience class in the case to fulfill the requirements of section 1129(a)(10) of the Bankruptcy Code and to garner at least one impaired accepting class under the plan.  The court admonished that approving such classification would effectively allow debtors to place claims in separate classes without meeting the necessary and reasonable test of section 1122(b).  The S&W case is not alone; other courts, likewise, have looked critically at plans that include dubious classification of small claims into a convenience class.  See, e.g., Oxford Life Ins. Co. v. Tucson Self-Storage, Inc. (In re Tucson Self-Storage, Inc.), 166 B.R. 892, 898 (B.A.P. 9th Cir. 1994).
What’s the bottom line?
Classifying claims in a convenience class requires more than simply placing low dollar-amount claims in a single class.  A debtor who creates a convenience class in its plan must ensure that the class is reasonable and necessary and has been created to ease a sizeable burden to the estate.