Insider's Acquisition Of Claims To Create Accepting Impaired Class Constitutes Impermissible Gerrymandering

The strategic importance of classifying claims and interests under a chapter 11 plan is sometimes an invitation for creative machinations designed to muster adequate support for confirmation of the plan. Although the Bankruptcy Code unequivocally states that only "substantially similar" claims or interests can be classified together, it neither defines "substantial similarity" nor requires that all claims or interests fitting the description be classified together. It has been left to the courts to develop hard-and-fast rules on classification, and the results have occasionally been inconsistent or controversial. An enduringly prominent bone of contention in the ongoing plan-classification dispute concerns the legitimacy of separately classifying similar, but arguably distinct, kinds of claims in an effort to create an accepting impaired class. Sometimes referred to as class "gerrymandering," this practice was the subject of a ruling recently handed down by the Third Circuit Court of Appeals. In In re Machne Menachem, Inc., the court upheld an order vacating confirmation of a chapter 11 plan because an insider of the debtor purchased unsecured claims during the case to ensure that an impaired unsecured class would vote in favor of the plan.

Voting and Plan Confirmation in Chapter 11

A fundamental precept underpinning the chapter 11 process is that stakeholders involved in the bankruptcy case have the right to vote for or against confirmation of a chapter 11 plan that specifies how their respective claims or interests are to be treated going forward. Confirmation of a plan is possible under two circumstances: (i) the requisite majorities of creditors and equity interest holders in every "class" (explained below) vote in favor of the plan (or are deemed to do so by reason of being "unimpaired"); or (ii) despite the absence of acceptance by all classes, the plan meets certain minimum standards of fairness spelled out in the nonconsensual confirmation, or "cramdown," provisions of the Bankruptcy Code.

Voting in chapter 11 is conducted by classes, rather than individual creditors or shareholders. This means that a dissenting individual creditor or shareholder can be outvoted if the remaining class members hold enough of the claims or interests in the class to achieve the voting majorities specified in the Bankruptcy Code for class acceptance. As such, how a claim or interest is classified can have a significant impact on the debtor's prospects for confirming a chapter 11 plan a creditor, for example, whose claim is substantial enough to give it voting control of a class may be able to block confirmation.

Confirmation is possible only if at least one "impaired" class of creditors or shareholders in the plan votes to accept it (without counting insider votes). This requirement, which appears in section 1129(a)(10) of the Bankruptcy Code, operates as a statutory gatekeeper to cramdown. Cramdown is a powerful remedy it imposes a binding reorganization (or liquidation) scheme upon a body of dissenting creditors and other stakeholders predicated upon sometimes complicated judicial determinations...