Fifth Circuit Issues Two Decisions Easing Path for Chapter 11 Debtors

Within the span of a few days, Judge Patrick Higginbotham of the Fifth Circuit released two decisions which will ease the way for chapter 11 debtors to confirm their plans. In the first decision, the Court definitively put a stake through the heart of the artificial impairment doctrine, while in the second, the Court held that the Till prime + formula, while not mandatory, was becoming the "default" rule for calculating interest in chapter 11 plans. The cases are Matter of Village at Camp Bowie I, LP, No. 12-10271 (5th Cir. 2/26/13), which can be found here, and Matter of Texas Grand Prairie Hotel Realty, LLC, No. 11-11109 (5th Cir. 3/1/13), which can be found here.

Village at Camp Bowie and Artificial Impairment

Village at Camp Bowie involved an oversecured creditor whose claim overshadowed those of other creditors. Western Real Estate Equities held a debt of $32.1 miliion secured by property valued by the court at $34 million. The Debtor owed $59,398 to thirty-eight (38) trade creditors. Under the plan, the Debtor's equity holders and related parties were to infuse $1.5 million in new equity. As a result, the Debtor had sufficient funds to simply pay off the trade creditors and leave their claims unimpaired. This would have allowed Western to veto the plan since there would not have been another class available to accept the plan.

Western objected that the Debtor's plan had not been proposed in good faith and that the plan hadn't really been accepted by an impaired class since the impairment was "artificial." The Bankruptcy Court confirmed the Plan over Western's objections.

The Court noted that the Eighth Circuit requires that impairment be driven by economic need, while the Ninth Circuit did not distinguish between "discretionary and artificially driven impairment."    The Court also noted that it had previously rejected the concept of artificial impairment in Matter of Sun Country, Ltd., 764 F.2d 406 (5th Cir. 1986), but that because the court concluded that the impairment in that case was economically motivated "we deprived our analysis of precedential force."    On the other hand, the court had expressed concern over potential artificial impairment in Matter of Sandy Ridge Development Corp., 881 F.2d 1346 (5th Cir. 1989). (Parenthetically, it is interesting to note that these cases involved two individuals who went on to achieve prominence on the Texas bench. Leif Clark was the Debtor's lawyer in Sun Country, while Wesley Steen was the bankruptcy judge for Sandy Ridge during the period in which he was a judge in Louisiana).

Judge Higginbotham found that artificial impairment was inconsistent with the statutory language of the Code, writing:

Today, we expressly reject Windsor [the Eighth Circuit decision] and join the Ninth Circuit in holding that § 1129(a)(10) does not distinguish between discretionary and economically driven impairment. As the Windsor court itself acknowledged, § 1124 provides that "any alteration of a creditor's rights, no matter how minor, constitutes 'impairment.'" By shoehorning a motive inquiry and materiality requirement into § 1129(a)(10), Windsor warps the text of the Code, requiring a court to "deem" a claim unimpaired for purposes of § 1129(a)(10) even though it plainly qualifies as impaired under § 1124. Windsor's motive inquiry is also inconsistent with § 1123(b)(1), which provides that a plan proponent "may impair or leave unimpaired any class of claims," and does not contain any indication that impairment must be driven by economic motives.

The Windsor court justified its strained reading of §§ 1129(a)(10) and 1124 on the ground that "Congress enacted section 1129(a)(10) . . . to provide some indicia of support [for a cramdown plan] by affected creditors," reasoning that interpreting § 1124 literally would vitiate this congressional purpose. But the Bankruptcy Code must be read literally, and congressional intent is relevant only when the statutory language is ambiguous. Moreover, even if we were inclined to consider congressional intent in divining the meaning of §§ 1129(a)(10) and 1124, the scant legislative history on § 1129(a)(10) provides virtually no insight as to the provision's intended role, and the Congress that passed § 1124 considered and rejected precisely the sort of materiality requirement that Windsor has imposed by judicial fiat.

The Windsor court also reasoned that condoning artificial impairment would "reduce [§ 1129](a)(10) to a nullity."   But this logic sets the cart before the horse, resting on the unsupported assumption that Congress intended § 1129(a)(10) to implicitly mandate a materiality requirement and motive inquiry. Moreover, it ignores the determinative role § 1129(a)(10) plays in the typical single-asset bankruptcy, in which the debtor has negative equity and the secured creditor receives a deficiency claim that allows it to control the vote of the unsecured class. In such circumstances, secured creditors routinely invoke § 1129(a)(10) to block a cramdown, aided rather than impeded by the Code's broad definition of impairment.

Opinion, pp. 8-10.

While the passage quoted above is rather long, I have quoted it in its entirety because I find its statutory analysis to be spot-on. There is no need to make things more complicated by delving into the meaning of a provision when the words used are clear. Congress set the bar for determining impairment quite low. Thus, when Congress required acceptance by an impaired class, it similarly set an easily met standard. (Note: when Judge Higginbotham speaks of judicial fiat, I can't help but think of a small Italian car filled with black-robed judges).

The Court also rejected the argument that Matter of Greystone III Joint Venture, 995 F.2d 1274 (5th Cir. 1991) embodied a "broad, extra statutory policy against 'voting manipulation.'"   He stated:

Greystone does not stand for the proposition that a court can ride roughshod over affirmative language in the Bankruptcy Code to enforce some Platonic ideal of a fair voting process.

Opinion, p. 11. While it is comforting to see Greystone limited to its actual holding, you also have to admire a judge who can work "Platonic ideal" into a bankruptcy opinion. (According to Wikipedia, Platonic idealism refers to universals or abstract objects. Thus, a Platonic ideal of voting would mean voting according to abstract, universal principles.)

Nevertheless, the Court did point out that good faith was still a relevant inquiry.

We emphasize, however, that our decision today does not circumscribe the factors bankruptcy courts may consider in evaluating a plan proponent's good faith. In particular, though we reject the concept of artificial impairment as developed in Windsor, we do not suggest that a debtor's methods for achieving literal compliance with § 1129(a)(10) enjoy a free pass from scrutiny under § 1129(a)(3). It bears mentioning that Western here concedes that the trade creditors are independent third parties who extended pre-petition credit to the Village in the ordinary course of business. An inference of bad faith might be stronger where a debtor creates an impaired accepting class out of whole cloth by incurring a debt with a related party, particularly if there is evidence that the lending transaction is a sham. Ultimately, the § 1129(a)(3) inquiry is fact specific, fully empowering the bankruptcy courts to deal with chicanery. We will continue to accord deference to their determinations.

Opinion, pp. 12-13.

Texas Grand Prairie and Cram-Down Interest Rates

In the second case, the Court affirmed a bankruptcy court ruling which confirmed a chapter 11 plan which using a 5% cram-down rate of interest under the Till decision. In Grand Prairie, the parties agreed that the Till decision provided the appropriate method for calculating a chapter 11 cram-down interest rate. The Debtor's expert, faithfully following the Till approach, concluded that prime + a risk factor of 1.75% was appropriate, so that the indicated interest rate was 5.0%. Even though the lender stipulated that Till was the correct approach, its expert did not follow its methodology. Instead, he opined that the proper rate was 8.8% by "taking the weighted average of the interest rates the market would charge for a multi-tiered exit financing package" and then adjusting for risk factors. The Court adopted the 5.0% rate which had the effect of costing the lender $1,485,000 in interest per year based on the appraised value of $39,080,000.

On appeal, Wells Fargo sought to exclude the Debtor's expert testimony on the basis that his "purely subjective approach to interest-rate setting" violated the Supreme Court's call for an "objective inquiry" in Till. The Court wisely observed that:

Here, Wells Fargo does not challenge Robichaux's factual findings, calculations, or financial projections, but rather argues that Robichaux's analysis as a whole rested on a flawed understanding of Till. As we read it, Wells Fargo's Daubert motion is indistinguishable from its argument on the merits. It follows that the bankruptcy judge reasonably deferred Wells Fargo's Daubert argument to the confirmation hearing instead of deciding it before the hearing. We pursue the same path and proceed to the merits.

Opinion, p. 7. 

Next, the Court addressed the proper legal standard for calculating an interest rate under section 1129(b). The court ultimately concluded that the Till decision was not binding on the court because:

  •  Till was a plurality opinion; and
  • Till expressly left open the issue of interest rates in chapter 11 in footnote 14.

As a result, the Court found that its prior decision in In re T-H New Orleans Partnership, 116 F.3d 790 (5th Cir. 1997) remained binding. T-H New Orleans held that the Court would not "establish a particular formula for determining an appropriate cramdown interest rate," but would review the Bankruptcy Court's decision for "clear error."   Having concluded that the Till formula was not mandatory, the Court nevertheless found that it was becoming the majority approach.

In spite of Justice Scalia's warning, the vast majority of bankruptcy courts have taken the Till plurality's invitation to apply the prime-plus formula under Chapter 11. While courts often acknowledge that Till's Footnote 14 appears to endorse a "market rate" approach under Chapter 11 if an "efficient market" for a loan substantially identical to the cramdown loan exists, courts almost invariably conclude that such markets are absent. Among the courts that follow Till's formula method in the Chapter 11 context, "risk adjustment" calculations have generally hewed to the plurality's suggested range of 1% to 3%. Within that range, courts typically select a rate on the basis of a holistic assessment of the risk of the debtor's default on its restructured obligations, evaluating factors including the quality of the debtor's management, the commitment of the debtor's owners, the health and future prospects of the debtor's business, the quality of the lender's collateral, and the feasibility and duration of the plan.

Opinion, pp. 14-15.

Under the Fifth Circuit's deferential clear error analysis, a bankruptcy court which followed the majority approach could not be faulted, even if the court could have found another approach more persuasive.

The Court found that the Debtor's expert properly followed the Till approach.

We agree with the bankruptcy court that Robichaux's § 1129(b) cramdown rate determination rests on an uncontroversial application of the Till plurality's formula method. As the plurality instructed, Robichaux engaged in a holistic evaluation of the Debtors, concluding that the quality of the bankruptcy estate was sterling, that the Debtors' revenues were exceeding projections, that Wells Fargo's collateral - primarily real estate - was liquid and stable or appreciating in value, and that the reorganization plan would be tight but feasible. On the basis of these findings - which were all independently verified by Ferrell - Robichaux assessed a risk adjustment of 1.75% over prime. This risk adjustment falls squarely within the range of adjustments other bankruptcy courts have assessed in similar circumstances.

Opinion, p. 18.

Finally, the Court rejected Wells Fargo's argument that the path taken by the Debtor's expert produces "absurd results."

Wells Fargo complains that Robichaux's analysis produces "absurd results," pointing to the undisputed fact that on the date of plan confirmation, the market was charging rates in excess of 5% on smaller, over-collateralized loans to comparable hotel owners. While Wells Fargo is undoubtedly correct that no willing lender would have extended credit on the terms it was forced to accept under the § 1129(b) cramdown plan, this "absurd result" is the natural consequence of the prime-plus method, which sacrifices market realities in favor of simple and feasible bankruptcy reorganizations. Stated differently, while it may be "impossible to view" Robichaux's 1.75% risk adjustment as "anything other than a smallish number picked out of a hat," the Till plurality's formula approach - not Justice Scalia's dissent - has become the default rule in Chapter 11 bankruptcies. (emphasis added).

Opinion, p. 19. Thus, the Court is not required to apply Till, but if it does, it is not error to pick a "smallish number" out of a hat.

Final Thoughts

These two opinions, while both affirming confirmation of chapter 11 plans, take very different approaches to judging. Village at Camp Bowie is very much a straightforward application of statutory analysis. While I thought that Sun Country's statement that "Congress made the cram down available to debtors; use of it to carry out a reorganization cannot be bad faith" effectively killed the doctrine of artificial impairment, it is nonetheless heartening to see a judge put the final nail in the coffin. Just as I noted in my prior post about Spillman Development Group, this is a case of a judge rejecting magical thinking. In this case, the magical thinking was that Greystone III Joint Venture can be cited in talismanic fashion for the proposition that the secured creditor automatically gets a veto.

Texas Grand Prairie is a much more subversive opinion. While ostensibly following T-H New Orleans' no formula approach, the court gave the green light to bankruptcy courts to follow the Till plurality's prime + approach, referring to it as the majority approach and the default rule. On the other hand, the Court left bankruptcy courts free to reject Till as well. If anything, this decision gives broad discretion to the factfinder, something that has been noticeably lacking since the adoption of BAPCPA. 

Finally, Texas Grand Prairie may spell the death of expert interest rate testimony in chapter 11 cases. If the Debtor's expert can pull a "smallish number" out of a hat, why can't the Debtor's attorney do so without the intervention of an expert witness?   The irony of Wells Fargo's Daubert argument is that it probably was right, but not for the reason that Wells Fargo thought. The logical extension of Till is that the fact-finder does not require "scientific, technical or other specialized knowledge . . . to understand the evidence or determine a fact in issue" as required by Fed.R.Evid. 702 so that neither side should have been allowed to tender an expert witness. This case will probably not preclude courts from considering experts pontificating on interest rates, but it frees up the court to take it or trash it.

Post-script:   While Judge Higginbotham may not receive as much recognition as a scholar of bankruptcy law as some of his colleagues, it is worth noting that he has now authored about 50 bankruptcy opinions, which is more than some bankruptcy judges. In addition to the opinions discussed in this post, some of his other influential opinions include Wells Fargo Bank, N.A. v. Stewart, 647 F.3d 553 (5th Cir. 2011); Milligan v. Trautman, 496 F.3d 366 (5th Cir. 2007); Supreme Beef Processors, Inc. v. USDA, 275 F.3d 432 (5th Cir. 2001); Krafsur v. Scurlock Petroleum Corp., 171 F.3d 249 (5th Cir. 1999); Miller v. J.D. Abrams, Inc., 156 F.3d 598 (5th Cir. 1998); In re Clay, 35 F.3d 190 (5th Cir. 1994); and In re Howard, 972 F.2d 639 (5th Cir. 1992). In my view, this is sufficient to earn him a place among the leading bankruptcy lights on the court.

Lexis.com subscribers can access enhanced versions of the opinions and annotated versions of the statutes cited in this article:

Till v. SCS Credit Corp., 541 U.S. 465 (May 17, 2004) 

Matter of Village at Camp Bowie I, LP, No. 12-10271, 2013 U.S. App. LEXIS 3949 (5th Cir. Feb. 26, 2013)

Matter of Texas Grand Prairie Hotel Realty, LLC, No. 11-11109, 2013 U.S. App. LEXIS 4514 (5th Cir. Mar. 1, 2013)

Matter of Sun Country, Ltd., 764 F.2d 406 (5th Cir. 1986)

Matter of Sandy Ridge Development Corp., 881 F.2d 1346 (5th Cir. 1989)

11 U.S.C. § 1129

11 U.S.C. § 1124

11 U.S.C. § 1123

Matter of Greystone III Joint Venture, 995 F.2d 1274 (5th Cir. 1991)

In re T-H New Orleans Partnership, 116 F.3d 790 (5th Cir. 1997)

Fed. R. Evid. 702

Wells Fargo Bank, N.A. v. Stewart, 647 F.3d 553 (5th Cir. 2011)

Milligan v. Trautman, 496 F.3d 366 (5th Cir. 2007)

Supreme Beef Processors, Inc. v. USDA, 275 F.3d 432 (5th Cir. 2001)

Krafsur v. Scurlock Petroleum Corp., 171 F.3d 249 (5th Cir. 1999)

Miller v. J.D. Abrams, Inc., 156 F.3d 598 (5th Cir. 1998)

In re Clay, 35 F.3d 190 (5th Cir. 1994)

In re Howard, 972 F.2d 639 (5th Cir. 1992)

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