One of These Things is Not Like the Other: 9th Circuit B.A.P. Holds That Bankruptcy Court May Consider the Existence of a Third-Party Source of Recovery When Determining Whether Unsecured Claims Are “Substantially Similar”

Contributed by Dana Hall
Affirming a decision by the United States Bankruptcy Court for the District of Arizona, the Bankruptcy Appellate Panel for the Ninth Circuit recently held that a bankruptcy court may consider the existence of a third-party (non-debtor) source of recovery when determining whether unsecured claims are “substantially similar” for purposes of plan classification under section 1122(a) of the Bankruptcy Code.
In In re Loop 76, LLC, a chapter 11 single asset real estate case, Wells Fargo provided the debtor with a $23 million construction loan secured by the debtor’s sole asset, an office/retail complex.  The secured loan was also guaranteed by the debtor’s principals.  After the debtor filed for chapter 11 protection, the debtor and Wells Fargo stipulated, for voting purposes, that the value of the property was approximately $17 million – leaving Wells Fargo undersecured by approximately $6 million.  Wells Fargo subsequently declined to make an election under section 1111(b) of the Bankruptcy Code and, accordingly, under the debtor’s proposed plan of reorganization, received a secured claim of approximately $17 million and a general unsecured deficiency claim of approximately $6 million.  The debtor’s plan placed Wells Fargo’s deficiency claim in Class 8(B) but placed all other general unsecured claims in Class 8(A).  Wells Fargo opposed the debtor’s plan of reorganization and acquired blocking positions in each class of claims created pursuant to the plan, such that, after voting on the plan of reorganization, the only impaired, accepting classes were the Class 8(A) general unsecured claims and a Class 3 impaired secured claim (to which Wells Fargo objected on other grounds).  Had Wells Fargo’s deficiency claim been placed in Class 8(A) along with all other general unsecured claims, Wells Fargo would have had a blocking position within that class as well.
Wells Fargo subsequently objected to the separate classification of its deficiency claim and contended that its claim was “substantially similar” to all other general unsecured claims and, accordingly, should have been included in Class 8(A).  The debtor defended its classification scheme by observing that Wells Fargo’s claim was different than those of other general unsecured creditors because Wells Fargo was partially secured and was involved in litigation with third party guarantors (the debtor’s principals) such that if Wells Fargo prevailed, it would have a wholly different source of recovery.
Section 1122(a) of the Bankruptcy Code provides that “a plan may place a claim or an interest in a particular class only if such claim or interest is substantially similar to the other claims or interests of such class.”  Wells Fargo argued that the proper inquiry for determining whether claims are “substantially similar” under section 1122(a) of the Bankruptcy Code is to evaluate the “nature” of the claim as it relates to assets of the debtor, not as it relates to factors extrinsic to the bankruptcy case (i.e. a third-party guarantee).  In support of its position, Wells Fargo pointed to the language of Chapter X of the Bankruptcy Act which required that classification of a claim be based on the “nature of the respective claim[ ]” as it relates to the assets of the debtor. The bankruptcy court, however, disagreed with Wells Fargo and relied on In re Johnston, a decision rendered by the United States Court of Appeals for the Ninth Circuit in which the Ninth Circuit upheld a debtor’s separate classification of a claimant’s general unsecured claim on the bases that the claimant had a potential third-party source of recovery (a guarantor), was involved in litigation with the debtor and, if successful in the litigation, may have been paid prior to all other unsecured creditors.  The bankruptcy court also found that Chapter XI of the Bankruptcy Act (which simply provided that the “court may fix the division of creditors into classes . . .”) formed the basis for section 1122(a) of the Bankruptcy Code and purposely omitted Chapter X’s “nature” language in favor of a broader standard.  The bankruptcy court, accordingly, held that classification of a claim need not be based strictly on the nature of the claim as it relates to the assets of the debtor, but rather that a bankruptcy court is permitted to look to the possibility of recovery from a third-party source in determining whether general unsecured claims are “substantially similar” for purposes of plan classification.
Notwithstanding the bankruptcy court’s analysis, Wells Fargo argued on appeal to the Ninth Circuit BAP that the bankruptcy court had misinterpreted In re Johnston and erred in concluding that the Bankruptcy Code superseded certain pre-Bankruptcy Code case law under Chapter X of the Bankruptcy Act requiring classification to be based on the nature of the claim as it relates to the assets of the debtor.  The BAP, however, adopting the reasoning of the bankruptcy court, concluded that chapter 11 of the Bankruptcy Code bears greater resemblance to Chapter XI of the Bankruptcy Act and that, accordingly, pre-Bankruptcy Code case law interpreting Chapter X of the Bankruptcy Act was inapplicable.  The BAP stated further that “classification . . . based on the nature of the claim as it relates to the assets of the debtor[ ] is not consistent with the more flexible approach to claim classification under the Code.”  Wells Fargo also cited In re Barakat, another Ninth Circuit case, for the proposition that deficiency claims and general unsecured claims are substantially similar, but the BAP rejected this interpretation.  The BAP found the Barakat decision inapposite to the facts in In re Loop because the deficiency claim in Barakat did not have any “special circumstances,” such as opportunity for third party recourse, to distinguish it from other general unsecured claims.
Notably, the In re Loop bankruptcy court (not the BAP) stated that similarity of claims for purposes of plan classification is a question of fact and that, to the extent that Wells Fargo could make a showing on confirmation that it had “no interest in pursuing the guarantee or that the guarantors are all insolvent, then the Court might conclude that the existence of the guarantee is not an appropriate distinguishing characteristic to render the claim substantially dissimilar.”
The BAP’s decision in In re Loop is one of only a handful of cases to squarely address the foregoing issues.  The decision is at odds with, among others, the In re Quigley decision issued by the United States Bankruptcy Court for the Southern District of New York, which held that, because the existence of a third-party guarantee does not change the nature of a claim with respect to the debtor’s estates, the potential for certain members of a class to look to third parties for payment does not mandate separate classification within a chapter 11 plan.
It remains to be seen whether courts in other jurisdictions will follow In re Loop and the other case law on which it relies.  For now, debtors and creditors should note that two different plans with substantially similar classification schemes may, depending on the jurisdiction, have substantially dissimilar outcomes.