Distressed Debt Investing Concepts: Impaired Accepting Classes

Over the past ten years, capital and corporate structures have become more and more complex with heavy issuance of unique debt instruments and layering in of entities to shield liabilities from various operating subsidiaries. This construct has significant impact and implications for bankruptcy confirmations and processes as well as the interplay between classes vying for different terms of confirmation. The Business Solutions, Governance, Restructuring & Bankruptcy of Proskauer Rose, frequent contributors to Distressed Debt Investing, tackle this and related issues in an exclusive article for our readers below. Enjoy!

The Puzzle of the Impaired Accepting Class

The recent wave of complex real estate and hospitality distress illuminated one potential impediment to any chapter 11 bankruptcy case; namely, the inability to confirm a plan of reorganization in the absence of an impaired accepting class of creditors at any special purpose entity (“SPE”) debtor.

Pursuant to Bankruptcy Code section 1129(a)(10), if a class of claims is impaired under a plan, then at least one impaired class must vote to accept the plan without counting insider votes. Although the Bankruptcy Code is quite clear that each debtor’s plan must have at least one impaired accepting class, a few decisions have raised the question of whether section 1129(a)(10) requires acceptance by one impaired class for each debtor individually or group of affiliated debtors.

While bankruptcy courts in New York and Arizona have confirmed “joint plans” that consist of numerous debtors with just one non-insider impaired accepting class at one debtor (see below), two recent bankruptcy court decisions in Delaware rejected this jurisprudence as violating the requirements of Bankruptcy Code section 1129(a)(10). See In re Tribune Co., 464 B.R. 126, (Bankr. D. Del. 2011); In re JER/Jameson Mezz Borrower II LLC, 461 B.R. 293 (Bankr. D. Del. 2011).

Indeed, in one of the decisions rejecting the “joint plan” approach, the Delaware Bankruptcy Court emphasized that Collier, one of the leading bankruptcy treatises, “contains no discussion of the ‘per plan/per debtor’ issue.” See Tribune, 464 B.R. at 182.

The Tribune and Jameson holdings explicitly rejected the joint plan approach endorsed by the Bankruptcy Court for the Southern District of New York in In re Charter Communications, 419 B.R. 221 (Bankr. S.D.N.Y. 2009) and In re Enron, 2004 Bankr.LEXIS 2549 (Bankr. S.D.N.Y. July 15, 2004), and ruled the impaired accepting class requirement of section 1129(a)(10) applies to each individual debtor. Notably, a recent bankruptcy court ruling in Arizona, In re Transwest Resort Properties, No. 10-37134 (Bankr. D. Ariz. Dec. 16, 2011) departed from Tribune and Jameson, and confirmed a joint chapter 11 plan with one impaired accepting class of creditors at only one of the debtors under the plan over the objection of the mezzanine lender. Although the mezzanine lender appealed the Transwest decision, the Arizona District Court dismissed the appeal on equitable mootness grounds, thereby leaving the section 1129(a)(10) issue undecided.

Significantly, in Charter, the use of one impaired accepting class for one debtor to count as an impaired accepting class for an affiliated debtor was pivotal to the entire reorganization. No plan could have been confirmed without that ruling. Charter settled before an appellate court ruled. Conversely, in Enron, the debtors, lacking an impaired, accepting class were inconsequential to the overall reorganization and no one objected to confirmation on the ground those debtors did not individually satisfy section 1129(a)(10). It is very possible that other bankruptcy judges in New York and Arizona will not follow Charter and Transwest.

Notwithstanding the overwhelming likelihood that section 1129(a)(10) will be on a per debtor basis, the presence of SPE borrowers alone does not render the section 1129(a)(10) hurdle insurmountable. In an effort to satisfy the impaired accepting class requirement and design a confirmable chapter 11 plan, debtors may create a separate classification of claims at each SPE borrower by either (i) impairing a class of claims that already exists at those entities (i.e., trade claims) or (ii) causing those entities to incur additional indebtedness or consolidating those entities into one entity that already has its own impaired accepting class of creditors.

That said, SPE organizational documents and mortgage loan agreements often contain (i) prohibitions on the transfer/consolidation of assets and (ii) limitations on the incurrence of additional indebtedness. These, however, may not frustrate the ability to implement these strategies without lender consent because the implementation is simply a default that will not matter if the entity commences a chapter 11 case.


Anonymous,  9/25/2012  

Hmm.. I thought the automatic stay would prevent the entities from incurring additional debt.


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.