The U.S. Court of Appeals for the Fifth Circuit recently issued two decisions that affect a borrower’s ability to confirm a bankruptcy plan, Western Real Estate Equities, L.L.C. v. Village at Camp Bowie I, L.P. (In re Village at Camp Bowie I, L.P.) and Wells Fargo Bank National Association v. Texas Grand Prairie Hotel Realty, L.L.C. (In re Texas Grand Prairie Hotel Realty, L.LC.). Village at Camp Bowie makes it easier for a borrower to obtain the votes necessary to confirm a plan and Texas Grand Prairie addresses the interest rate that a borrower can force upon a lender under a plan. Although these decisions do not prevent a lender from successfully challenging a plan, they do level the playing field.
In re Village at Camp Bowie I, L.P.
Village at Camp Bowie I, LLC owned a real estate development in Fort Worth, Texas that had defaulted on its loan from its lender. Upon the expiration of its final forbearance period, Western Real Estate Equities, L.L.C., which had acquired the notes, posted the real property for a nonjudicial foreclosure. On August 2, 2010, just one day before the scheduled foreclosure sale, Village at Camp Bowie filed a Chapter 11 bankruptcy petition, which stayed the foreclosure sale. As of the filing of the bankruptcy petition, the two general classes of creditors that had claims against the borrower were Western, which was owed $32,112,711, and 38 trade creditors, which were owed $59,398 in total. The bankruptcy court valued the real property at $34 million; thus, Western was an oversecured creditor.
Village at Camp Bowie proposed a plan that separately classified Western and the trade creditors as the only two impaired classes entitled to vote. Village at Camp Bowie proposed that (a) Western would receive a five-year note for the full amount of its secured claim at an interest rate of 5.84% per annum and with a balloon payment at maturity; (b) trade creditors would receive the full amount of their claim, without interest, three months after the effective date; and (c) prepetition owners would provide a capital contribution of $1.5 million in consideration for equity of the reorganized entity. All of the trade creditors voted in favor of the plan, which the bankruptcy court confirmed over Western’s objection.
On appeal, Western contended that Village at Camp Bowie artificially impaired the class of trade creditors to satisfy Bankruptcy Code § 1129(a)(10), which requires that at least one class of impaired claims vote to accept the plan. According to Western, the claims of trade creditors would not have been impaired if Village at Camp Bowie had paid trade creditors interest totaling approximately $900. Western asserted that the plan was not proposed in good faith (and therefore, was not confirmable pursuant to Bankruptcy Code § 1129(a)(3)) because of this artificial impairment.
The Fifth Circuit disagreed, holding that the impairment of a class of claims could be “discretionarily or economically driven.” Although the Fifth Circuit determined that § 1129(a)(10) had been satisfied, it noted that the borrower’s motives and methods in impairing a class of creditors should be considered in the context of another requirement—the need to propose a plan “in good faith and not by any means forbidden by law” pursuant to § 1129(a)(3). Nonetheless, the Fifth Circuit determined that Village at Camp Bowie’s plan had been proposed in good faith because “it had proposed a feasible cramdown plan for the legitimate purposes of reorganizing its debts, continuing its real estate venture, and preserving its non-trivial equity in its properties.”
Although Village at Camp Bowie I, L.P. provides borrowers another avenue to trigger the cramdown provisions of § 1129(b), a borrower’s strategy is constrained by the requirement that a plan be proposed in good faith. For instance, the Fifth Circuit noted that the borrower may not be able to demonstrate compliance with § 1129(a)(3) (which requires that a plan be proposed in good faith) if it, among other things, incurs debt from a related party on the eve of bankruptcy to generate the votes needed to confirm the plan of reorganization.
Moreover, the Fifth Circuit’s decision leaves unaffected many of the other weapons in a lender’s arsenal to challenge confirmation of a plan. For instance, in most circumstances, the secured lender is under- and not over-secured. As a result, unless the borrower can justify classifying the lender in a separate class from other creditors, the lender will often control the trade creditor class and the borrower will not be able to garner the votes necessary to satisfy § 1129(a)(10). Phoenix Mutual Life Insuance. Co. v. Greystone III Joint Venture (In re Greystone III Joint Venture), 995 F.2d 1274 (5th Cir. 1991). In addition, a lender may still be able to counteract the effects of artificial impairment by (a) purchasing the claims of trade creditors and voting those claims against the plan of reorganization; or (b) proposing a competing plan that pays unsecured creditors in full, thereby leaving them unimpaired.
Thus, although the Fifth Circuit’s decision in Village at Camp Bowie I, L.P. is troubling from the perspective of lenders, lenders still have other weapons to defend themselves from unacceptable plans.
In re Texas Grand Prairie Hotel Realty, L.LC.
Just four days after its decision in Village at Camp Bowie I, L.P., the Fifth Circuit issued another decision concerning Chapter 11 bankruptcy plans. Texas Grand Prairie Hotel Realty, LLC and its affiliates had obtained a $49 million loan to acquire and renovate four hotels in Texas and granted the lender a deed of trust to secure the loan, which was eventually assigned to Wells Fargo Bank National Association, which was the trustee of a trust to which the loan was transferred and which was acting through its special servicer. Texas Grand Prairie Hotel was unable to make the scheduled payments on the loan, so it filed a Chapter 11 bankruptcy petition. Texas Grand Prairie Hotel proposed a plan valuing its real property at approximately $39.1 million and issuing Wells Fargo a new note in that amount payable over seven years with interest accruing at 5% per annum. The bankruptcy court overruled Wells Fargo’s objection to the plan that the 5% interest rate was insufficient, and the district court affirmed.
At the center of the dispute in Texas Grand Prairie Hotel was Bankruptcy Code § 1129(b), which provides that a plan may be “crammed down” on a lender if, among other things, the present value of the stream of payments to be made to a dissenting lender equals the allowed amount of the lender’s claim. Relying on the Supreme Court decision in Till v. SCS Credit Corp., 541 U.S. 465 (2004), many courts have determined the appropriate discount rate by starting with the prime rate and increasing it for the risks associated with the circumstances of the borrower, the nature of the security, and the duration and feasibility of the plan. In setting forth this so-called formula approach, the Supreme Court had acknowledged that “courts have generally approved adjustments of 1% to 3%.”
The Fifth Circuit determined that bankruptcy courts should not be bound to use the “prime-plus formula” because it is too restrictive. Instead, the Fifth Circuit held that the bankruptcy court should determine the appropriate discount rate based on the facts and circumstances of the case at hand. The Fifth Circuit refused to “tie the bankruptcy courts to a specific methodology as they assess the appropriate Chapter 11 cramdown rate of interest.”
Despite its holding, the Fifth Circuit analyzed the appropriate discount rate utilizing the prime-plus formula because the parties had stipulated that it was appropriate. Concluding that the risk of default of the borrower was “just to the left of the middle of the risk scale” and relying on the Supreme Court’s observation that adjustments generally fall between 1% and 3%, the borrower’s expert reasoned that an appropriate risk adjustment would be 1.75% above the prime rate of 3.25%. In contrast, Wells Fargo’s expert utilized the “capital stack” method pursuant to which the interest rate is calculated by taking the weighted average of rates of return that the market would charge for a financing package composed of senior debt, mezzanine debt and equity. Utilizing this method, Wells Fargo took the position that it was entitled to a cramdown rate of 8.8%. The Fifth Circuit was critical of the methodology utilized by Wells Fargo’s expert because of its similarity to the “forced loan approach” that the majority of the Supreme Court rejected in Till. Therefore, it concluded that the methodology utilized by the borrower was more appropriate under the circumstances.
The Fifth Circuit’s holding in Texas Grand Prairie creates uncertainty regarding the appropriate method to calculate the cramdown interest rate (the court did not provide a bright-line test). One of the consequences of this uncertainty is likely the need for additional work by a lender’s expert to evaluate other possible formulations of the appropriate interest rate. Troubling from the perspective of lenders is the Fifth Circuit’s apparent approval of prime plus 1% to 3% being the standard range for cramdown rates. The Fifth Circuit’s holding also places significant discretion in the bankruptcy court, so it is possible that a bankruptcy court would determine that the circumstances of a given case justify a cramdown rate that is outside that range.
The recent Fifth Circuit decisions will undoubtedly augment the legal landscape with respect to the plan confirmation process. The decisions make it easier for borrowers to (a) identify an accepting class of impaired creditors, thereby potentially triggering the cramdown provisions that affect secured lenders; and (b) justify lower cramdown interest rates to provide to secured lenders. The consequence of these decisions within the Fifth Circuit will not be known until bankruptcy courts begin evaluating whether a plan that artificially impairs a class of creditors is proposed in good faith and to what extent they have discretion to set a cramdown rate greater than prime plus 1% to 3%.