Reverse Cramdown Another Option in the Secured Creditors Playbook
If you haven't done so already, it may be time to add the term "reverse cramdown" to your list of clever and distinctive chapter 11 parlance—right alongside such familiar expressions as "artificial impairment," "negative amortization" and the "new value corollary." Boiled down to its essentials, the term "reverse cramdown" refers to a reorganization strategy in which a chapter 11 debtor's secured lenders—holding liens on all of the debtor's assets yet still substantially undersecured—join with the debtor's existing equity and/or management and effectively agree to divide up among themselves the equity in the reorganized debtor while distributing little or nothing to those unsecured creditors who are considered nonessential to the reorganized debtor's post-confirmation operations.
To illustrate a reverse cramdown in operation, assume that ABC Company—a chapter 11 debtor in the business of manufacturing and distributing "widgets"—has the following debt structure at the time that it files for chapter 11 relief:
|Creditor Group||Amount Outstanding|
|Secured Bank Facility||$100 million|
|Unsecured Bondholders||$30 million|
|Unsecured Trade Creditors||$10 million|
Further assume that while the lenders participating in the Secured Bank Facility (the secured lenders) have a wall-to-wall lien on all of ABC's assets, the value of these assets—even on a going-concern basis—is somewhere south of $70 million (i.e., at least $30 million less than what it is owed by the debtor to the secured lenders). Certainly, the secured lenders are less than enthusiastic about finding themselves grossly undersecured at the commencement of ABC's bankruptcy proceedings. Nevertheless, they believe that in the long-term, ABC has some real upside growth potential. Accordingly, they pragmatically conclude that the best way for them to maximize their ultimate recovery is to have ABC reorganize with its existing management in place and to take an equity position in "Reorganized ABC." To insure that existing equity and management remain properly incentivized with respect to the long-term success of Reorganized ABC, the secured lenders are willing to allow the existing management and equity to retain a minority equity position in Reorganized ABC. Moreover, in order to insure that Reorganized ABC has sufficient support from its vendors, the secured creditors are also prepared to allow the debtor's unsecured trade creditors to be paid in full. For obvious reasons, however, the secured lenders have no interest in taking care of ABC's unsecured bondholders and/or allowing these bondholders to participate in any potential upside in the event Reorganized ABC ultimately succeeds.
With the foregoing objectives in mind, the secured lenders get together with ABC's existing management and equity and devise a chapter 11 plan under which (1) ABC will reorganize and emerge out of bankruptcy as "Reorganized ABC;" (2) the secured lenders' secured debt will be reduced down and re-amortized to a level that Reorganized ABC can realistically manage; (3) the unsecured trade creditors will get paid in full; (3) the senior lenders will receive an 85 percent equity stake in Reorganized ABC; (4) most, if not all, of the remaining equity in Reorganized ABC will go to ABC's existing equity; and (5) the unsecured bondholders will receive nothing or some form of nominal consideration such as warrants (with an out-of-the-money strike price) in Reorganized ABC.
Of course, the unsecured bondholders will vote against such a chapter 11 plan. Consequently, the secured lenders and the other supporters of the plan will have to seek confirmation under the "cramdown provisions" set forth in Bankruptcy Code §1129(b). In response, the unsecured bondholder will undoubtedly contend that "cramdown" is not permissible because (1) the plan violates §1129(b)'s prohibition against "unfair discrimination" by providing for unsecured trade creditors to be paid in full while the bondholders—who, under applicable non-bankruptcy law, occupy the same priority as the unsecured trade creditors—are to receive little or nothing, and (2) the plan fails to meet the absolute priority rule embodied in §1129(b)'s "fair and equitable" requirement because it provides for the existing equity to obtain an equity interest in Reorganized ABC even though the (higher priority) unsecured bondholders will not be paid or otherwise satisfied in full.
In light of the forgoing objections, it would appear that the proposed plan cannot be confirmed—but not so fast! A growing number of cases suggest that the secured lenders in the above hypothetical may be able to overcome the bondholders' objections pursuant to a rationale that first appeared to gain ground (at least, under the modern Code1) in the First Circuit Court of Appeals's decision in In re SPM Manufacturing Corp., 984 F.2d 1305 (1st Cir. 1993).
The SPM Manufacturing case involved an unsuccessful attempt by a family-owned business to reorganize in a chapter 11 proceeding that was eventually converted to a chapter 7 proceeding. Prior to conversion, the debtor's secured lender entered into an agreement with the unsecured creditors' committee appointed in the case under which the secured lender agreed to share a portion of its recovery with the debtor's general, unsecured creditors in exchange for the committee's commitment to, among other things, cooperate with the secured lender's efforts to maximize the value of its collateral through a sale of the collateral under Code §363(f). Id. at 1308.
Although the §363 sale was consummated during the chapter 11 proceedings, the proceeds from the sale remained in the custody of the bankruptcy estate at the time of conversion. Following conversion, the committee and the secured lender petitioned the bankruptcy court to direct the recently appointed chapter 7 trustee to distribute the sale proceeds to the secured lender, whereupon the secured lender would pay-over the portion of the proceeds owing to the debtor's general unsecured creditors in accordance with the secured lender's pre-conversion agreement with the committee. At the time, however, there were a number of outstanding unsecured, priority claims pending against the bankruptcy estate—including a claim for more than $750,000 in unpaid withholding taxes allegedly owing to the Internal Revenue Service (IRS). Id. at 1308. Consequently, several parties objected to the proposed pay-out requested by the secured lender and the committee, arguing that it constituted a circumvention of the Code's priority scheme.
Agreeing with the latter parties, the bankruptcy court authorized the chapter 7 trustee to distribute the sale proceeds to the secured lender, but expressly required the secured lender to pay back to the chapter 7 trustee the portion of the proceeds that the secured creditor had previously agreed to relinquish to the debtor's general unsecured creditors. Specifically, the bankruptcy court held that the latter funds had to be distributed by the chapter 7 trustee to both priority and non-priority unsecured creditors in accordance with the Code's priority scheme (which, as a practical matter, would mean that all of the funds would be paid to unsecured, priority claimants, and the debtor's general unsecured creditors would receive nothing). Id. at 1310-1.
The committee appealed the bankruptcy court's decision all the way up to the First Circuit Court of Appeals, which found that the bankruptcy court had erred as a matter of law in requiring the secured lender to pay over to the chapter 7 trustee the portion of the sale proceeds that the secured lender had previously agreed to make available to the general unsecured creditors. Id. at 1318. In so ruling, the First Circuit flatly rejected the contention that the secured lender's agreement with the committee somehow undermines the Code's priority scheme. As the court observed, absent any agreement with the committee, the secured lender would have been entitled to recover and retain all of the sale proceeds at issue, "leaving nothing for the estate to distribute to other creditors, including the IRS." Id. at 1312. Thus, the court found "it hard to see how the priority creditors lost anything given the fact there would have been nothing left for [them...anyway] after the [sale proceeds...were] distributed to [the secured lender]." Id.
Moreover, the First Circuit noted, "the bankruptcy court has no authority to control how [a secured creditor] disposes of the proceeds [of its collateral] once it receives them. There is nothing in the Code forbidding [a secured creditor...from] voluntarily [paying] part of these monies to some or all of the general, unsecured creditors after the bankruptcy proceedings are finished." Id. at 1313. Accordingly, the First Circuit remanded the case to the bankruptcy court so that the sale proceeds could be distributed in accordance with the secured lender's original agreement with the committee.2
Picking up on the First Circuit's apparent endorsement of the proposition that a secured creditor should remain free to divvy up the value of its collateral however it so pleases, a number of parties have recently invoked the SPM Manufacturing decision to successfully defeat "unfair discrimination" and "fair and equitable" objections raised by parties in a position essentially equivalent to the unsecured bondholders in the hypothetical described above.
Thus, for instance, in In re Genesis Health Ventures Inc., 266 B.R. 591 (Bankr. D. Del. 2001), appeal dismissed, 280 B.R. 339 (D. Del. 2002), certain unsecured creditors of a group of bankrupt health care and related service providers opposed the debtors' chapter 11 reorganization plan under which the debtors' senior secured creditors—together with the debtors' existing management—would receive most of the equity in the reorganized debtor, while the objecting parties would receive little or no distribution on certain of their claims. Like the unsecured bondholders in the hypothetical above, the objecting parties in Genesis Health asserted that the proposed reorganization plan discriminated unfairly against them because it provided greater distribution to other unsecured creditors, and was not fair and equitable because it provided for debtors' existing management to receive equity in the reorganized debtor while the objecting parties' claims were not being repaid in full.
Expressly relying on the SPM Manufacturing decision, the bankruptcy court in Genesis Health rejected both of the foregoing objections and ruled that the debtors' reorganization plan should be confirmed. Specifically, the court determined that the total enterprise value of the debtors was around $1.33 billion, whereas the outstanding indebtedness owing to the debtor's senior secured creditors was approximately $1.46 billion. Id. at 616. Based on this determination, the court concluded that even if the senior secured creditors "receive all of the debt and equity distributed under the debtors' plan, [their] claims...would not be satisfied in full." Id. at 616. Accordingly, the bankruptcy court believed that the entire enterprise value of the debtors was properly allocable to the senior secured creditors. Under such circumstances, the objecting parties could not rightfully complain that they were receiving less under the proposed chapter 11 plan than other similarly situated unsecured creditors, since—but for the grace of the senior secured creditors—none of the unsecured creditors would receive anything. Thus, like the elder son in the parable of the prodigal son, the objecting parties should have rejoiced in being permitted to partake in any portion of the fatted calf and not concerned themselves with the fact that their brethren were receiving a significantly larger cut.3
Employing essentially identical reasoning, the Genesis Health court was also able to easily dispense with the objecting parties' fair and equitable objection. As the court explained, "the issuance of stock and warrants to management represents an allocation of the enterprise value otherwise distributable to the senior lenders, which the senior lenders have agreed to offer to the top executives as further incentive to them to remain and effectuate the debtors' reorganization. The senior lenders are free to allocate such value without violating the 'fair and equitable' requirement." Id. at 618.4
Comparison with Secured Creditor's State Law Rights
At first blush, the results achieved through a reverse cramdown might not seem that remarkable given that under state law, a secured lender has the ability to foreclose upon its collateral and, thereby, put the collateral outside the reach of its borrower's unsecured creditors. Thus, it is certainly conceivable that outside of bankruptcy, a secured creditor could achieve the same results as those obtained under a reverse cramdown by engaging in a "friendly foreclosure" in which the assets of an existing borrower are foreclosed upon and sold to a "new company" formed by the original borrower's equity-holders and management. In fact, a number of state statutory schemes contain special safeguards that would protect such a transaction from an attack or challenge otherwise available under such statutes. Thus, for instance, the Uniform Fraudulent Transfer Act (UFTA) expressly exempts from avoidance under the UFTA's constructive fraud provisions any transfer that occurs pursuant to the "enforcement of a security interest in compliance with Article 9 of the Uniform Commercial Code."5 Similarly, most (if not all) bulk transfer statutes still remaining on the books contain a special carve-out for transfers that occur by way of foreclosure.6
Nevertheless, it would be a mistake to conclude that there are not substantial risks for a secured creditor that attempts to cleanse or "whitewash" a borrower's business of its unsecured debt by engaging in a friendly foreclosure outside of bankruptcy in which the assets of the business are transferred to a new company formed in conjunction with the existing borrower's management and equity. The case law reporters are replete with decisions involving such circumstances, wherein unsecured creditors of the original borrower are permitted to pursue their claims against the new company.7 Indeed, this is true not only with respect to unsecured creditors with product liability claims, but also those with contract and statutory causes of action.8
Of course, under a successful reverse cramdown strategy, the risks of such successor liability claims should be eliminated.
Analysis and Conclusion
In the final analysis, the reverse cramdown strategy—at least, to the extent that it is looked to as a mechanism for overcoming the absolute priority rule—seems to rest on a flawed and mistaken foundation. While the Code requires that secured creditors receive the full value of their collateral as of the effective date of a chapter 11 plan,9 this value does not include the potential appreciation in the enterprise value that the reorganized debtor as a whole might experience post-confirmation (i.e., such appreciation does not constitute a "proceed" or "product" of the secured creditor's collateral).10 Instead, such potential appreciation would seem to fall outside a secured creditor's package of collateral and, as such, would be something to which undercollateralized secured creditors would only be entitled to participate in their capacity as and to the extent they are unsecured creditors, in which case they should be required to share such potential appreciation on a pro rata basis along with all of the debtor's other unsecured creditors (rather than being deemed the sole and exclusive beneficiary of all such potential appreciation with the unbridled discretion to parcel out shares of such potential appreciation to whomever they so choose).
Moreover, the notion that "reverse cramdown" plans are a permissible method of defeating possible absolute priority objections by intervening creditors or interest-holders is directly contradicted by the legislative history to the current Bankruptcy Code. Indeed, the bankruptcy reform bill originally passed by the Senate contemplated a reverse cramdown provision that "would permit a senior creditor to adjust his participation for the benefit of stockholders," in which case "junior creditors, who have not been satisfied in full, may not object if, absent the 'give up,' they are receiving all that a fair and equitable plan would give them."11 Ultimately, however, this approach was abandoned in favor of the current statutory language that the drafters expressly believed would prohibit the confirmation of reverse cramdown plans.12
Apparently, however, such academic fine points
didn't slow down the secured creditor parties in cases such as Genesis Health from coming away
with the desired victory.13 So for those of you out
there calling the plays on behalf of undercollateralized secured lenders, you may want to give some serious consideration to having your team attempt a reverse cramdown.
1 See Klee, K., "Barbarians at the Trough: Riposte in Defense of the Warrant Carve-out Proposal," 82 Cornell L. Rev. 1466, 1481 (September 1997) (referencing reverse cramdown-like practices that occurred in equity receivership cases of the early 20th Century). Return to article
2 For a case apparently reaching a similar result, see In re Shoe Corp. of America Inc., Case No. 99-55400 (Bankr. S.D. Ohio) (wherein the bankruptcy court approved a "distribution agreement" under which secured creditors agreed to allow a portion of their collateral proceeds to be paid to general unsecured creditors notwithstanding outstanding priority claims), described in Indyke, J. and Weisberg, B., "Committee Issues: Carve-outs; Liquidations for Benefit of Banks; Liability; Inconvenient Delaware Issues; Liquidations for the Benefit of Secured Creditors: An Unsecured Creditor's Committee Perspective," 041802 ABI-CLE 223 (20th Annual Spring Meeting, April 18-21, 2002). Return to article
3 See, also, Matter of Union Financial Services Group Inc., 303 B.R. 390, 424 (Bankr. E.D. Mo. 2003) (wherein the court—citing to the SPM Manufacturing decision—found that a chapter 11 plan was not unfairly discriminatory for purposes of Code §1129(b), even though it provided for payment in full of the unsecured claims of certain necessary trade vendors and utilities while the debtor's unsecured noteholders only received a very small equity stake in the reorganized debtor); In re MCorp Financial Inc., 160 B.R. 941, 960 (S.D. Tex. 1993) (chapter 11 plan did not unfairly discriminate against class of junior noteholders as larger share of distribution to be paid to another class of arguably equal rank represented a reallocation of funds otherwise payable to the class of senior noteholders); but, see In re Sentry Operating Co. of Texas Inc., 264 B.R. 850, 864 (Bankr. S.D. Tex. 2001) (categorically rejecting the notion that a chapter 11 plan may discriminate among junior creditors under a reverse cramdown rationale). Return to article
4 Cf. In re Exide Technologies, 303 B.R. 48, 77 (Bankr. D. Del. 2003) (wherein the court appeared to acknowledge the potential permissibility of a reverse cramdown plan but found that the reverse cramdown rationale was not applicable in the case before it because the debtor's secured lenders were oversecured). Return to article
7 See, e.g., Continental Insurance Co. v. Schneider, 810 A.2d 127, 133 (Pa. Super. 2002) (a foreclosure "sale pursuant to §9504 of the UCC does not, as a matter of law, preclude a creditor's claim against the purchaser based upon successor liability;" Equal Employment Opportunity Commission v. SWP Inc., 153 F. Supp. 911 (N.D. Ind. 2001) (EEOC could seek to enforce sexual harassment judgment against an entity that purchased assets of judgment debtor pursuant to friendly foreclosure); Ed Peters Jewelry Co. Inc. v. C & J Jewelry Co. Inc., 124 F.3d 252, 267 (1st Cir. 1997) ("existing case law overwhelmingly confirms that an intervening foreclosure sale affords an acquiring corporation no automatic exemption from successor liability"); Glynwed v. Plastimatic Inc., 869 F. Supp. 265, 274 (D. N.J. 1994) ("a corporation may held liable for the debts and liabilities of a corporation whose assets it purchased at a UCC foreclosure sale"). Return to article
10 See, e.g., Beal Bank S.S.B. v. Waters Edge Limited Partnership, 248 B.R. 668, 679-680 (D. Mass. 2000) (secured creditor's right to credit bid the full amount of its secured claim pursuant to 11 U.S.C. §363(k) does not apply or extend to auctions or sales of the equity in the reorganized debtor). Return to article
11 Sen. Report (Judiciary Committee) No. 95-598, p. 127, reprinted in 1978 U.S.C.C.A.N. 5913. The Senate Judiciary Committee Report goes on to provide an example that is very similar to the hypothetical posed in this article. Return to article
12 124 Cong. Rec. H. 11089 (Remarks of Rep. Edwards) (Sept. 28, 1978), reprinted in 1978 U.S.C.C.A.N. 6436, 6477 ("Contrary to the example contained in the Senate report, a senior class will not be able to give up value to a junior class over the dissent of an intervening class unless the intervening class receives the full amount, as opposed to value, of its claims or interests"); 124 Cong. Rec. S 11089 (Remarks of Sen. DeConcini) (Oct. 6, 1978), reprinted in 1978 U.S.C.C.A.N. 6505, 6546 (same); see, also, Klee, K., "All You Ever Wanted to Know About Cramdown Under the New Bankruptcy Code," 53 Am. Bankr. L. J. 133, 144 (Spring 1979) ("a dissenting class of unsecured creditors that is not provided for in full will be able to prevent confirmation of a plan in which a class of senior claims proposes to give value to a class lower in priority to the dissenting class—for example, a class of equity interests"). Return to article
13 For outside commentary suggesting that reverse cramdown plans are a permissible method of defeating potential absolute priority objections, see Breach, R., "LaSalle, the "Market Test" and "Competing Plans: Still in the Fog," 21 Am. Bankr. Inst. J. 18, 50 (January 2003) ("The senior classes are free to allocate their property as they wish without violating the absolute priority rule."); Houser, B., "Disclosure Statements, Confirmation and Cramdown of Chapter 11 Plans," SH054 ALI-ABA 337, 383 (May 2003) ("Similarly, the absolute priority rule is not violated where the value being given to old equity comes from funds which would otherwise be distributed to a senior class but is instead distributed to old equity with the senior class's consent"). Return to article