Cramdown in Chapter 11: Balancing Equity and Efficiency in Bankruptcy
The aim of every chapter 11 case is to balance providing equitable treatment to pre-existing creditors with the need to try to create the most efficient outcome for the debtor possible which, in turn, will hopefully allow them to stay a going-concern long after they exit bankruptcy.
This balancing act frequently leads to tension. As I’ve written before, many think of chapter 11 as being a system typified by strict rules, procedures, and processes. While that’s certainly true, it’s also a system that has inherent ambiguity built-in and that consequently imbues the judge overseeing the case with the power to, when necessary, render decisions to clear logjams when they develop and keep the case on track.
Nowhere is this more obvious than when it comes to valuation. For chapter 7 cases there’s a certain level of intuitive fairness and objectivity to the way that “valuation” is ascertained: you just liquidate the company and tally up the cash. This cash is then dolled out based on the rule of absolute priority to creditors. So, what you get as a creditor is a predictable result of how much the company was ultimately liquidated for and where you stand in the capital structure. This makes it’s hard to argue you’ve been treated inequitably since the process is all so mechanical -- the results just are what they are.
But when it comes to chapter 11 cases, the debtor needs to place a value on the company moving forward that will inform what each class receives in consideration (if anything) in order to create their Plan of Reorganization. This is obviously a much more nebulous form of valuation than doing a straight liquidation, just as is true when valuing a healthy company for M&A purposes.
Further, the issue of valuation is complicated by the various incentives at play between the debtor and various types of creditors. From the debtor’s perspective, they’ll want as low of a valuation as possible as that’ll mean they can emerge with a slimmer capital structure. Likewise, for creditors who are getting back par via the debtor’s Plan they’d prefer as low of a valuation as possible – as long as it doesn’t crimp their own recovery any – so that the debtor can emerge with a slimmer capital structure that will make the company less likely to get into distress down the road.
However, if you’re part of an impaired class getting just a few percent (or less) in recovery pursuant to the Plan put forward by the debtor, you have an obvious incentive to argue for a higher valuation as any marginal increase in valuation will result in a marginal increase in your recovery. And if you have some likeminded creditors in your class who are equally aggrieved by their proposed recovery and believe the valuation of the debtor should be higher, you can muster up the ability to block the Plan and try to bring the debtor to the negotiating table.
This is where the judge overseeing the case needs to step in. While every judge has a wide degree of discretion in how they manage a case – with some allowing valuation fights to go on for a little while – in the end there needs to be some kind of resolution in order to get the Plan approved by the court and have the debtor exit bankruptcy. Ultimately, if one or more classes are blocking a Plan from being approved - and it appears no one is willing to budge - the judge will need to decide whether or not to cramdown the Plan or not.
Note: Since I’ll be getting into a bit more detail than you’d ever need for an interview in this post, if you have an upcoming interview make sure to focus on the types of things that will come up most (e.g., go through the traditional restructuring interview questions, make sure you have a general understanding of what restructuring investment banking is, know what structural subordination is, etc.).
Cramdown in Chapter 11
Since this is another quite long post branching in a few different directions, I’ve broken it down into a few different sections.
So, let’s back up a bit. When a company files chapter 11 they’ll need to dream up a Plan of Reorganization that places creditors into various classes, defines how each class will be treated, and then discusses how the debtor intends on implementing the Plan (among many other things).
Which of the debtor's classes are impaired or unimpaired will always be clearly laid out in a table within the debtor's PoR, like as follows:
In order for the PoR to be confirmed by the court, it must meet the requirements of Section 1129 of the Bankruptcy Code. Most importantly, Section 1129(a)(8) requires that each class of claims must either vote to accept the Plan or not be impaired (as only classes who are impaired get to vote to accept or reject the Plan).
However, if this is where the discussion ended then there would be an obvious issue: what if a class of impaired creditors simply holds the case hostage (by voting to reject the Plan) until they get the recovery value they want? This would obviously not only drag out a case, but it’d also put in jeopardy the recovery of the classes above the one blocking the case (as maybe the value of the debtor would deteriorate significantly as it wallows away in court).
With exactly this issue in mind, the Code has Section 1129(b) which allows the confirmation of a plan over the objection (rejection) of an impaired class if all other subsections of Section 1129(a) are met and the plan, “…does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.”
Therefore, when a Plan is confirmed by the court pursuant to Section 1129(b) that is what we mean by a “cramdown”. In layman’s terms, if the court deems that a Plan does not “discriminate unfairly” against rejecting class(es), that it is “fair and equitable” to rejecting class(es), and if at least one impaired class has voted to accept the Plan, then the court may force the Plan (cram it down) on those class(es) who have voted to reject it.
Below is some pretty standard language you’ll find in the Disclosure Statement accompanying any Plan of Reorganization regarding what is meant by "unfair discrimination" and "fair and equitable" in this context:
In the end, it’s not the wish of any judge to confirm a Plan via a cramdown after an impaired class has rejected it. They’d prefer for a consensual Plan to be reached that has support from all the impaired classes. However, a judge does bare the burden of knowing that prolonged Plan confirmation fights can create significant economic harm and if the Plan is deemed not to discriminate unfairly and is fair and equitable, then it is in the best interests of a wide set of stakeholders for the Plan to be consummated and for the debtor to be able to exit bankruptcy as quickly as possible.
Part of the reason I decided to write a post on cramdowns – even though it won’t really come up in interviews, beyond it being a good idea to know the definition – is to illustrate a broader point about extra-textual language.
While I suppose I’m biased, chapter 11 of the Bankruptcy Code is really quite an ingenious text and it’s especially impressive when you realize that there was nothing remotely similar to it anywhere in the world when it was adopted.
However, there are many parts of the Code that have superficially clear meaning, but that are a bit more ambiguous when you really begin to think about them. An obvious example of this is the “unfair discrimination” language contained in Section 1129(b), which the Code doesn’t define or provide an approved test for anywhere.
While at first blush the meaning may seem clear, how exactly would you define it in the context of cramming a plan down on a rejecting class? Is there a fair form of discrimination? If so, when does fair discrimination tip into the universe of the unfair?
As the world of restructuring has exploded over the past three decades – beyond the size anyone would have expected when the Code was adopted – there has needed to be extra-textual appendages added to grease the wheels of modern restructurings.
By extra-textual appendages what I’m referring to are, for lack of a better turn of phrase, generally agreed upon ways to do things that are influenced by the spirit Code, but that aren’t per se rooted in the text of the Code itself.
A recent example of this phenomenon that’s currently causing controversy in the PG&E case – far beyond what we really need to get into here – is at what level, if any, post-petition interest should be paid to unimpaired unsecured creditors when there’s a solvent debtor. The Code stays entirely silent on this issue – perhaps because no one envisioned this edge case – so a textualist reading of the Code would lead one to believe that these creditors should never get post-petition interest (as the Code says nothing about it).
However, the issue of original litigation in PG&E's case surrounded not whether these unimpaired unsecured creditors should get post-petition interest, but rather at what rate the post-petition should be at (the contractual or state law rate vs. the federal judgement rate, the latter of which is much lower). This can seem like an incredibly minor distinction, but there’s quite a spread between the two rates and the difference amounts to hundreds of millions in post-petition interest due to the sheer size of PG&E’s outstanding unimpaired unsecured debt.
Anyway, the point is that it was a forgone conclusion - agreed to by both the debtor and the creditors - that even though the Code was completely silent on the post-petition interest question for unsecured creditors, they still deserved something -- it was just a matter of what rate should be utilized. Then in Judge Ikuta’s incredible dissent on the Ninth Circuit she argued that because the text of the Code said nothing about paying post-petition interest to unimpaired unsecured creditors, these creditors deserved nothing at all (which, again, no one was even arguing for to begin with!).
Now this is all very in the weeds. But the point worth keeping in mind for those just joining the industry or those who are about to join is how many generally agreed upon and commonly used conventions (e.g., third-party releases) have no basis in the text of the Code. These things are extra-textual appendages – to use my turn of phrase – and, consequentially, there is always the risk of differences in judicial interpretation wrecking havoc on the way you had anticipated a certain case or situation unfolding.
Anyway, as discussed before venturing on this little digression, cramdowns do have a basis in the text of the Code. But you’ll frequently see arguments from sophisticated creditors within an aggrieved class over whether or not they’ve been unfairly discriminated against because of the unsettled nature of how these two words ought to be defined and the divergent tests courts will use to determine if unfair discrimination has actually occurred (hint: none of these “tests” are quantitative models with objective outputs!).
While there is no universal cramdown test, significant thought has gone into how to determine whether or not to proceed with one when issues of unfair discrimination arise within a rejecting class of creditors.
Ultimately, what’s often first looked at is whether there is any “reasonable basis” for the discrimination and whether the plan could be consummated without the discrimination being in place. Afterwards, a number of different tests could be considered (in the case of Tribune, four separate tests were considered).
Even though there is no universally agreed upon test when it comes to unfair discrimination, an increasingly popular one is the Markell test:
“A rebuttable presumption of unfair discrimination exists when there is 1) a dissenting class; 2) another class of the same priority; and 3) a difference in the plan’s treatment of the two classes that results in either a) a materially lower percentage recovery for the dissenting class (measured in terms of the net present value of all payments) or b) regardless of the percentage recovery, an allocation under the plan of materially greater risk to the dissenting class in connection with its proposed distribution.”
With that said, unfair discrimination could be overcome if the court finds a lower recovery as being consistent with what they would have achieved outside of bankruptcy or that another classes higher recovery is offset by some contributions to the reorganization of the debtor.
In the case of Mallinckrodt this year, several subclasses of Class 6 (the General Unsecured Creditors) rejected the proposed Plan of Reorganization on unfair discrimination grounds (although, since this was a quite complicated case, exactly what the unfair discrimination each subclass claimed was different).
In Judge Dorsey’s long opinion confirming the debtor’s plan, he provided a pragmatic overview of cramdowns, how courts have judged matters of unfair discrimination, and why the debtor’s proposed Plan does not unfairly discriminate against rejecting classess and thus satisfies the cramdown requirements of Section 1129(b).
This is how Judge Dorsey opened his opinion on Section 1129(b)…
“Because not all classes of creditors voted to accept the Plan or were otherwise deemed to have rejected the Plan because they are receiving no recovery, Debtors cannot comply with the requirements of Section 1129(a)(8) of the Code, which mandates that all classes of creditors must either vote to accept the Plan or receive payment in full. Therefore, to have the Plan approved, Debtors must show that the Plan ‘does not discriminate unfairly and is fair and equitable with respect to each class of claims or interests that is impaired under and has not accepted the [P]lan. In bankruptcy parlance, this is referred to as a cramdown plan. The Third Circuit has recognized that cramdown plans ‘are an antidote to one or more classes of claims holding up confirmation of an otherwise consensual plan’”.
Ultimately, Judge Dorsey found that any unfair discrimination that may arise due to differentials between the Plan’s distribution among classes is rebutted by the fact that each rejecting subclass is receiving no less than the de minimums distribution it was entitled to in the first place (as another class – Class 5, the Guaranteed Unsecured Notes – were gifting recoveries to several classes of junior creditors, albeit not all in pro rata amounts).
To that end the debtor’s (read: debtor’s advisors) put together a waterfall showing that while there’s a disparity in recoveries for Class 6 under the PoR, if the rule of absolute priority were strictly applied they would have received much less or nothing at all.
While Mallinckrodt is an incredibly sprawling case, the takeaway here should be that a level of reasonableness needs to be infused into the situation. As Judge Dorsey said when shooing away one of the subclasses of Class 6:
“Similarly, Sanofi’s argument that it suffers unfair discrimination because Class 7 Trade Creditors are receiving a 100% recovery while Class 6(f) is receiving far less also fails. Sanofi’s argument that Debtors cannot rely on Nuverra and Genesis Health because the gift is coming from Debtors, not Class 5 is plainly contradicted by the record. Both Class 6 and Class 7 are only receiving more than the de minimus recovery to which they are entitled because another creditor group is allocating its recoveries to fund the distribution. Without the gift from Class 5, Class 6 gets next to nothing. The fact that Class 7 gets a greater gift than Class 6 does no harm to Class 6 claimants.”
Just to tie up the Mallinckrodt example, you may be wondering why it is that Class 5 is giving a sizeable "gift" to these more junior classes – only a few of whom are owed anything by rule of absolute priority – to begin with.
Class 5 was entitled to a recovery of $1.37b representing 89% of its original claims of $1.54b due to having guarantees from nearly every entity within the debtor’s sprawling corporate structure. While Class 6 – some of the subclasses of whom argued they were being unfairly discriminated against – are larger in size at $5.5b, most of those comprising Class 6 have few if any guarantees and are entitled to no recovery pursuant to the rule of absolute priority. (Remember that Class 5 are the Guaranteed Unsecured Notes and Class 6 are the General Unsecured Creditors.)
However, as Judge Dorsey said in his opinion: “To avoid litigation with constituents in the other unsecured classes and facilitate settlements, the holders of Class 5 claims agreed to reallocate or ‘gift’ $228.5 million of their Entitled Recovery to Class 6 and Class 7.” The size of this gift was ultimately decided through mediation between the debtor and the Unsecured Creditor’s Committee (UCC).
Something that takes awhile to get your head around can be just how many ambiguous situations arise in a chapter 11 case, especially a complex one like Mallinckrodt, and how those ambiguities can lead to unpredictable outcomes. There’s no per se right valuation for Mallinckrodt that should have been used by the debtor, no per se right amount (if any) Class 5 should have gifted to other classes (before mediation only $100m was offered!), and it wasn’t inevitable (although it was likely) that Judge Dorsey would shoo away the unfair discrimination claims of the rejecting subclasses of Class 6.
But this is what makes chapter 11 cases interesting: while there is a mechanical process at play, there are also always ambiguous situations that arise that can massively influence the direction of the case (sometimes due to the views of the judge overseeing the case, which is partly why venue selection is so important).
As per usual, this post was much longer than I originally intended it to be. However, it struck me as worthwhile to use this post to lightly introduce the concept of extra-textual impact, ambiguities that are going to exist in every chapter 11 case, and the power invested in the court to make final decisions to get cases done as quickly as possible (trying to balance the equitable treatment of creditors with the need to efficiently reach a conclusion that they believe maximizes the value of the estate, and thus the recovery values of all the creditors).
With all that said, it’s important to recognize that for interview purposes this is all well beyond the scope of what you need to know (although you should know the basic definition of a cramdown, which just involves the court approving a Plan despite an impaired class rejecting it). Beyond that, what you should takeaway from this post is that while all chapter 11 processes follow a familiar script, when you dig a bit deeper a number of ambiguities begin to crop up that give rise to many difficult questions (thankfully this is the case, as otherwise the amount of fees that could be charged by restructuring bankers and lawyers would be much harder to justify!).