Subordination Agreement Ignored in a Cramdown — But What’s So Unfair About That?
Recently, in In re Tribune Company, the Third Circuit affirmed that the Bankruptcy Code means exactly what it says and that the enforcement of subordination agreements can be abridged when cramming down confirmation of a chapter 11 plan over a rejecting class entitled to the benefit of the subordination agreement, so long as doing so does not “unfairly discriminate” against the rejecting class (and the other requirements for a cramdown are satisfied).
The Tribune ruling arises out of the chapter 11 restructuring of the Tribune Company debtors, once one of the largest media conglomerates in the United States. In 2008, following a failed leveraged buyout, the debtors filed for chapter 11 with a complex capital structure. In 2012 after several years of litigation, the Bankruptcy Court confirmed a plan of reorganization (one of several competing plans) proposed by the debtors and supported by the unsecured creditors committee and certain financial sponsors (the “Plan”).
The Plan classified unsecured claims against the debtors’ parent entity (“Parent”) into multiple classes based on the origin and nature of the claims. Class 1E was comprised of claims under certain unsecured notes (the “Senior Notes”) whose governing indenture contained a subordination covenant requiring the Senior Notes be repaid in full prior to all other unsecured debts of the Parent. The Plan also included a combined Class 1F which included all claims against the Parent arising under a terminated interest rate swap (the “Swap Claims”) as well as unsecured retiree claims and claims of other trade and general creditors (the “Other Claims”). All other unsecured creditor classes of the Parent were contractually subordinated to the Senior Notes and the Swap Claims. Under the Plan, holders of the Senior Notes (the “Senior Noteholders”) and the Other Claims (including retirees and trade creditors) were afforded the benefit of the subordination of the other unsecured creditors and received distributions resulting in a 33.6% recovery on account of their claims. The Senior Noteholders’ appeal concerned roughly $13 million that should have been used to pay the Senior Notes but instead, was allocated to pay the retirees and trade creditors included in the Other Claims.
The undisputed facts established that had only the Senior Notes and the Swap Claims received the full benefit of the subordination arrangements the Senior Noteholders would have received a distribution of 34.5% of their claims while the retirees and trade creditors would have recovered only 21.9% of their claims.
The Senior Noteholders’ main objection to confirmation and on appeal was that because § 1129(b)(1) provides for plan confirmation via cramdown “notwithstanding § 510(a) of the [Bankruptcy Code]” (which provides for the enforcement of subordination agreements) a plan must give full effect to the subordination arrangement in their favor. In the alternative, they argued that the Plan’s misallocation of certain of the funds they were entitled to had the subordination agreement been enforced constituted impermissible “unfair discrimination”.
The Third Circuit made short work of the Senior Noteholders’ principal argument that the cramdown provisions of § 1129(b) of the Bankruptcy Code mandate full enforcement of contractual subordination rights under § 510(a). Examining both the plain meaning of the word “notwithstanding” and the legislative history regarding 1129(b)—the court concluded that the reference in § 1129(b) to § 510(a) had precisely the opposite effect of that asserted by the Senior Noteholders: That the cramdown provisions of § 1129(b) supersede the enforcement of contractual subordination arrangements under § 510(a). Thus, the Plan could be confirmed notwithstanding the contractual subordination provisions so long as the other requirements of § 1129(b) were satisfied.
The court then examined the two elements of section 1129(b)(1). The Third Circuit noted that the “unfair discrimination" element is a horizontal comparative assessment that evaluates the relative treatment of similarly situated creditors, here unsecured creditors. The “fair and equitable” element, which was not at issue in the case, is a vertical assessment which focuses on the treatment of classes entitled to different priority, i.e. secured and unsecured creditors.
Turning to the question of “unfair discrimination”—after a thorough discussion of the element and the principles it advances, the Third Circuit agreed with the lower courts that under the circumstances of the case, the Plan’s allocation of some value from the Senior Noteholders to retirees and trade creditors was not “unfair discrimination.” The court noted that the Senior Noteholders would still receive the overwhelming benefit of the subordination agreement and that any seemingly excessive recovery by retirees and trade creditors was largely due to the substantially smaller amount of these claims. In short, the Plan’s allocation of 0.9% in recovery value (roughly $13 million) from the Senior Noteholders (which held over $1.283 billion in claims) to the retiree and trade creditor claims (which totaled only $113.8 million) merely abridged the Senior Noteholders subordination rights and did not, when viewed from the Senior Noteholder’s perspective, materially diminish their recovery or unfairly discriminate against them.
The Third Circuit acknowledged that other courts have focused on the differences between the recoveries of the benefitted creditors (here the 21.9% retirees and trade creditors would have received without benefiting from the subordination of other creditors versus the 33.6% they actually received under the confirmed plan) rather than on the loss suffered by the rejecting class (the 0.9% recovery reduction suffered by Senior Noteholders). The Third Circuit went on the state that the method chosen by the bankruptcy court in this case is not the preferred way to test unfair discrimination, but it was appropriate under the circumstances of the case because the difference in the Senior Noteholders’ recovery was not material.
There is a relative paucity of decisions examining the interplay of § 510(a) and the protections afforded dissenting creditors in a cramdown, making the Tribune ruling notable for several reasons. For one, the ruling conclusively affirms the primacy of the cramdown provisions over the exacting enforcement of contractual subordination rights. The Bankruptcy Code’s cramdown protections—in particular the “unfair discrimination” test-provide bankruptcy courts the “play in the joints” needed to confirm a plan without giving courts leeway to completely disregard pre-bankruptcy contractual arrangements. Additionally, though it did not forswear the use of other tests, the court endorsed the use of the “rebuttable presumption test” to evaluate unfair discrimination and added to the growing use of this relatively new standard by courts across the country. Finally, while the Circuit held that unfair discrimination is rough justice, and that a 0.9% loss in recovery is clearly immaterial, it did not set the outer boundary of what may qualify as immaterial. We expect that future cases will help define the boundaries of materiality.