Restructuring

Contributed by Frank Grese
In In re Reid Park Properties, LLC, the United States Bankruptcy Court for the District of Arizona considered whether a debtor’s classification of two promissory notes, one of which was subordinate to the other, in the same class under its plan of reorganization was proper.  Reid Park involved a debtor who financed its purchase of a hotel with two loans made by the same financial institution:  one loan with a principal balance of $27,500,000 and the other loan with a principal balance of $3,783,300.  The two loans were made on the same date and had the same servicer, but were documented by two separate promissory notes – Note A and Note B.  Each of the notes stated that Note B “Shall at all times be junior, subject and subordinate to … the A Loan.”  Both notes were secured by the same collateral – a deed of trust on the hotel.  Both loans also were guaranteed by the debtor’s principal, who was an individual debtor in a separate chapter 11 case.  Very shortly after their origination, the notes were sold to two different third parties, who proceeded to enter into an intercreditor agreement (to which the debtor was not a party) that provided that the holder of Note B was subordinate to holder of Note A.  The intercreditor agreement provided that WBCMT, the party that purchased Note A, was granted authority to administer both of the notes.
The bankruptcy court eventually determined that the value of the hotel was $17 million.  Based upon this valuation, the terms of the notes, and the intercreditor agreement, WBCMT had a partially secured claim on account of Note A, while the creditor holding Note B had a wholly unsecured claim.  The debtor listed the notes separately on its Schedule D and classified them separately in its initial plan of reorganization.  In its fourth amended plan of reorganization, however, the debtor treated the notes together as one claim in Class 5 of its plan, while providing for two alternate treatments:  1) If the section 1111(b) election was not made, the Class 5 claim (consisting solely of each of the notes) would be bifurcated into a secured claim of $17 million, with the remainder being treated as an unsecured deficiency Class 6 claim (consisting solely of the deficiency claim related to each of the notes and classified separate and apart from other unsecured creditors), or 2) If the section 1111(b) election was made, then both Class 5 claimants would be given a new note in the principal amount of $32,657,121.99 due and payable over approximately 26 years with no amortization of the note occurring in the first three years.  The debtor subsequently claimed that the section 1111(b) election was unavailable to Class 5 because only the holder of Note A timely made the election, and, therefore, section 1111(b)(1)(A)(i) was not satisfied because not more than half in number of Class 5 made the election.
The debtor argued that it was appropriate to treat the noteholders’ claims as one claim and, therefore, classify them in the same class because the notes were secured by the same deed of trust and guaranteed by the same guarantor.  The debtor distinguished the notes from other secured claims that would be classified separately, such as obligations secured by different collateral or deeds of trust that expressly create a first lien and a second lien.  The debtor asserted that, notwithstanding the language in the notes and the intercreditor agreement, the holders of the notes simply were two secured creditors sharing a lien on the same collateral and, therefore, should be classified together.  The debtor stated that from its perspective, it effectively had one secured debt with two owners.  Furthermore, the debtor characterized the intercreditor agreement and the subordination language in the notes as simply an agreement between creditors on how payments were to be shared and asserted that no evidence was presented that demonstrated that the notes were dissimilar in their rights against the debtor.  Finally, the debtor argued that the Note B unsecured claim should not be classified with other general unsecured claims in the case because the guaranty provided by the debtor’s principal provides an alternative source of payment to the holder of the note claim in accordance with In re Loop 76, LLC, 465 B.R. 525 (B.A.P. 9^th Cir. 2012) (which we blogged about here).
On the other hand, the noteholders argued that the claims arising from the notes were two separate claims, arising from two separate promissory notes, held by two separate parties, and paid separately by the debtor.  Taken together, among other things, the noteholders asserted that such facts demonstrated that the notes were two separate legal obligations that created two independent “rights to payment” under section 101(5)(A) of the Bankruptcy Code.  Moreover, the noteholders argued that the claims could not be classified together because, given the valuation of the hotel and priority of the Note A obligations over the Note B obligations, Note A was partially secured, while Note B was wholly unsecured; therefore, such claims could not be “substantially similar.”  Moreover, the holder of Note A had elected to be treated as fully secured pursuant to section 1111(b) of the Bankruptcy Code (although it had the right to reconsider its 1111(b) election for a certain period of time), and the holder of Note B had not.  In fact, the noteholders took the position that the Note B holder could not make the 1111(b) election because its claim was entirely unsecured.
After considering the arguments made by the parties and the evidence, the bankruptcy court first found that the claims based on the notes were separate claims under section 101(5)(A) of the Bankruptcy Code because each creditor held a separate note with different payment amounts.  The court reached this conclusion even though the notes were secured by the same collateral and the debtor was not a party to the intercreditor agreement.  The court noted that the debtor was on notice that Note B was subordinate to Note A because the debtor was a party to the notes themselves, which provided for such subordination.  The court also found it relevant that the debtor made separate payments on Note A and Note B on certain occasions.
Given the court’s finding that the claims arising from the notes were separate claims, the court next considered whether the debtor’s proposed classification complied with section 1122(a) of the Bankruptcy Code.   Because the Note A holder had a claim that was partially secured (and partially unsecured), while the Note B holder had a fully unsecured claim, the court concluded that that such claims were not substantially similar and could not be classified together.  In any event, the court concluded that, even if the claims were substantially similar, the disparate treatment of such claims (i.e., Note A being partially secured and Note B being wholly unsecured) violated section 1123(a)(4) of the Bankruptcy Code.
Finally, the court found that the guaranty of both notes by the debtor’s principal did not justify classifying the Note A deficiency claim and the Note B wholly unsecured claim separately from other general unsecured creditors.  Because the debtor’s principal was insolvent and the subject of an individual chapter 11 case, there was no basis to assume that either creditor had another viable source of repayment for its unsecured claims.  These facts, the court concluded, distinguished the case from Loop 76 and In re Red Mountain Machinery Co.
While not completely clear from the court’s opinion, it appears that one of the debtor’s primary motivations for attempting to classify the notes in the same class was to prevent the Note A holder from being able to exercise the 1111(b) election.  Similarly, the debtor accused the noteholders of advocating separate classification just so the Note A holder could make 1111(b) election, while the Note B holder could choose not to make such an election, a tactic the debtor likened to creditor gerrymandering.  Moreover, the debtor likely wanted to classify the Note A deficiency claim and the Note B wholly unsecured claim separately from other general unsecured creditors because it viewed the general unsecured creditors as a potential impaired, accepting class that might allow it to cram down its plan on dissenting creditors such as the noteholders.  Similarly, the noteholders appear to have wanted the Note A deficiency claim and Note B wholly unsecured claim to be classified together with other general unsecured creditors to enable them to control the general unsecured creditor class and because they viewed the proposed Class 6 treatment as inferior to treatment the debtor proposed to provide to the other general unsecured creditors under the plan.
It is clear that the trigger for separate classification based on a lack of similarity of the senior and subordinated debt in Reid Park was not based exclusively upon the existence of a subordination agreement itself.  Instead, the value of the collateral, which resulted the senior note being partially secured and the subordinated note wholly unsecured, resulted in disparate treatment under section 1123(a)(4) of the Bankruptcy Code.  Reid Park is also another example of a bankruptcy court applying the broad test affirmed by the Ninth Circuit BAP in Loop 76 that allows a court to look not only to the nature of a claim as it relates to the rights and assets of a debtor, but also to other circumstances affecting holders of those claims, such as the ability to recover from a third-party source, for purposes of determining whether such claims are “similarly situated.”  Courts that adopt this broader standard for classifying claims strengthen a debtor’s ability to cram down an undersecured creditor if the creditor also has a third party guaranty, particularly in single asset real estate cases where such guaranties are common.