Contributed by Kyle J. Ortiz
Despite a valiant effort by the United States Bankruptcy Court for the District of New Mexico to give the debtor the benefit of every conceivable doubt, the debtor in In re Deming Hospitality, LLC  was unable to obtain approval of its proposed disclosure statement over the objections of, among others, a junior lien holder.  The junior lien holder objected to approval of the debtor’s proposed disclosure statement on the grounds that the debtor’s proposed chapter 11 plan was “facially unconfirmable.”
The debtor’s proposed plan provided the following classifications relevant to the junior lien holder’s objection:

  • Class 2 Secured: Junior lien holder’s $1.5 million claim.
    • Treatment:  Junior lien holder’s lien would be stripped, and its claim treated as wholly unsecured and reclassified as a class 7 unsecured claim.
  • Class 5 Executory Contract:  Claim of franchisor under a licensing agreement.
    • Treatment:  Debtor proposes to assume the contract and pay an agreed amount in satisfaction of the prepetition arrearage owed the franchisor.
  • Class 6 General Unsecured Claims:
    • Treatment:  To be paid 75% of their claims 30 days after the effective date.
  • Class 7 Deficiency Claim:  The junior lien holder’s deficiency claim.
    • Treatment:  To be paid $25,000 (1.67%) on its $1.5 million deficiency claim.
  • Class 8 Equity Interest:
    • Treatment:  Equity interests would retain their equity, in exchange for investing $150,000 of “new value” into the debtor.

Faced with such obviously disparate treatment, the junior lien holder raised various objections:

  • the classification of its deficiency claim in a separate class from the general unsecured creditor class violated section 1122(a) of the Bankruptcy Code;
  • the remarkably disparate treatment provided to the junior lien holder’s deficiency claim vis-à-vis other general unsecured constituted unfair discrimination under section 1129(b)(1) of the Bankruptcy Code;
  •  the general unsecured claims, which totaled roughly $10,000 in the aggregate, were artificially impaired to manufacture a consenting impaired class;
  • the executory contract holder has no “claim” against the estate and should not be entitled to vote; and
  • the plan violated the absolute priority rule reflected in section 1129(b)(2)(B)(ii) of the Bankruptcy Code despite the purported “new value” contributed by equity.

The bankruptcy court evaluated each objection in turn and, although telegraphing that it found almost nothing about the proposed plan confirmable or proper, generally determined that it would defer consideration of all but one of the junior lien holder’s objections until confimation.  The one objection on which it ruled, however, sunk the debtor’s plan at the disclosure statement phase.
With regard to the section 1122(a) based objection, the court summarized the case law on the subsection as prohibiting “a debtor from separately classifying similar claims to ‘gerrymander’ a consenting class.”  The court stated that it would “place the burden on the plan proponent to justify any separate classification of substantially similar claims,” but that the debtor should be afforded the opportunity to satisfy that burden.  Thus, the Court held that, although the junior lien holder’s claim “could well” have been classified separately to gerrymander the vote, “the court [would] not rule on the issue until the debtor was given the opportunity to present evidence to explain its classification scheme.”
The court reached a similar conclusion in regard to the allegedly unfairly disparate treatment of the junior lien holder’s deficiency claim versus the treatment of the claims of the general unsecured creditors – 1.67% payment for the deficiency claim versus 75% payment for the general unsecured claims.  After surveying the caselaw and finding the reasonable basis test favored in certain districts too vague and the rebuttable presumption standard favored in other districts too restrictive, the court settled on an in-between standard based on what it found to be the one agreed upon standard in every jurisdiction: that “if the treatment of substantially similar claims” is “grossly disparate,” plan proponents face an uphill battle in demonstrating that the disparate treatment is the result of “fair discrimination.”  The court stated that, although the treatment of the claims in the present case clearly resulted in a “gross disparity,” the proposed plan, nonetheless, was not unconfirmable on its face because the debtor might be able to carry the “heavy burden” of justifying the disparate treatment as fair.
The court continued that theme with its evaluation of the debtor’s alleged artificial impairment of the general unsecured claims, holding that the debtor “should be given a chance to present evidence to explain the reason for” returning only 75% of the general unsecured claims aggregate claims of roughly $10,000 in the face of a “new value” contribution by equity of $150,000 that clearly was enough to provide payment in full to the general unsecured creditor class.
In considering the debtor’s unprecedented inclusion of a class for the franchisor’s assumed executory contract, the court determined that the debtor’s inclusion of such a class was a “harmless error” because “[s]o long as the Debtor and [the franchisor] understand that [the franchisor] may not vote,” the error could be corrected by a plan amendment or in a confirmation order.
Although compliance with the absolute priority rule is also a confirmation issue, the bankruptcy court reached its limit in considering the debtor’s assertion that equity holders could retain their interests under the new value exception.  The debtor’s plan proposed to allow existing equity holders to retain their equity while providing a 1.67% recovery to the junior lien holder on the basis of a $150,000 infusion of “new capital.”  The debtor, however, had not set up a competitive bidding process or permitted the junior lien holder to credit bid its substantial claim.  The debtor argued that it was premature to consider the absolute priority rule at the disclosure statement hearing because the debtor “may still be able to convince [the junior lien holder] to vote in favor of the Plan, in which case no . . . auction would be required.”  Although the court had proved willing to defer consideration of other plan issues, the court found this argument to be the straw that broke the camel’s back.  Thus, the court held that, although the debtor’s contention was “theoretically true,” the junior lien holder’s “opposition to the current Plan [was] strong enough, and the Debtor’s treatment of [the junior lien holder’s] claim [was] harsh enough” that the debtor must comply with the market/competition requirements elucidated in the absolute priority rule caselaw before the court would allow it to proceed with the proposed disclosure statement.  Thus, the court sustained the junior lien holder’s objection and refused to approve the proposed disclosure statement.
Deming demonstrates that courts will grant wide latitude to debtors at the disclosure statement stage to allow debtors to explain or resolve any potential defects or concerns during the plan confirmation process, but even the most lenient courts have their limits.