When a corporate debtor files a bankruptcy petition, it often has subsidiaries, parents or other affiliates that simultaneously file their own bankruptcy petitions. Indeed, corporate structure and debt guaranties often require the co-filing of affiliated companies.

When multiple debtors file bankruptcy, the only efficient means of administration is through joint administration. Otherwise, multiple copies of the same pleading are filed and served, thereby increasing the cost to the bankruptcy estates. Also, considering the average size of plan and disclosure statements, requiring the filing and service of a separate plan and disclosure statement for each debtor can result in mass defoliation.

Congress foresaw the benefits of jointly administered cases and provided for such procedural consolidation. See Fed. R. Bankr. P. 1015. Congress did not, however, provide specific guidelines for the subsequent administration of jointly administered cases. Nor did Congress address the application of other Bankruptcy Code provisions and/or other Bankruptcy Rules to jointly administered bankruptcy estates.

Nonetheless, in an effort to save additional time and expense, joint administration naturally leads to the filing of a joint reorganization plan/liquidation, which is also not addressed in the jointly administered context. Without any such guidance, joint-plan proponents often make assumptions regarding the proper means of classification and balloting. Specifically, when jointly administered debtors, who are not substantively consolidated, file a joint plan, an issue arises as to whether that joint plan may place the unsecured creditors of two or more joint debtors into one class, without any subclasses, and then solicit votes for that class, as if the jointly administered debtors were previously substantively consolidated. When this occurs, the joint debtors have "cross-classified" claims, as one might cross-collateralize a loan outside of bankruptcy.

These procedures have received little attention from the judiciary, at least in published form, but can have tremendous impact on the success or failure of a joint debtors' reorganization efforts. Without much precedence, joint-plan proponents are left guessing as to the propriety of "cross-classification."

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This new form of gerrymandering can harm the substantive rights of cross-classified creditors because separate classification and balloting could prevent the confirmation of at least one debtor in a joint-debtor case.

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Classification and Substantive Consolidation

A plan may place a claim or an interest in a particular class only if such claim or interest is substantially similar to the other claims or interests of such class. See 11 U.S.C. §1122(a). Section 1122, however, does not address the classification of claims against different debtors in a joint plan. Yet such a classification is frequently used in joint plans that contemplate substantive consolidation of joint debtors upon confirmation. When that occurs, creditors of debtor A vote equally to accept the plan on behalf of debtor A, debtor B and debtor C, even though they are not creditors of debtors B and C.

The problem is that a creditor of one debtor cannot vote to accept the plan of another debtor because it does not have a claim against that separate debtor. See 11 U.S.C. §502. In addition, the Code expressly provides that "[t]he holder of a claim or interest allowed under §502 of this title may accept or reject a plan." See 11 U.S.C. §1126(a). Thus, pursuant to §§502 and 1126(a), a creditor of debtor A cannot vote to accept the plan of debtor B, unless debtors A and B have substantively consolidated their bankruptcy estates, or the creditor otherwise has a claim against debtor B.

In fact, quite often, joint debtors file a joint plan that contemplates substantive consolidation for purposes of voting and distributions. However, such provisions have no binding effect until the court enters an order that substantively consolidates the debtors' bankruptcy estates. Until such an order is entered, joint debtors are not substantively consolidated, particularly not for voting purposes. See In re N.S. Garrott & Sons, 48 B.R. 13, 17 (Bankr. E.D. Ark. 1984). In fact, a court has an obligation to make an independent inquiry into the necessity and desirability of substantive consolidation, which prevents substantive consolidation via mere suggestion. See Id. at 18; see, also, Fed. R. Bankr. P. 1015(a). Clearly, joint debtors that wish to file a joint plan without classifying creditors by class and bankruptcy estate must seek an order on substantive consolidation before filing such a joint plan.

In addition, a court must also consider that a benefit/detriment analysis similar to the substantive consolidation analysis, as a joint plan that pools assets of different bankruptcy estates, may very well run afoul of 11 U.S.C. §1129(a)'s confirmation requirements. Specifically, §1129(a)(7)(A) requires that, with respect to an impaired class of claims or interests, each holder has accepted the plan, or will receive or retain property of a value that is not less than the amount that such holder would receive or retain if the debtor were liquidated under chapter 7. In contrast to §1122, which references "debtor" and "debtors," §1129(a) (7)(A)(ii) makes clear that the liquidation analysis is particular for both creditor and debtor. And, regardless of the asserted benefits of the proposed plan, a debtor cannot cram down a §1129(a)(7)(A)(ii) objection, only a §1129(a)(8) objection. See 11 U.S.C. §1129(b)(1).

Thus, the obvious objection to cross-classification is where one debtor has substantial assets, while another debtor has few assets. In certain circumstances, such as a liquidating plan, the classification of creditors of joint debtors into one class is of benefit to the insolvent debtor's bankruptcy estate, but improperly dilutes the value of the solvent debtor's bankruptcy estate.

Granted, if joint debtors guaranteed and/or cross-collateralized their obligations, such cross-classification has no impact. But when one considers the various exits from bankruptcy that a plan may propose, a real issue exists as to the propriety of classifying creditors of more than one bankruptcy estate into one class, as if there were only one bankruptcy estate, because a chapter 11 confirmation order discharges a debtor's obligations, except as provided in the plan, on the effective date of the plan. See 11 U.S.C. §1141. Thus, even a cross-classifying joint plan that proposes payment of 100 percent of general unsecured claims puts creditors' interests at risk because of the potential for a subsequent default. Such a default could result in a liquidation of assets, which implicates the aforementioned liquidation analysis. The liquidation analysis objection is in addition to a more familiar objection: gerrymandering.

Gerrymandering via Cross-classification

Even if a cross-classifying joint plan is not detrimental due to differing liquidation values, an objection to such cross-classification still exists. Specifically, joint debtors might seek to cross-classify creditors to gerrymander classes for voting purposes. For example, where debtor A has numerous unsecured creditors that will vote to accept the plan, whereas debtor B has only a few unsecured creditors and/or a very large unsecured creditor that will rule that class and will vote to reject the plan, such cross-classification is the equivalent of improper gerrymandering.

This new form of gerrymandering can harm the substantive rights of cross-classified creditors because separate classification and balloting could prevent the confirmation of at least one debtor in a joint-debtor case. Though two of three joint debtors may fulfill §1129(a)(8)'s provisions, thereby confirming the joint plan as to their bankruptcy estates, the inability to confirm the third joint debtor could prove catastrophic. Indeed, depending on corporate structure and cross-collateralization, the inability of the third debtor to confirm the joint plan as to its bankruptcy estate could effectively undermine and render moot confirmation of the joint plan as to the other two debtor's bankruptcy estates. These considerations are fact-specific and occasionally will not matter.

On the other hand, such considerations will occasionally matter and create havoc in an otherwise seemingly confirmable joint plan. Conversely, the court may require the joint debtors to amend their joint plan and/or formulate separate plans along with the corresponding disclosure and dissemination requirements. Indeed, such objections were asserted in both the WorldCom and Daisytek bankruptcy cases. Although in both cases the debtors confirmed their joint plans, or a version thereof, these cases demonstrate the potential for serious issues arising from cross-classification.

Conclusion

Neither the Bankruptcy Code nor case law provides much guidance on the cross-classification of creditors and claims in a joint plan, yet joint plans are commonplace in today's bankruptcy cases. Perhaps the lack of guidance from case law stems from the realities of many bankruptcy cases, which is that often unsecured creditors face a dismal liquidation value and distribution potential regardless of classification. Indeed, in many bankruptcy cases, the above analysis simply does not matter because the bankruptcy estates are all insolvent, and either sufficient votes exist for each debtor to confirm its own plan, or §1129(b) would allow confirmation over any objecting creditors.

However, a few cases have and will occur where there is a substantial difference in liquidation values and the effects of such cross-classification gerrymandering are of consequence. In such cases, albeit inconvenient, joint debtors are wise to seek substantive consolidation prior to plan dissemination and/or formulate separate plans and prepare for separate confirmation results.