Bankruptcy courts have substantial discretion to modify the terms of loan agreements through reorganization plans.1 On Dec. 30, 2011, Judge Eileen Hollowell of the U.S. Bankruptcy Court of Arizona exercised this discretion and approved a controversial reorganization plan (the Plan) for Transwest Resort Properties and its affiliates (collectively Transwest).2 The Plan makes significant modifications to many of the material provisions in the loan documents of the senior secured claimant, JPMCC 2007 C-1 Grasslawn Lodging (JPMCC).3
Specifically, the Plan extended the remaining term of the loan from 2017 to 2033, increased the principal amount of the loan from approximately $200 million to $240 million, and cut the interest rate of the loan from 5.625 percent to 5.25 percent.4 The Transwest resorts, which constituted JPMCC’s collateral under the loan documents, were valued at $92.5 million and Transwest’s indebtedness amounted to approximately $247 million.5 JPMCC objected to the proposed Plan because of its extreme modifications to the original loan documents.6
The court in Transwest found that the Plan was fair and equitable and confirmed the Plan under what is commonly known as the cramdown provision of the U.S. Bankruptcy Code.7 The court’s approval of the Plan is concerning because of the extent to which the Plan makes extreme modifications to the original loan agreements. The extent of the court’s modifications to the original loan documents has already sent ripples through the real estate finance industry.8
Fair and Equitable Cramdown
In order for a bankruptcy court to cramdown a reorganization plan, the plan: (1) must meet all of the requirements in 11 U.S.C.A. §1129(a), except for §1129(a)(8);9 (2) must be fair and equitable with respect to the claimholders who reject the plan; and (3) cannot discriminate unfairly against differing classes of claims.10 The controversy in Transwest focuses on whether the cramdown bankruptcy plan satisfies the fair and equitable requirement. Courts determine whether a plan is fair and equitable on a case-by-case basis.11
The fair and equitable requirement can be satisfied by meeting one of three alternative provisions.12 Under the first alternative, the plan must preserve the impaired claimholders’ liens regardless of whether the property is retained by the debtor or transferred to another entity.13 The plan must provide that each impaired claimholder receives “deferred cash payments totaling at least the allowed amount of such claim” that, as of the date of the plan, are equal to the value of the claimholder’s interest “in the estate’s interest in such property.”14 This alternative requires that the claimholder receive the present value of its secured claim, which includes the present value of accrued interest on an existing oversecured claim, as well as interest for the period after the plan is enacted.15
The second alternative requires that the plan provides for the sale of any property that is subject to the lienholders’ liens under 11 U.S.C.A. §363(k).16 The sale provision must ensure that the claimholders’ liens attach to the proceeds of the sale and the treatment of such liens on proceeds must comply with one of the other two available alternatives.17 At any such sale, the claimholder shall be given an opportunity to credit-bid on its debt.
The Supreme Court recently emphasized that unless the lienholder is given an opportunity to credit-bid, the plan cannot be confirmed.18 The debtor, a commercial real estate developer, proposed selling the majority of its collateral at an auction and paying the secured creditor, a bank, with the sale proceeds.19 Under the debtor’s plan, however, the bank would not be allowed to place a bid for the collateral property with the debt it was owed—a credit bid—for the original loan it had provided.20Like other potential bidders, the bank would be forced to make a cash bid under the plan.21 When the creditor objected on the basis of its 11 U.S.C.A. §1129(b)(2)(A) right to credit-bid, the debtor alleged that a cash payment of the sale proceeds would provide the bank with the indubitable equivalent of its secured claim, which Justice Antonin Scalia, in a unanimous opinion, dismissed as a “hyperliteral and contrary to common sense reading” of the statute.22
Under the third alternative, the plan must provide a claimholder with the ability to realize the “indubitable equivalent” of their claim.23 To constitute an “indubitable equivalent,” the replacement collateral must “compensate for present value and insure the safety of the principal.”24 These two components—compensation for present value and safety of the principal—require an examination of the available alternative collateral substitutes for the claim as well as the new risks placed on the creditor.25
In order to satisfy the “indubitable equivalent” requirement, a reorganization plan must provide substitute collateral that is not speculative, must present a very small possibility that the holder’s claim will become unsecured, must not raise the creditor’s risk exposure, and it must be likely that the value of the substitute collateral will increase.26 Pursuant to the Plan approved by the court for Transwest, the reorganized debtors retain the collateral property and do not provide an “indubitable equivalent,” so the fair and equitable analysis hinges on the remaining two alternatives.
Bankruptcy courts across the country have reached a wide range of decisions on the issue of whether a cramdown reorganization plan satisfies the fair and equitable requirement.27 For example, one bankruptcy court held that a reorganization plan was fair and equitable to the secured creditor of a franchisee hotel debtor because the debtor’s plan provided “for the termination of the existing equity interests, and the issuance of new equity interests” to the new owner of the property without circumventing the creditors’ §1129 rights.28
Similarly, another bankruptcy court held that a reorganization plan which extended the term of the loan from ten years to twelve years was fair and equitable to the secured creditor.29 The court noted that the reorganization plan provided for the claimholder to retain its lien, incorporated a reasonable interest rate for the claimholder to receive the present value and included a fair adjustment of 2.25 percent to the prime rate.30 Moreover, the court determined that the debtors could make their scheduled payments under the extended plan, that the claimholder was oversecured, and that the collateral was not likely to depreciate in value.31 The court’s justification for extending the term of the loan included a review of the lender’s general practices, which evidenced a willingness to make 10-year loans as opposed to five-year loans, like the loan at issue in the case.32
Other bankruptcy courts have held that certain reorganization plans violate the fair and equitable standard. For example, a bankruptcy court held that a proposed reorganization plan was not fair and equitable because it prejudiced the lienholder by giving insider investors a cash flow note on the effective date of the agreement and allowed the insider investors’ cash flow note to “be paid in full at any time [after two years] so long as the debtor [was] not otherwise in default under the plan.”33 The court based its ruling on the fact that the insider investors could “be paid in full long before the [claimholder] received payment of its principal debt.”34
Finally, in another proceeding, the court denied confirmation of the proposed reorganization plan because it provided a variable interest rate for repayment and §1129 requires a fixed interest rate for present value calculations.35 In addition, the plan restricted the lender’s ability to pursue claims against the debtor’s third-party guarantors and therefore violated the fair and equitable standard.36
As demonstrated by this wide range of decisions, bankruptcy courts outside of New York have reached varying conclusions with respect to the fair and equitable nature of their respective cramdown plans.
New York’s Bankruptcy Courts
New York bankruptcy courts have generally adopted an approach to the fair and equitable analysis that emphasizes judicial deference to negotiated, pre-bankruptcy filing agreements and avoids the extreme loan modifications approved by the Transwest court.37 In a case decided earlier this year by the Bankruptcy Court for the Southern District of New York, the debtor, a real estate owner, submitted a reorganization plan and contended that the late payment premium and the default interest rate provision in its original loans were unfair and inequitable.38 The court noted that the creditor and the debtor were both sophisticated parties negotiating at arms-length and held that notwithstanding a seemingly high default rate, the court would not impose “its own notions of fairness and equity.”39 The New York Court of Appeals has also emphasized its deference to sophisticated parties with “even greater force in the context of real property transactions where commercial certainty is a paramount concern and where…the instrument was negotiated between sophisticated, counseled business people negotiating at arm’s length.”40 If an agreement concerns a real property transaction, a New York court will be even more loathe to modify the agreement’s terms.41
Bankruptcy courts in New York are not inclined to approve reorganization plans that include dramatic modifications to material terms of the claimholder’s loan. In the case of In re Dindiyal,42 the secured claimholder objected to the debtor’s plan on the grounds that it was not fair and equitable…because it proposes to greatly reduce the interest payable to [the secured claimholder] and to unduly extend the term of the [secured claimholder's] mortgages.”43 The court held that the plan was not fair and equitable because the debtor’s plan would have extended the term of the loans by an average of 6.2 years. The court also observed that lenders were reluctant to make long-term loans with low rates because of economic uncertainty within the market.44 Although decisions such as Transwest and others in bankruptcy courts around the country45 are disconcerting to lenders, thus far, bankruptcy courts in New York have not shown a willingness to approve these extreme loan modifications as fair and equitable.
After the court’s confirmation order in Transwest, JPMCC immediately appealed the order approving the Plan,46 and the U.S. District Court of Arizona may yet address the fairness and equity issues in dispute. The real estate finance industry will be following the Transwest developments very closely. Of utmost concern to the industry is the potential adoption of the Transwest decision’s rationale in other jurisdictions. While New York bankruptcy courts have interpreted the application of the cramdown provision differently than the Arizona bankruptcy court, as this and other decisions from across the country illustrate, the fair and equitable analysis has yielded wide-ranging results.
Jeffrey B. Steiner and Jason R. Goldstein are members of DLA Piper. Michael Volodarsky, a summer associate at the firm, assisted in the preparation of this article.
1. See e.g., In re TCI 2 Holdings, 428 B.R. 117, 167 (Bankr. D.N.J. 2010); In re Stratford Assoc., 145 B.R. 689, 703 (Bankr. D. Kan. 1992); In re Airadigm Commc’ns, 519 F.3d 640, 654-55 (7th Cir. 2007).
2. In re Transwest Resort Prop., No. 10-37134 (Bankr. D. Az. Dec. 30, 2011).
5. Memorandum In Support of Confirmation of Third Amended and Restated Joint Plan of Reorganization, In re Transwest Resort Prop., No. 10-37134 (Nov. 27, 2011).
6. Objection to Second Amended and Restated Joint Plan of Reorganization, In re Transwest Resort Prop., No. 10-37134 (Nov. 23, 2011).
7. 11 U.S.C.A. §1129(b).
8. See e.g., Al Yoon, Commercial Investors Fear New Precedent Set for ‘Extend and Pretend’, Wall Street Journal (May 10, 2012, 7:19 PM), http://blogs.wsj.com/developments/2012/05/10/commercial-investors-fear-new-precedent-set-for-extend-and-pretend.
9. This statutory section pertains to acceptance of the reorganization plan, which is obviated by a cramdown.
10. 11 U.S.C.A. §1129(b)(1).
11. In re Grandfather Mountain, 207 B.R. 475, 487 (Bankr. M.D.N.C. 1996).
12. 11 U.S.C.A. §1129(b)(2)(A).
13. 11 U.S.C.A. §1129(b)(2)(A)(i).
15. In re N.S. Garrott & Sons, 48 B.R. 13 (Bankr. E.D. Ark. 1984).
16. 11 U.S.C.A. §11229(b)(2)(A)(ii).
17. 11 U.S.C.A. §363(k).
18. Radlax Gateway Hotel v. Amalgamated Bank, No. 11-166, slip op. at *10 ( May 29, 2012).
19. Id. at *2.
20. Id. at *3.
23. 11 U.S.C.A. §11229(b)(2)(A)(iii).
25. In re Weiersma, 324 B.R. 92 (B.A.P. 9th Cir. 2005).
27. In re Associated Wood Products, 323 B.R. 479 (Bankr. D. Minn. 2005); In re Bravo Enter. USA, 331 B.R. 459 (Bankr. M.D. Fla. 2005); In re Bryant, 439 B.R. 724 (Bankr. E.D. Ark. 2010); In re Hickey, 370 B.R. 219 (Bankr. D. Neb. 2007); In re Prussia Associates, 322 B.R. 572 (Bankr. E.D. Pa. 2005); In re Riverbend Leasing, 458 B.R. 520 (Bankr. S.D. Iowa 2011); In re Smithfield Estates, 52 B.R. 220 (Bankr. D.R.I. 1985).
28. Bravo, 331 B.R. at 477.
29. Bryant, 439 B.R. at 729.
30. Id. at 744.
33. In re Prussia Associates, 322 B.R. 572, 595 (Bankr.E.D. Pa. 2005).
35. In re Associated Wood Products, 323 B.R. 479 (Bankr. Minn. 2005).
36. Id. at 483.
37. See e.g., In re 785 Partners, 470 B.R. 126 (Bankr. S.D.N.Y. 2012); In re Johns–Manville, No. 11 Civ. 1312(JGK), 2012 WL 667084, at*10 (S.D.N.Y. March 1, 2012) (“New York law is clear that subjective notions of fairness or equity are not a permissible basis for a court to rewrite a contract or to excuse compliance with conditions precedent”); Law Debenture Trust of N.Y. v. Maverick Tube, 595 F.3d 458, 468 (2d Cir. 2010) (“If the agreement on its face is reasonably susceptible of only one meaning, a court is not free to alter the contract to reflect its personal notions of fairness and equity”) (citations and alteration omitted); Cruden v. Bank of N.Y., 957 F.2d 961, 976 (2d Cir. 1992) (“A court may neither rewrite, under the guise of interpretation, a term of the contract when the term is clear and unambiguous…nor redraft a contract to accord with its instinct for the dispensation of equity upon the facts of a given case.”) (citation omitted).
38. 785, 470 B.R. at 131.
39. Id. at 132.
40. Wallace v. 600 Partners, 86 N.Y.2d 543, 634 (1995).
42. 1993 WL 540373 (E.D.N.Y. Sept. 30, 1993).
43. Id. at *3.
45. See e.g., Richardson v. The Gifford State Bank (In re Crane), Adv. Pro. No. 11-9067 (Bankr. C.D. Ill. 2011).
46. Notice of Appeal, In re Transwest Resort Prop., No. 10-37134 (Jan. 3, 2012).