In an important decision issued at the end of August, the United States Court of Appeals for the Third Circuit, in In re Tribune Co., Case No. 18-2909 (3d Cir. Aug. 26, 2020), held that subordination agreements need not be strictly enforced when confirming a chapter 11 plan pursuant to the Bankruptcy Code’s cramdown provision in section 1129(b)(1). In its decision, the Third Circuit also encouraged bankruptcy courts to apply “a more flexible unfair discrimination standard” and set forth eight guiding principles to aid in that effort. While debtors will surely appreciate the flexibility when seeking to cramdown a chapter 11 plan, creditors that found comfort in subordination agreements are now facing uncertainty, the extent of which remains to be seen.
Between 1992 and 2005, Tribune Company issued unsecured senior notes (the “Senior Notes”), which were governed by indentures containing covenants that required their payment before any other debt incurred by Tribune. In 1999, Tribune issued unsecured exchangeable subordinated debentures (the “PHONES Notes”). Years later in 2007, Tribune was acquired through a leveraged buyout (“LBO”), which added substantial new debt to the company’s capital structure, including $225 million in subordinated unsecured notes (the “EGI Notes”). Pursuant to their respective indentures, the PHONES Notes were subordinated to “Senior Indebtedness” and the EGI Notes were subordinated to “Senior Obligations.”
The Tribune LBO ultimately proved unsuccessful and the company sought bankruptcy protection in the U.S. Bankruptcy Court for the District of Delaware in 2008. In addition to the unsecured Senior Notes, Tribune’s unsecured creditors included: (i) the PHONES Notes; (ii) the EGI Notes; (iii) a $150.9 million unsecured claim based on the termination of an interest rate swap agreement (the “Swap Claim”); (iv) $105 million of unsecured claims held by Tribune Media Retirees (the “Retirees”); and (v) $8.8 million of unsecured claims held by trade and miscellaneous creditors (the “Trade Creditors”). Tribune’s chapter 11 plan (the “Plan”) separated unsecured creditors into multiple classes, with the holders of Senior Notes (the “Senior Noteholders”) comprising Class 1E and the Swap Claim, the Retirees, and the Trade Creditors comprising Class 1F. Under the Plan, creditors in both Class 1E and Class 1F were paid 33.6% of their outstanding claims from the initial distributions, which payments reflected the subordination of the PHONES and EGI Notes.
The Senior Noteholders1 objected, arguing that the Plan was not confirmable because it did not fully enforce the subordination provisions contained in the various indentures by improperly allocating over $30 million of the recovery from the PHONES and EGI Notes to Class 1F, which did not constitute Senior Obligations. Alternatively, the Senior Noteholders argued that the Plan unfairly discriminated against Class 1E based on the allocation of subordination payments to Class 1F.
On the first argument, a central issue was whether any claims in Class 1F qualified as Senior Obligations. A determination that they did not know would potentially increase the Senior Noteholders’ recovery from 33.6% to up to 35.9%. While the bankruptcy court decided that the Swap Claim qualified as a Senior Obligation in a footnote, it did not make a determination as to the Retirees’ claim. Nevertheless, over the Senior Noteholders’ objections, the bankruptcy court crammed down the Plan. The bankruptcy court determined that section 1129(b)(1) of the Bankruptcy Code did not require the strict enforcement of subordination provisions and also rejected the Senior Noteholders’ unfair discrimination argument. See In re Tribune Co., 472 B.R. 223 (Bankr. D. Del. 2012). The district court affirmed and another appeal was taken, during which time the Plan was consummated.
At the outset of its analysis, the Third Circuit explained that cramdown plans provide a tool to prevent “one [or] more classes of claims [from] holding up confirmation of an otherwise consensual plan” and provide an exception to the general rule that “all classes either vote to accept the plan or recover their debt in full under it.” In re Tribune Co., Case No. 18-2909, at * 14 (3d Cir. Aug. 26, 2020). The Third Circuit also explained that “unfair discrimination” (comparing recoveries horizontally between similarly situated creditor classes) and “fair and equitable” (comparing recoveries vertically between senior and junior creditor classes) provide safeguards for dissenting creditor classes in cramdown plans.
The Third Circuit then addressed the Senior Noteholders’ argument that the Plan was not confirmable because it failed to strictly enforce the PHONES and EGI Notes’ subordination agreements under section 510(a). In doing so, the Third Circuit conducted a textual analysis of section 1129(b)(1), which sets forth the standards for cramdown, and specifically focused on the word “notwithstanding” in the provision’s command that cramdown plans are confirmable “[n]otwithstanding section 510(a). Id. at *15; 11 U.S.C. § 1129(b)(1). The Third Circuit reasoned that “the phrase ‘notwithstanding’ in the bankruptcy context  mean[s] ‘in spite of’ or ‘without prevention or obstruction from or by’” and that a statutory analysis of a federal law containing a preemption clause should focus on its plain wording. Tribune Co., Case No. 18-2909, at * 15 (quoting In re Goody’s Family Clothing Inc., 610 F.3d 812, 817 (3d Cir. 2010)) (citing In re Federal-Mogul Global Inc., 684 F.3d 355, 369 (3d Cir. 2012)). Accordingly, the Third Circuit concluded that section 1129(b)(1) “overrides” section 510(a), and thus an otherwise confirmable chapter 11 plan should be confirmed despite the rights conferred by section 510(a). Id. at *16.
The Third Circuit found additional support for this conclusion in the purpose of section 1129(b)(1), which it described as permitting a court to confirm a plan if the interests of the dissenting class are protected through the fair-and-equitable and unfair discrimination tests. Recognizing that both section 510(a) and the cramdown provision’s unfair discrimination test “are concerned with distributions among creditors”— the former “by agreement” while the latter “tests, among other things, whether involuntary reallocations of subordinated sums under a plan unfairly discriminate against the dissenting class”—the Third Circuit reasoned that “[o]nly one can supersede, and that is the cramdown provision” due to its flexibility when negotiating a confirmable plan in the face of complex intercreditor rights resulting from private ordering. Id. at *16–*17. Based on this, the Third Circuit held that “subordination agreements need not be strictly enforced for a court to confirm a cramdown plan.” Id. at 19.
The Third Circuit next turned to the Senior Noteholders’ alternative argument, which was that the Plan unfairly discriminated against them. In its unfair discrimination analysis, the bankruptcy court compared the Senior Noteholders’ 33.6% distribution recovery under the Plan to its 34.5% recovery if the subordination agreements had been strictly enforced, ultimately determining that the 0.9% difference was immaterial. The Senior Noteholders alleged that the bankruptcy court’s analysis was flawed in two ways. First, the bankruptcy court should have, but did not, compare the Plan recoveries between Class 1E and Class 1F as though no subordination agreements existed, which would have amounted to 21.9% and 33.6%, respectively. Second, the Senior Noteholders argued that the bankruptcy court incorrectly refused to compare the respective percentage recoveries of Class 1E and Class 1F, which also would have amounted to 21.9% and 33.6%, respectively, of each’s total claims.
In its analysis, the Third Circuit outlined the four tests—“mechanical,” “restrictive,” “broad,” and “rebuttable presumption”—employed by courts to determine whether unfair discrimination has occurred. Based on these unfair discrimination analyses, the Third Circuit distilled several principles:
- first, that the language “discriminate unfairly” is straightforward and direct, and courts have a need for flexibility when conducting this analysis;
- second, unfair discrimination only applies to dissenting classes of creditors, not individuals;
- third, unfair discrimination should be evaluated by comparing the recovery of the preferred class and the dissenting class, but this is not necessarily the only acceptable approach;
- fourth, classes must be “aligned” (i.e., classification must be correct) for an effective assessment to occur;
- fifth, “courts should resolve how a plan proposes to pay each creditor’s recovery” in terms of net present value of all payments or the “allocation … of materially greater risk”;
- sixth, courts should begin an unfair discrimination analysis by finding a “pro rata baseline” for creditors of equal priority, and then consider what actually happens if the plan is implemented; if subordination agreements exist, courts should first determine which creditors are entitled to benefit from such agreements and should apply the analysis in this factor by including subordinated sums in the plan distributions;
- seventh, to presume unfair discrimination, the dissenting class must receive a “materially lower percentage recovery” or undertake a “materially greater risk” in connection with the proposed distribution (the Third Circuit leaves the issue of what is “material” to further judicial developments in bankruptcy courts); and
- eighth, courts that follow the rebuttable presumption test should find one in favor of the dissenting class where there is a finding of material discrimination. Id. at *24–*28.
In addressing the Senior Noteholders’ arguments, the Third Circuit recognized that the bankruptcy court’s comparison of the Senior Noteholders’ recovery to their recovery if the subordination agreements had been strictly enforced was not the “preferred way to test” unfair discrimination, but nonetheless determined that that the bankruptcy court “did not necessarily err” given the circumstances of the case. Id. at *29. The Court noted the need for lower courts to be “pragmatic” in testing unfair discrimination and that a strict class-to-class comparison was not always required.
Moreover, the Third Circuit noted that the disparity in the size of the respective claims of the Senior Noteholders and the Retirees and Trade Creditors meant that the increased recovery of 11.7 percentage points for the latter two only minimally reduced the Senior Noteholders’ recovery by nine-tenths of a percent. The Third Circuit was careful not to create a bright-line rule for determining what difference in recoveries would be material, noting that this is a “distinct and context-specific inquiry.” Id. at *30. However, it was comfortable noting that a nine-tenths of a percentage point difference in recoveries “is without a doubt, not material.” Accordingly, the Third Circuit found that the Plan was not presumptively unfair.
In conclusion, the Third Circuit held that subordination agreements need not be strictly enforced for a bankruptcy court to confirm a cramdown plan, as well as provided guidance for courts seeking to apply the unfair discrimination test by encouraging them to take a flexible approach.
In holding that bankruptcy courts need not strictly enforce subordination agreements when deciding whether to confirm a cramdown plan, the Third Circuit made it easier for debtors to confirm cramdown plans. Debtors may be able to utilize this newfound flexibility to exert leverage in plan negotiations with uncooperative creditors by threatening to pursue a cramdown plan in contexts where such an option may not have previously existed. On the other hand, creditors that found comfort in subordination agreements and assumed such private ordering would be strictly enforced in the event of a bankruptcy filing may have cause for concern due to the Third Circuit’s holding. With respect to the unfair discrimination test, the Third Circuit outlined several principles for courts to follow when conducting such an analysis. Given that the Third Circuit favored a flexible approach instead of a bright-line rule for courts to follow, it will be interesting to see how the jurisprudence on this issue develops.