Chapter 8 Classification and Treatment of Secured Claims Under Chapter 11 Plans

• Jurisdiction: United States

Chapter 8: Classification and Treatment of Secured Claims Under Chapter 11 Plans

Mark G. Stingley and Michelle M. Masoner

The Bankruptcy Code requires a chapter 11 plan to designate classes of claims and interests.⁸⁵⁴ Claims classification is governed by § 1122. A plan may place claims in the same class only if they are "substantially similar."⁸⁵⁵ Claims that are not "substantially similar" cannot be placed in the same class. Each secured creditor is most often put in its own class.

A. Claim Classification and Pre-Confirmation Issues: "Substantially Similar" Claims

Bankruptcy Rule 3013 provides as follows:

For the purposes of the plan and its acceptance, the court may, on motion after hearing on notice as the court may direct, determine classes of creditors and equity security holders pursuant to §§ 1122, 1222(b)(1), and 1322(b)(1) of the Code.

As noted in the advisory committee notes to Bankruptcy Rule 3013, § 1122 sets the standard for classifying claims and interests but provides that such classification is accomplished in the plan. Section 1122(a) addresses the classification of claims in a chapter 11 plan:

Except as provided in subsection (b) of this section, 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.

Rule 3013 does not change the standards; rather, it recognizes that it may be desirable or necessary to establish proper classification before a plan can be formulated. It provides for a court hearing on such notice as the court may direct.

While confirmation hearings may provide a forum for resolution of these issues, circumstances may dictate that issues concerning the proper classification of claims are best addressed prior to the plan-confirmation hearing. Resolution of classification issues prior to confirmation avoids a contested confirmation hearing.

For example, the debtor's plan may attempt to separately classify its primary secured lender's deficiency claim from the general unsecured claims of all other creditors. Debtors try to separate the lender's deficiency to create an unsecured class not dominated by the secured lender. Debtors hope that the separately classified class of general unsecured claims will accept the plan and provide the impaired assenting class required for cramdown under § 1129(a)(10). If the secured lender's deficiency claim is substantially similar to the other general unsecured claims against the debtor, there may be no valid reason for separately classifying (and treating) the secured lender's unsecured claim from general unsecured claims. Such disparate treatment is not permitted by the Bankruptcy Code. When an issue of classification becomes of critical importance to the confirmation process and to the lender's rights, a ruling on the appropriateness of such classification in advance of any confirmation is warranted.

Courts have significant flexibility in determining whether claims are "substantially similar."⁸⁵⁶ "To resolve that question [of whether claims are substantially similar], bankruptcy judges must evaluate the nature of each claim, i.e., the kind, species, or character of each category of claims."⁸⁵⁷ Substantially similar claims are those claims "which share common priority and rights against the debtor's estate."⁸⁵⁸

Courts typically look to how the legal character of the claim relates to the assets of the debtor and whether the claims exhibit a similar effect on the debtor's estate.⁸⁵⁹

Although § 1122(a) is stated in terms of a limitation as to which claims may be classified together by precluding dissimilar claims from being classified with each other, § 1122(a) also works to place limitations on the ability of a plan proponent to separately classify similar claims.⁸⁶⁰ The Bankruptcy Code does not expressly require that all "substantially similar claims" must be classified together, but claims cannot be separately classified in order to gerrymander an affirmative vote on a plan of reorganization.⁸⁶¹

B. Separate Classification: Legitimate Business Reasons

Court have typically required a "good business reason," "a reasonable or rational justification," a "legitimate business or economic justification," "credible proof of any legitimate reason" or a reason that "does not offend one's sensibility of due process and fair play" to justify separate classification of similar claims.⁸⁶²

1. Separate Classification of Deficiency Claims

One way to distinguish a claim is to argue that the lender's deficiency claim on a nonrecourse debt and the lender's ability to make a § 1111(b) election do not exist outside of bankruptcy, so such a claim is legally distinct from other unsecured claims. This bankruptcy-created claim may justify separate classification.⁸⁶³ However, the legal manner in which a claim is created has also been held to be irrelevant to the nature of the claim, thus prohibiting separate classification.⁸⁶⁴ "[A]bsent legitimate business or economic justification, it is impermissible for [the debtor] to classify [the secured lender's] deficiency claim separately from general unsecured claims."⁸⁶⁵

Separate classification for deficiencies is tempting for single-asset debtors because otherwise the single-asset debtor cannot use the Bankruptcy Code's cramdown provisions. Barakat was not convinced that this strategy qualified as a legitimate business or economic justification for separate classification.⁸⁶⁶ The fact that a secured lender's deficiency claim arises by virtue of § 1111(b) does not render it dissimilar from other general unsecured claims.⁸⁶⁷ Because the rank and priority of such claims are identical, there is no basis for concluding that such claims are dissimilar.⁸⁶⁸

Indeed, there are other situations where claims arise under provisions of the Bankruptcy Code, but there is no suggestion that such claims are dissimilar from other claims of similar priority merely because of the statutory nature of their genesis.⁸⁶⁹ Section 506(a)(1) applies, of course, even in those situations where § 1111(b) is inapplicable (e.g., claims that are recourse contractually).

2. Separate Classification of Claims Guaranteed by a Third Party or Secured by Non-Estate Collateral

The existence of a third-party source of payment (i.e., a guarantee or collateral) may render a claim substantially dissimilar from other general unsecured claims.⁸⁷⁰ Some courts may require factual analysis regarding the collectability from the third-party source.⁸⁷¹ On the other hand, whether the secured lender's deficiency claim is substantially similar for purposes of § 1122(a) does not turn on the existence of a guaranty claim against a nondebtor.⁸⁷² This is because "[t]he existence of a third-party guarantor does not change the nature of a claim vis-a-vis the bankrupt estate."⁸⁷³

3. Separate Classification of Claims Subject to Litigation or Setoff

The existence of pending litigation over a claim whereby the claim is in dispute or subject to setoff may render that claim dissimilar and provide a reason for separate classification.⁸⁷⁴ On the other hand, ongoing litigation and setoff rights might not matter where the unsecured claims are basically alike, whether they are disputed or not.⁸⁷⁵ The focus of classification depends on the legal status of the claim, not its disputed or undisputed status.⁸⁷⁶

4. Separate Classification of Essential Trade Creditors

Certain trade creditors essential to the debtor's operations post-bankruptcy may offer a reasonable business justification for separate classification.⁸⁷⁷ The difference between a secured creditor's deficiency claim, where a continued business relationship is unlikely, and trade creditors' claims, where the debtor intends to have a continuing business relationship, justifies separate classification.⁸⁷⁸ Similarly, a chapter 11 plan's separate classification of the debtor's trade vendors, which were critical to its continued operations, from a judgment creditor, an unsecured creditor that wanted to see the debtor liquidated, was a reasonable separate classification.⁸⁷⁹

The debtor may need to meet the "critical vendor" standard and show that separate classification is necessary for its ongoing business, and alternative goods and services are not available.⁸⁸⁰ For example, creditors providing such services as trash collection, pool maintenance and roof repair do not justify a separate class for ongoing business reasons because there are plenty of alternative service providers.⁸⁸¹ Where all the unsecured claims received the same treatment in terms of the plan distribution, albeit in separate classes, the debtor's reason for separate classification is highly suspect.⁸⁸²

5. Alternative Sources of Payment Affecting Classification

In In re Loop 76, the Bankruptcy Appellate Panel (BAP) affirmed a decision of the bankruptcy court,⁸⁸³ holding that a third-party guarantor "is a factor the bankruptcy court may consider when determining whether claims are substantially similar under 11 U.S.C. § 1122(a)."⁸⁸⁴ In that single-asset real estate case, the debtor, over the objection of the secured lender, classified the secured lender's deficiency class in a class separate from general unsecured creditors (assuming that the secured lender did not elect to opt out of § 1111(b)).⁸⁸⁵

In affirming the bankruptcy court decision, the BAP reasoned that Congress, in enacting the Bankruptcy Code, intended to give the plan proponent flexibility with regard to classification under § 1122(a) and therefore that the Bankruptcy Code was more flexible on this issue than the more rigid classification rules of Chapter X of the former Bankruptcy Act.⁸⁸⁶ Accordingly, in the view of the BAP, "the Ninth Circuit's pre-Code holding in Los Angeles Land, that classification be 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."⁸⁸⁷

The Bankruptcy Appellate Panel in...