Artificial Impairment Revisited

Artificial Impairment Revisited

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The Third Circuit's recent decision in In re Combustion Engineering Inc., 391 F.3d 190 (3d Cir. 2004), focused primarily on the limits of §105(a) to channel non-derivative claims against non-debtor affiliates in an asbestos-related plan.2 However, the Third Circuit also revisited the concept of artificial impairment, which has received less attention with the decline in single-asset real estate bankruptcies since the mid-1990s. In doing so, the Third Circuit not only confirmed that the concept of artificial impairment is alive and well as a defense to confirmation of a cramdown plan, it added a new twist. Rather than limiting the inquiry to impairment under the plan itself, the court will consider the debtor's pre-petition conduct in disenfranchising creditors by engineering the composition of the unsecured creditor class.

History and Theory

Artificial impairment is a judicially created concept developed to thwart needless impairment of claims in order to satisfy the requirements of §1129 (a)(10) of the Code. That section provides that in order to confirm a plan in which a class of claims is impaired, the plan must be affirmatively accepted by at least one class of impaired creditors, without including insiders. The policy behind §1129(a)(10) was to assure that a cramdown plan had some indicia of creditor support to justify the involuntary confirmation of the plan over the objection of dissenting creditors. Section 1129(a)(10) most frequently arises in single-asset real estate cases where the debtor convinces its few unsecured trade creditors to accept less than they are owed so the debtor can resort to the cramdown provisions of §1129(b) to force confirmation on an intransigent secured creditor.

The plain language of the Code places no limitations on the ability of a debtor to impair a properly constituted class of creditors. Many courts, relying on the unambiguous text of the statute, permit minimal impairment of a class in order to satisfy §1129(a)(10). In In re L & J Anaheim Assocs., 995 F.2d 940 (9th Cir. 1993), the Ninth Circuit found no suggestion in the definition of impairment in §1124 that only alterations of a particular kind or degree could constitute impairment. Accordingly, the court upheld confirmation of the secured creditor's plan based on the creditor's favorable vote on the plan. The court confined its analysis to whether the creditor's rights were changed and concluded that any alteration constituted impairment sufficient to satisfy §1129(a)(10). The Ninth Circuit held that any abuse of the chapter 11 process by the proponent should be addressed under §1129(a)(3) in determining whether the plan was proposed in good faith. See, also, In re Witt, 60 B.R. 556 (Bankr. N.D. Iowa 1986) (finding §1129(a)(10) satisfied by $75 impairment but denying confirmation on other grounds); In re Duval Manor Assocs., 191 B.R. 622, 627 (Bankr. E.D. Pa. 1996) (finding impairment of security deposit claims by slightly delayed repayment sufficient to satisfy §1129(a)(10) but denying confirmation on other grounds).

Other courts were offended by the idea that §1129(a)(10) could be rendered superfluous by minimal impairment and adopted the concept of artificial impairment to preclude compliance with §1129(a)(10) through unjustified or needless impairment of a class. In Windsor on the River Assocs. Ltd. v. Balcor Real Estate Fin. Inc. (In re Windsor on the River Assocs. Ltd.), 7 F.3d 127, 132 (8th Cir. 1993), the Eighth Circuit required economic justification for impairment. It rejected a plan in a single-asset case that impaired a $13,000 class of trade creditors by delaying payment for 60 days after the plan's effective date. The court had found that there was more than $600,000 equity in the debtor's apartment complex and that the impairment of the trade creditors was included purely as a matter of the debtor's discretion to satisfy §1129(a)(10). The court reasoned that such manufactured impairment circumvented what it found to be the purpose of the Code—namely, consensual reorganization.

Although the doctrine of artificial impairment gained some acceptance, other courts continued to find justification in the Code for permitting modest impairment in order to satisfy §1129(a)(10). In Conn. Gen. Life Ins. Co. v. Hotel Assocs. of Tucson (In re Hotel Assocs. of Tucson), 165 B.R. 470 (BAP 9th Cir. 1994), the Ninth Circuit Bankruptcy Appellate Panel (BAP) specifically rejected the per se rule laid down in Windsor and recognized a class as impaired, even though the only impairment was a 30-day delay in payment to the class. Other courts and commentators seized on the elimination of former §1124(3) in the 1994 Amendments to the Code as further support for finding that §1129(a)(10) is satisfied even when a class of creditors is paid in full on confirmation. In Equitable Life Ins. Co. of Iowa v. Atlanta-Stewart Partners (In re Atlanta-Stewart Partners), 193 B.R. 79 (Bankr. N.D. Ga. 1996), the court held that the payment of either 95 or 100 percent to holders of claims in an administrative convenience class would result in impairment after the 1994 Amendments eliminated the option of leaving a class unimpaired by providing for payment in full on the effective date.3

The running debate over artificial impairment has continued with no apparent reconciliation between the two camps. Compare Beal Bank S.S.B. v. Waters Edge Ltd. P'ship., 248 B.R. 668, 690-91 (D. Mass. 2000) (holding that a class of claims should not be considered "impaired" for the purpose of satisfying §1129(a)(10) unless the impairment was necessary to accomplish a proper business purpose), with In re Greate Bay Hotel & Casino Inc., 251 B.R. 213, 240 (Bankr. D. N.J. 2000) (finding no statutory impediment to impairing creditors to satisfy §1129(a)(10)).

The Combustion Engineering Decision

The Third Circuit's recent decision has added a new twist to the artificial-impairment debate. The Combustion Engineering (CE) case was a second-level appeal to the Third Circuit from bankruptcy and district court orders approving confirmation of CE's prepackaged plan.4 The plan was designed to address a multitude of asbestos claims against CE and two affiliates that manufactured different asbestos-containing products but operated out of common facilities, shared coverage under certain liability insurance policies and were related by having a common parent. Prior to filing the petition, CE transferred assets worth around $400 million to a settlement trust (the CE Settlement Trust). Participants in the CE Settlement Trust ultimately were divided into four groups that stood to receive differing percentages based on the status of their claims and settlements with CE. A class of claimants whose claims were already settled and were threatening to file an involuntary petition against CE would receive 95 percent of their claims. A class whose claimants who had settled with CE or had agreed to a dispute resolution process, but whose payments were not yet due, would receive 85 percent. A third group whose claims were not yet adjudicated would receive 37.5 percent with the possibility of later recovering up to 75 percent. Finally, a fourth class of claimants whose claims were first asserted shortly before the bankruptcy filing would receive a lesser amount.

Importantly, for purposes of the Third Circuit's artificial-impairment discussion, all CE Settlement Trust participants agreed not to collect the balance of their claims from CE except through filing proofs of claim in the anticipated pre-packaged chapter 11. The plan created a second trust (the Asbestos PI Trust) under §524(g) of the Code to satisfy claims not paid through the CE Settlement Trust. The "stub claims" held by the CE Settlement Trust participants formed the majority of the claims in the chapter 11 case and thus assured acceptance of the plan by the class of general unsecured creditors.

The Third Circuit overturned confirmation of the CE plan primarily because it overstepped the bounds of §§105(a) and 524(g) in attempting to shield the two non-debtor affiliates from further asbestos liability. However, the Third Circuit did not stop there, as it remanded the case for further consideration of artificial impairment. 391 F.3d at 242-45.

The court acknowledged that other courts have found the practice of artificial impairment "troubling" despite the absence of a specific statutory prohibition and aligned itself with courts that reject artificial impairment in order to satisfy §1129(a)(10). The Third Circuit explained that impairment is artificial where a plan proposes an insignificant or de minimis impairment to engineer literal compliance with §1129(a)(10) while avoiding opposition to reorganization by truly impaired creditors. 391 F.3d at 243.

Unlike traditional artificial impairment analysis, the Third Circuit did not focus on the nature or degree of impairment, as it was clear that all claims were impaired under the Asbestos PI Trust. Instead, the court's criticism of the plan was levied at the uneven treatment of claimants resulting from the preferential side deal with the CE Settlement Trust participants 87 days before bankruptcy. The pre-petition settlement allowed the CE Settlement Trust participants to be less "impaired" than the future claimants or the certain cancer claimants who were not involved in the first phase of the settlement and thus were excluded from participation in the CE Settlement Trust. The court's underlying conviction was that the acceptance of the plan had been manipulated by the debtor's engineering of the class in a fashion that disenfranchised seriously injured claimants by intentionally placing them in the minority.


The Third Circuit's discussion of artificial impairment is more properly seen as an extension of the good-faith requirements of §1129(a)(3), on which the court also remanded for further findings. When artificial-impairment issues arise in future commercial cases, the court is likely to consider the debtor's motivation in artificially impairing a class of creditors and will be guided by the evolving good-faith doctrines applicable in chapter 11. If claims are impaired to effect a workout that is perceived to be in the best interests of creditors, the plan will be approved. However, if the debtor's subjective good faith is called into question, the court will refuse to find compliance with the technical requirement of §1129(a)(10), and the debtor will be denied the opportunity to use §1129(b) to confirm its plan.


1 Board Certified in Business Bankruptcy Law by the American Board of Certification. Return to article

2 See p. 36 of this issue. Return to article

3 See Clemency, John R., and Saks, Glenn, "Even an Act of Congress Can't Stop the Fight over Artificial Impairment," ABIJournal, November 1998 at 18; Rubin, Paul, "Fleeting Hope for Single-asset Real Estate Debtors?" ABI Journal, March 1997 at 1. Return to article

4 The summary provided herein is intended only to identify the facts needed to discuss the artificial-impairment aspects of the case. For a detailed description of the underlying issues and the decisions of the lower courts, see Pasquale, Kenneth, "Combustion Engineering: Can a Pre-packaged Bankruptcy Plan Satisfy §524(g)?," ABI Journal, June 2004 at 1. Return to article

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Tuesday, February 1, 2005