In an interesting decision issued last month in a case called In re Machne Manachem, Inc., the Third Circuit upheld a district court’s decision to reverse confirmation of a Chapter 11 plan of reorganization. The decision stemmed from steps taken to obtain votes required for approval of the plan. Before discussing the details, a bit of background on bankruptcy plans and the rules governing voting is in order.
Classes And Plans Of Reorganization. Bankruptcy plans must classify creditors and equity holders into various classes, usually based on the type of debt or equity security they hold or on other characteristics of their claims or interests. Each secured creditor is typically put in a separate class or subclass, bondholders may be put in a separate class based on the bond issue involved, general unsecured creditors may be grouped together in one class, and the claims held by insiders are occasionally put in a separate class.
Voting Requirements For Plans. The Bankruptcy Code spells out the voting rules for Chapter 11 plans of reorganization.
- Under Section 1129(a)(10) of the Bankruptcy Code, at least one "impaired" class must vote to accept a plan. In the bankruptcy world, "impaired" means that under the plan the holder of the claim or interest will receive treatment that is different (usually worse) than what it would get outside of bankruptcy. This may involve stretching out repayment terms over time, paying less than 100 cents on the dollar, or canceling all shares of prepetition stock.
- To accept a plan, the tally of votes from the impaired class must meet or exceed two thresholds. Two-thirds in dollar amount and a majority in number of those creditors voting must accept the plan.
- If these tests are satisfied, as happened in the Third Circuit case, and if other requirements are met, the debtor may be able to "cram down" the plan on the rest of the creditor body, even if other creditors voted to reject the plan.
A Case Of Gerrymandering. In this case, the plan got the required votes from the impaired class. So what prompted the Court of Appeals to throw out the plan? In short, the Court found that by purchasing a select set of impaired claims, an insider of the debtor gerrymandered the vote in favor of the debtor’s plan. The Court ruled that the insider’s purchase of four claims in the only impaired class that accepted the plan was done to win the vote of that class. Once they were purchased, those claims were shifted out of the key class and into another class where their votes would not matter. This conduct, the Court held, was improper and "undermined the critical confirmation requirements of the bankruptcy code."
- Although there was little evidence either way, the Court seem concerned that the vote in that one critical accepting class — 7 claims accepting and 4 claims rejecting — could have ended up as 7 claims accepting and 8 claims rejecting if the four purchased claims had stayed in the original class.
- The Court also found troubling that the purchased claims received less than 100 cents on the dollar, which was the treatment the proposed plan provided for the rest of the creditors in the key class.
Conclusion. Classifying claims into classes for Chapter 11 plans and the voting process are critical aspects of the reorganization process in a business bankruptcy case. From time to time objecting creditors may accuse the debtor or other plan proponent of gerrymandering those classes to win confirmation, but when the Third Circuit issues a decision finding that improper gerrymandering actually took place, it’s a case worth reading. Special thanks to the Delaware Business Bankruptcy Report for first posting on the case.