Restructuring

Contributed by Brian Wells
In Western Real Estate Equities, L.L.C. v. Village at Camp Bowie I, L.P., the United States Court of Appeals for the Fifth Circuit upheld a plan crammed down over a dissenting secured creditor on the basis of an accepting but artificially impaired class.  Artificial impairment, where a debtor nominally impairs a class to obtain the accepting impaired class necessary for cramdown (previously discussed on this Blog here), has ignited some controversy and a split in the circuits. The Eighth Circuit prohibits the practice, generally finding that cramdown requires acceptance by a class impaired for economic reasons.  The Ninth Circuit and, now, Fifth Circuit, instead find that the practice is technically allowed by the Bankruptcy Code, but should be scrutinized under the rubric of good faith.  Depending on how courts interpret “good faith,” outcomes under this test could converge with those under the Eighth Circuit’s approach.  However, the Fifth Circuit took the opposite tack in its Village at Camp Bowie decision, indicating that good faith is generally satisfied where a plan is proposed to reorganize debts and, as a result, implying that artificial impairment is a generally permissible basis to cram down a plan.  Debtors and creditors, and in particular secured creditors of single-asset real estate businesses, should take note.
Background
At the center of what would become a protracted fight – and the Fifth Circuit’s decision – was the Village at Camp Bowie, a fusion of residential, commercial and retail space in a modern village-like setting.  Owned by the aptly-named Village at Camp Bowie I, LLC, the Village had been built on the back of $10 million in equity capital, $36 million in short-term notes secured by the property, and the promise of becoming the next “place to be” in an upscale neighborhood of Fort Worth, Texas.  After construction, however, the strip-mall/village concept did not immediately catch on, and occupancy quickly lagged behind projections.  The Village faced what appeared to be a temporary cash shortage, and when the secured notes matured, the Village couldn’t afford to pay them.  Wells Fargo, who owned the notes, gave the Village a chance to recover by agreeing to modify the loans and push back maturity.  Two years and several modifications later, Wells Fargo let the Village default, but (perhaps aware of the troubles the Village would face in bankruptcy) agreed to hold back on exercising its right of foreclosure.  Two years after that, Wells Fargo called it quits, selling the distressed notes at a steep discount to Western Real Estate Equities, a real-estate investor.
To Western, who admittedly had bought the notes solely to acquire the property and had no interest in negotiating a restructuring, the play appeared simple:  buy the notes at a discount, foreclose on the property, and add a high-profile asset to its real estate portfolio.  To this end, Western immediately initiated a non-judicial foreclosure.  But the Village, whose owners had already invested over $10 million into the property, wouldn’t give up without a fight.  On the eve of foreclosure, the Village filed a petition for chapter 11 and put the brakes on Western’s takeover attempt.    
Western, with a $32 million secured claim, appeared to have considerable leverage in the chapter 11 case.  Indeed, Village’s 38 other creditors (unsecured trade creditors such as accountants, landscapers, utilities, and janitors) had combined claims of approximately $59,000, which amounted to roughly two-tenths of one percent of Western’s claim.  Right from the get-go Western tried to take the reins of the proceeding, arguing that it should be able to foreclose because the property was worth less than the value of its secured claim.  After a valuation fight spanning several months, the court found a small sliver of equity in the property (roughly $2 million out of the $34 million value) and, accordingly, denied Western’s motion for relief from the stay. 
As the valuation fight raged, the Village began formulating a strategy of its own.  Winning on that front would stave off foreclosure, but what Village needed was a confirmable plan that would preserve its equity interest.  Given Western’s hostility and Village’s inability to pay off the secured claim, it would have to be a cram down plan.  Section 1129 of the Bankruptcy Code allows debtors to force a non-consensual plan on dissenting creditors (such as Western) where, among other things, those creditors receive fair and equitable treatment, the plan was proposed in good faith, and at least one impaired class votes to accept the plan.  With respect to secured creditors, section 1129(b)(2)(A)(i) further provides that one form of fair and equitable treatment is a replacement loan, whereby the secured creditor retains its liens and receives deferred cash payments in the amount of its claim.  Assuming the other requirements for confirmation could be met, these provisions provided Village with a path forward.  If the Village could convince the trade creditors to take a haircut and still accept a plan (and if the court would view this as an accepting, impaired class), then Village would be able to lock Western into a replacement loan and preserve its equity position. 
The Village adopted this strategy in a four-piece plan.  First, Western’s secured claim would be replaced with a five-year, 6.4% note with a balloon payment of principal and accrued interest due at maturity.  Second, the owners would inject $1.5 million cash into the business in exchange for newly-issued equity.  Third, that cash would satisfy administrative and unsecured claims, and also provide the necessary liquidity to fund continuing operations.  Fourth, and key to the success of it all, the trade claims would be paid in three monthly installments without interest.  This delay would decrease the aggregate value of the trade claims by approximately $900, such that their acceptance, in theory, would give Village the impaired accepting class necessary for a cramdown. 
Western, who was not in the business of servicing loans, was beside itself.  How could a loss of $900 cut the legs out from its $32 million position and force it into a replacement loan?  Western argued that the trade creditors weren’t truly impaired and that, even if they were, their impairment had been manufactured in bad faith – arguments that addressed both sides of a circuit split on the issue of artificial impairment.  On one side, in Matter of L & J Anaheim Associates, the Ninth Circuit rejected the argument that artificial impairment was not impairment and held that the appropriate context to address an abuse of the Bankruptcy Code was through the requirement that the plan be proposed in good faith.  The Anaheim court found that the Bankruptcy Code’s broad definition of “impairment,” located in section 1124(1), clearly encompasses any alteration of legal, equitable, or contractual rights on a claim, without discrimination between nominal or intentional alterations.  The court further noted that section 1129(a)(10) only requires the acceptance of an impaired class, again without qualification.  The court concluded that any impairment – artificial or otherwise – would satisfy the requirements clearly established in the text of the statute.  On the other side of the artificial impairment fight, in Matter of Windsor on the River Associates, Ltd., the Eighth Circuit found that artificial impairment would not satisfy section 1129(a)(10) because finding otherwise would undermine the purpose of that section.  The Windsor court pointed out that section 1129(a)(10) had been added to the Bankruptcy Code to protect creditors from cramdown by ensuring that at least one affected class approved their treatment under a cramdown plan.  Even though the plain meaning of the statute would permit artificial impairment, the Eighth Circuit found that the purpose of section 1129(a)(10) warranted looking into the motivations behind and materiality of an impairment when assessing whether a class’s vote could support a cramdown.  Allowing a debtor to engineer the impairment of the only approving class in order to secure a cramdown, the Eighth Circuit decided, would render section 1129(a)(10) a nullity. 
The Bankruptcy Court’s Holding
The bankruptcy court in Village at Camp Bowie I, L.P. adopted the plain meaning approach of the Ninth Circuit, finding that the trade creditors were properly impaired under section 1129(a)(10) and that the cramdown requirements had thus been satisfied.  The court, noting artificial impairment usually would not amount to bad faith, went on to find that Village’s plan was proposed in good faith for the legitimate purposes of reorganizing its debts and preserving its equity in the real estate. 
The Fifth Circuit Appeal
Western appealed the bankruptcy court’s decision directly to the Fifth Circuit, which upheld the bankruptcy court’s decision.  The Fifth Circuit disagreed with the Eighth Circuit’s inquiry into the motives behind and materiality of a given impairment, noting that “shoehorning” these requirements into section 1129(a)(10) “warps the text of the Code.”  The Bankruptcy Code must be read literally, the Fifth Circuit continued, noting that congressional intent is only relevant where statutory provisions are ambiguous.  The Fifth Circuit also agreed with the Ninth Circuit in finding that the appropriate rubric for scrutinizing the motives and methods behind creation of an accepting impaired class is through the good faith requirement – which, importantly, is reviewed on appeal only for clear error.  The Fifth Circuit declined to find that artificial impairment was in itself proof of bad faith and further held that the bankruptcy court did not clearly err by finding good faith based on Village’s purposes of restructuring its debt and preserving its equity position.  When would artificial impairment constitute bad faith?  The Fifth Circuit suggested the inference of bad faith could be “stronger” where a debtor creates an impaired accepting class by incurring debt with an insider, particularly if in a sham transaction – an example suggesting that many instances of artificial impairment will pass muster. 
At the end of the day, the Village’s owners came out on top, but, going forward, the dynamics in the Fifth Circuit may change.  Other single-asset real estate ventures may have a harder time obtaining low-rate secured financing in the first place.  Although secured creditors will come to understand their remedies can be affected by the Bankruptcy Code in unpredictable ways, the Fifth Circuit’s decision may also bring additional certainty to the bankruptcy process by further paving the way for debtors to encourage negotiation with recalcitrant creditors and, if necessary, cram down a plan.