The Impact of Potential Avoidance Actions on the Best Interests of Creditors Test in Contested Plan Confirmation

The Impact of Potential Avoidance Actions on the Best Interests of Creditors Test in Contested Plan Confirmation

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Unsecured creditors faced with cramdown plans, after exhausting all of their "good faith" and other similar types of arguments, frequently rely heavily on the so-called "best interests" of creditors test found in Bankruptcy Code §1129(a)(7)(A). This test, of course, requires that with respect to a plan, each creditor receives as much as it would receive in a chapter 7 bankruptcy unless that creditor affirmatively votes for other treatment. The "best interests" test is applicable to each claim, not to a class of claims, and therefore applies presumably even if the plan is not a cramdown plan. Moreover, it applies as long as there is a single dissenting creditor.

In a recent decision out of the Eastern District of California, the impact of potential avoidance actions on the so-called "best interests" test was examined in the plan confirmation context. See In re Sierra-Cal, B.R. , 1997 WESTLAW 369711 (Bankr. E.D.Cal. June 27, 1997). In Sierra-Cal, the debtor had substantial debts due and owing to insiders, all of whom had relationships with an individual who owned over 90 percent of the stock of the debtor (directly and through affiliates) and who was the control person for the debtor corporation. The debtor was seeking confirmation of a plan which provided for payments to the insider creditors as well as the other creditors.

In the Sierra-Cal case, the debtor was attempting to treat an insider claim as secured because of an unperfected personal property security interest, a portion of which had been paid without court authorization post-bankruptcy. The plan also provided that the existing stockholders would retain their interests.

At the confirmation hearing, a creditor objected to the treatment of the secured insider because of the alleged avoidability of that insider's lien (i.e., it was allegedly avoidable under §544). The debtor made an oral modification to the plan at the confirmation hearing to treat the secured claim as unsecured in an effort to avoid denial of confirmation.

The court denied confirmation of the plan upon a finding that it did not meet the "best interests" test. The court held that the existence of potential avoidance actions against creditors (in this case, insider creditors) must be taken into account in determining if the "best interests" test is met. Specifically, Code §502(d) requires mandatory claim disallowance of any claim of any entity from which property is recoverable by a trustee, or that is the transferee of an avoidable transfer, unless and until the property is turned over and the transfer is paid.[1]

The court in Sierra-Cal decided that because the insider secured creditor had an avoidable lien (the granting of a lien is also considered a "transfer"), in order to do a "best interests" analysis the court needed to consider what the recovery to creditors would be without taking into account any amount for the claim of the insider creditor that received the avoidable transfer. In a hypothetical chapter 7 liquidation, the court determined that the claims of insider creditors who received potential avoidable transfers would not be payable from the assets of the estate under §502(d). The court further ruled that the merits of potential avoidance actions need not be adjudicated before imposing the "§502(d) disability." Accordingly, a hypothetical liquidation distribution should not consider any recovery to those insider creditors. In the Sierra-Cal case, without considering the insider claims, creditors would be paid 100 percent. Those creditors were obviously not receiving 100 percent under the plan. Accordingly, the court held that the "best interests" test was not met and therefore the plan could not be crammed down on the non-insider creditors.[2]

Finally, the court also found that confirmation was not appropriate because of inadequate disclosure under §1125. Specifically, the court held that a plan proponent is under an affirmative duty to disclose potentially avoidable transfers, and every plan proponent must provide a §502(d) analysis as part of its hypothetical chapter 7 liquidation. If the disclosure statement fails to address that, it did not disclose adequate information and as such the plan proponent did not comply with the applicable provisions of the Bankruptcy Code.

The Sierra-Cal case is interesting, particularly when dealing with contested plan confirmation in which there is substantial insider debt. It implicitly requires that debtor's counsel must do an actual claims analysis to determine potential avoidance actions (presumably not only with respect to insiders, but all creditors), and according to Bankruptcy Judge Klein, the plan proponent is under an affirmative duty to disclose the existence of potential avoidance actions. While Judge Klein recognizes that "plan proponents may be reluctant to disclose potentially avoidable transfers that they prefer not to challenge, every plan proponent who would rely on the 'best interests' test must include a liquidation analysis in the disclosure statement.[3] As the §502(d) question can be central to the hypothetical chapter 7 liquidation, it must be addressed in the disclosure statement as part of the liquidation analysis, if only to assert that there are no known potential §502(d) disabilities or that the known §502(d) disabilities would not affect the liquidation analysis with respect to a particular class." Sierra-Cal, 1997 WESTLAW at 6. In the defective plan being shot down in Sierra-Cal, the court found that because the disclosure statement did not include this §502(d) analysis in the disclosure statement, the plan could also not be confirmed because it violated §1125 (i.e., had inadequate disclosure), and as such the plan proponent did not comply with the applicable provisions of the Bankruptcy Code as required by §1129(a)(2). This separate and distinct failure independently precluded confirmation.

The Sierra-Cal decision, if widely accepted, puts the plan proponent in an interesting and delicate situation. In order to pass muster under the Sierra-Cal standard, a plan proponent must fully disclose any and all potential avoidance actions against insiders, and in addition must take the existence of those actions (even if the plan proponent ultimately believes that they might not be successful in avoidance litigation) when doing the "best interests" test for contested plan confirmation purposes. The Sierra-Cal case provides an interesting way for disgruntled unsecured creditors to attack confirmation of a cramdown plan.


[1]A "transfer" would also include the incurrence of a liability, not just payments or transfers of property.

[2] As set forth above, in an effort to avoid denial of confirmation, debtor's counsel attempted to orally modify the plan to, in essence, have the insider lien voided. The court ruled that the oral modification changing the insider secured claim to an unsecured claim did not remedy the problem because, even assuming an unsecured claim existed, this would further dilute the recovery to the unsecured creditors.[RETURN TO TEXT]

[3] It is unclear what Judge Klein refers to when he identifies plan proponents who "would rely on the ‘best interests' test." The best interests test is not, of course, discretionary, but must be met as a mandatory plan confirmation standard as long as there is one dissenting creditor. Indeed, the court is required to assess this issue even if no parties raise it since the plan proponent must establish the requirements for plan confirmation by a preponderance of the evidence. SeeIn re Briscoe Ent. Ltd., 994 F.2d 1160 (5th Cir. 1993).[RETURN TO TEXT]

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Monday, September 1, 1997
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