Contributed by Andrea Saavedra
The Colonial Bancorp chapter 11 case has been closely watched because it involves a number of key issues at the intersection of the banking laws and the bankruptcy laws.  This post discusses the latest developments in this contentious case, which resulted in confirmation of a liquidating chapter 11 plan, but first a little background.
In September 2010, the United States Bankruptcy Court for the Middle District of Alabama held that the Colonial Bancorp chapter 11 debtor, a bank holding company whose bank subsidiary was put into receivership by the FDIC and sold by it to BB&T Corp., did not have a capital maintenance obligation to the FDIC within the meaning of Bankruptcy Code section 365(o).  In contrast to a debtor in possession’s usual powers with respect to rejection or assumption of executory contracts, section 365(o) of the Bankruptcy Code requires a chapter 11 debtor to assume and immediately cure any deficit under a commitment to a federal depository institution regulatory agency (such as the FDIC) to maintain the capital of a bank.  Thus, when a bank holding company files for chapter 11, the FDIC often demands that the debtor immediately honor any outstanding capital commitment obligations to its bank subsidiary, which can threaten the administrative solvency of the debtor’s chapter 11 case and potentially result in conversion of the debtor’s case to a case under chapter 7 of the Bankruptcy Code (which, in turn, results in the FDIC having a priority claim in any chapter 7 liquidation under section 507(a)(9)).  As we previously reported here, in January 2011 the Colonial Bancorp court rejected arguments of the Federal Deposit Insurance Corporation, as receiver for the failed bank, regarding setoff rights against deposit accounts.  These decisions are on appeal before the District Court for the Middle District of Alabama, but the FDIC did not seek or obtain a stay pending appeal so the bankruptcy case has proceeded.
In a May 2011 decision, the bankruptcy court denied confirmation of the debtor’s chapter 11 liquidating plan because of certain objections raised by the FDIC and other creditors.  Specifically, the FDIC and the purchaser of Colonial’s bank subsidiary, BB&T, had objected to the plan, arguing that it: (i) improperly gerrymandered claims of unsecured creditors by placing their claims in a class separate from that of other unsecured note claimants; (ii) was not feasible; (iii) was not in the best interests of creditors (i.e., that creditors would receive greater recoveries in a chapter 7 liquidation than as provided under the plan); and (iv) was not proposed in good faith.  The decision, however, was a narrow one, with the court denying confirmation on the ground that the plan’s mechanisms for post-bankruptcy investigation and pursuit of estate claims against third parties resulted in a situation where creditors might do better in a chapter 7 liquidation, thus making the plan unconfirmable under the “best interests of creditors” test in section 1129(a)(7) of the Bankruptcy Code.  Shortly after issuance of its decision, the debtor revised the plan to address the court’s concerns and the modified plan was confirmed.  The debtor’s plan became effective as of June 3, 2011; no appeal has been filed.
The most interesting aspect of the decision is the court’s rejection of the FDIC’s argument that the plan failed to account for the possibility that the bankruptcy court’s prior ruling on application of section 365(o) might be reversed on appeal.  Noting that the FDIC had failed to seek or obtain a stay pending appeal of the denial of a priority claim under section 365(o), the bankruptcy court rejected the FDIC’s challenge to the feasibility of the plan, which asserted that the plan failed because it would not provide for payment to the FDIC in the event of reversal of the bankruptcy court’s earlier 365(o) decision..
As to the gerrymandering argument, the bankruptcy court found that the debtor had adequately established that its noteholder claimants represented a voting interest “sufficiently distinct and weighty to merit a separate voice in the decision whether the proposed reorganization should proceed.”  The court concluded that the nature of the noteholder claims and the reliance of both the debtor and the claimants on the fiduciary role of the indenture trustees for each series of notes in voting on and participating in the plan, given that the notes were widely held, justified separate classification.
The FDIC and BB&T also argued that the plan failed the best interest of creditors test because the cost of administering a chapter 11 plan of liquidation would be greater than the cost of having a trustee administer a hypothetical chapter 7 liquidation.  The court rejected this contention, finding that the proposed trustee had historical knowledge of the case and ostensibly would be more cost-effective in his pursuit of estate claims than a newly appointed chapter 7 trustee.
The court, however, did agree that the “prerogative” of a “plan committee” to undertake litigation that the plan trustee had previously declined to pursue was inappropriate, especially where the “lion’s share of the assets in the instant estate are choses in action.”  The court stated that:

If a trustee, in the exercise of his fiduciary duty, determines that pursuit of a cause of action is not warranted on behalf of the estate, such litigation can only be deemed high-risk and speculative.  Pursuit of the same cause of action by the Plan Committee using estate funds would constitute an additional layer of expense that would not exist in a chapter 7 case.

The court assumed a plan trustee and chapter 7 trustee would “reach the same decision” on pursuit of these claims and therefore determined that the additional expense of the plan committee to investigate and litigate claims would not be incurred in a chapter 7.  As a result, overall recoveries for creditors would be higher in a chapter 7 and the plan was not in the best interests of creditors.  Thus, the court denied confirmation of the plan.  Ultimately, however, this proved a fleeting victory for the objectors.  The debtor amended the plan to address this defect and the court quickly confirmed the amended plan, which went effective less than a month after issuance of the decision.
Although one chapter of the Colonial Bancorp has closed, we’ll continue to provide updates on the case given the pending appeals before the District Court regarding the section 365(o) issues.