Restructuring

Recently in Novinda,¹ the Tenth Circuit Bankruptcy Appellate Panel² upheld the separate classification of creditor claims in a chapter 11 plan on the basis that, among other things, such claims possessed certain attributes (described as “non-creditor interests”) that distinguished them from other similarly situated claims, overruling objections from Appellant creditors affected by the separate classification.
In its ruling, the Tenth Circuit B.A.P. held that the debtor, Novinda Corp. (“Novinda”), did not separately classify claims in order to gerrymander votes and relied on two key findings to arrive at this conclusion: first, the Court accepted that Novinda was reasonably certain that it would have an otherwise impaired accepting class regardless of the classification of the Appellants’ claims; and second, Novinda had a reasonable basis for separately classifying Appellants’ general unsecured claims from other general unsecured claims, including trade claims, because Appellants had a non-creditor interest and placing Appellants’ claims in a class with trade claims could potentially waive Novinda’s ability to equitably subordinate such claims.

Background

Novinda, an advanced air quality technology company, commenced its chapter 11 case after Colloid, the exclusive manufacturer of its product, imposed on it a significant increase in manufacturing costs and a change in its payment terms.

Prior to filing for chapter 11, Novinda had financed the development and production of its product through venture capital funding, secured loans, and unsecured loans. Appellants (including Colloid, “Appellants”) were creditors of, and 18% equity holders in, Novinda.

As a condition to Novinda receiving additional funding from Appellants prior to filing for chapter 11, Colloid became the exclusive manufacturer of Novinda’s product. Novinda also received substantial equity infusions from certain third-party investment firms that help capitalize struggling businesses (the “Funds”).

Following its chapter 11 filing, Novinda alleged that Colloid fabricated a manufacturing cost increase to drive Novinda out of business and, thus, maintained that it had breach of contract and fraud claims against Appellants, and could potentially equitably subordinate their claims for distribution purposes.

Novinda structured its chapter 11 liquidating plan into 12 classes of claims, set out below. In structuring its chapter 11 plan, Novinda was reasonably certain that it would have an impaired accepting class of priority wage claims from Class 1. The claims in Class 1 were deemed “impaired” because they would not receive interest on the deferred payment of their claims.

1. priority claims of employees (impaired);
2. secured claims;
3. unsecured trade claims (other than Appellants’ claims), including the unsecured claims of the Funds;
4. Appellants’ – separately classified – unsecured claims; and
5. an administrative convenience class which consisted of unsecured claims of $1,000 or less.

Classes 6 to 12 of Novinda’s chapter 11 plan were comprised of the remaining equity holders who would not receive a recovery.

Following the chapter 11 plan waterfall, if any proceeds from Novinda’s estate remained after the payment of claims in Classes 1 and 2, all claims in Class 3 and claims in Class 4 would receive a pro rata share of the remainder (with certain exceptions not relevant here).

Novinda’s chapter 11 plan also provided that the Funds would contribute $400,000 to Novinda’s estate for distributions thereunder (which could also be used to fund an investigation of Novinda’s breach of contract claims against Appellants).

Appellants objected to the plan on the basis of gerrymandering and unfair discrimination, and sought to convert the case to a chapter 7 liquidation. Appellants contended that Novinda was first required to classify their claims with other unsecured creditors and then separately move to designate their votes in order to equitably subordinate them. One of the consequences of a failure of the chapter 11 plan to be confirmed, and a conversion to chapter 7, would be the loss of a $400,000 contribution to the estate by the Funds, potentially resulting in no funding being available to pursue affirmative claims against the Appellants.

Separate Classification Upheld

The Court upheld Novinda’s separate classification of Appellants’ claims, finding first that Novinda did not separately classify claims in order to gerrymander votes. The Court reasoned that once a plan has been accepted by an impaired class of claims that was not created for gerrymandering purposes, any claims of gerrymandered voting have little further relevance under section 1129(a)(10). Here, the Court found that Class 1, consisting of priority wage claims, was appropriate — even necessary — because the wage claims were not substantially similar to Novinda’s other general unsecured claims and could not be classified with them.

Relying on the Bankruptcy Court’s specific factual findings that the Appellants sought to force Novinda into a position in which its business would fail, and would now benefit from a failure of the chapter 11 plan to be confirmed and thereby avoid litigation, the Court found that the Appellants had a non-creditor interest which justified separate classification of their claims from other general unsecured claims. The Court found no error in the Bankruptcy Court’s conclusion that, based on the evidence and its own observation of their actions in the bankruptcy case, Appellants’ actions demonstrated that they had not been pursuing a legitimate interest in maximizing their recovery as a creditor, justifying separate classification of their claims.

Finally, the Court found that placing Appellants’ claims in a class with trade claims could potentially prejudice Novinda’s ability to equitably subordinate such claims, because under section 1123(a)(4), the same treatment must be given to each claim in a class unless a holder agrees to less favorable treatment. Accordingly, the Court held that Novinda had a reasonable basis for separately classifying Appellants’ claims from trade claims.

Conclusion

The justifications advanced by Novinda to support separately classifying Appellants’ claims, namely the distinct characteristic of a non-creditor interest — Appellants’ objective of avoiding affirmative claims against them by Novinda, and Novinda’s desire to preserve its ability to equitably subordinate such claims — were sufficient to overcome the gerrymandering claims from Appellants that tend to inevitably follow a debtor when it makes strategic decisions to separately classify claims under a chapter 11 plan. Despite the attendant cost and delay that may result from a debtor’s decision to separately classify certain claims, the Novinda decision reinforces the flexibility that a debtor has in developing classification schemes that will preserve valuable options for its estate.

Weil summer associate Christopher Martin contributed to this post.