Second Circuit Weighs In On Bankruptcy Code V. Chapter 11 Plan Impairment And The Solvent-Debtor Exception

• Jurisdiction: United States,Federal
• Law Firm: Jones Day
• Subject Matter: Insolvency/Bankruptcy/Re-structuring, Insolvency/Bankruptcy
• Author: Mr Dan Prieto and Mark Douglas
• Published date: 31 March 2023

A handful of recent high-profile court rulings have considered whether a chapter 11 debtor is obligated to pay postpetition, pre-effective date interest ("pendency interest") to unsecured creditors to render their claims "unimpaired" under a chapter 11 plan in accordance with the pre-Bankruptcy Code common law "solvent-debtor" exception requiring a solvent debtor to pay pendency interest to unsecured creditors. The U.S. Court of Appeals for the Second Circuit weighed in on this question in In re LATAM Airlines Grp. S.A., 55 F.4th 377 (2d Cir. 2022).

The Second Circuit ruled as a matter of first impression that a claim is "impaired" within the meaning of the Bankruptcy Code only when a chapter 11 plan, rather than the Bankruptcy Code, alters the creditor's legal, equitable, or contractual rights. It also ruled as a matter of first impression that the solvent-debtor exception requiring a solvent debtor to pay pendency interest to unsecured creditors to render their claims unimpaired survived the enactment of the Bankruptcy Code.

The Bankruptcy Code's Priority Scheme

The Bankruptcy Code sets forth certain priority rules governing distributions to creditors in both chapter 7 and chapter 11 cases. Secured claims enjoy the highest priority under the Bankruptcy Code. See generally 11 U.S.C. ' 506. The Bankruptcy Code then recognizes certain priority unsecured claims, including claims for administrative expenses, wages, and certain taxes. See id. ' 507(a). General unsecured claims come next in the priority scheme, followed by any subordinated claims and the interests of equity holders.

In a chapter 7 case, the order of priority for distributions on unsecured claims is determined by section 726 of the Bankruptcy Code. The order of distribution ranges from payments on claims in the order of priority specified in section 507(a), which have the highest priority, to payment of any residual assets after satisfaction of all claims to the debtor, which has the sixth or lowest priority. Fifth priority in a chapter 7 liquidation is given to "interest at the legal rate from the date of the filing of the petition" on any claim with a higher liquidation priority, including various categories of unsecured claims. See id. ' 726(a)(5).

Distributions are to be made pro rata to parties of equal priority within each of the six categories specified in section 726. If claimants in a higher category of distribution do not receive full payment of their claims, no distributions can be made to parties in lower categories.

In a chapter 11 case, the chapter 11 plan determines the treatment of secured and unsecured claims (as well as equity interests), subject to the requirements of the Bankruptcy Code.

Impairment of Claims Under a Chapter 11 Plan

Creditor claims and equity interests must be placed into classes in a chapter 11 plan and treated in accordance with the Bankruptcy Code's plan confirmation requirements. Such classes of claims or interests may be either "impaired" or "unimpaired" by a chapter 11 plan. The distinction is important because only impaired classes have the ability to vote to accept or reject a plan. Under section 1126(f) of the Bankruptcy Code, unimpaired classes of creditors and interest holders are conclusively presumed to have accepted a plan. Section 1126(g) provides that classes of creditors or interest holders that receive or retain nothing under a plan are deemed not to have accepted the plan.

Section 1124 provides that a class of creditors is impaired under a plan unless the plan: (i) "leaves unaltered the legal, equitable, and contractual rights" to which each creditor in the class is entitled; or (ii) cures any defaults (with limited exceptions), reinstates the maturity and other terms of the obligation, and compensates each creditor in the class for resulting losses.

Section 1124 originally included a third option, then section 1124(3), for rendering a claim unimpaired'by providing the claimant with cash equal to the allowed amount of its claim. In In re New Valley Corp., 168 B.R. 73 (Bankr. D.N.J. 1994), the court ruled that, in light of this third option, and because sections 726(a)(5) and 1129(a)(7) of the Bankruptcy Code (described below) are applicable in a chapter 11 case only to impaired creditors, a solvent debtor's chapter 11 plan that paid unsecured claims in full in cash, but without pendency interest, did not impair the claims. The perceived unfairness of New Valley led Congress to remove this option from section 1124 of the Bankruptcy Code in 1994. Since then, most courts considering the issue have held that, if an unsecured claim is paid in full in cash with pendency interest at an appropriate rate, the claim is unimpaired under section 1124. See, e.g., In re PPI Enterprises (U.S.), Inc., 324 F.3d 197, 205-07 (3d Cir. 2003).

Section 1124(1) "define[s] impairment in the broadest possible terms," so that "any change in legal, equitable or contractual rights creates impairment." In re Taddeo, 685 F.2d 24, 28 (2d Cir. 1982); accord PPI, 324 F.3d at 202 ("If the debtor's Chapter 11 reorganization plan does not leave the creditor's rights entirely 'unaltered,' the creditor's claim will be labeled as impaired under ' 1124(1) of the Bankruptcy Code."); In re L&J Anaheim Assocs., 995 F.2d 940, 942 (9th Cir. 1993) (adopting the Taddeo approach).

However, the Third, Fifth, and Ninth Circuits have concluded that, because section 1124(1) expressly refers to impairment imposed by a "plan," it does not apply to modifications that occur by operation of the Bankruptcy Code. See PPI, 324 F.3d at 204 ("[A] creditor's claim outside of bankruptcy is not the relevant barometer for impairment; [courts] must examine whether the plan itself is a source of limitation on a creditor's legal, equitable, or contractual rights."); In re Ultra Petroleum Corp., 943 F.3d 758, 763 (5th Cir. 2019) ("The plain text of ' 1124(1) requires that 'the plan' do the altering. We therefore hold a creditor is impaired under ' 1124(1) only if 'the plan' itself alters a claimant's 'legal, equitable, [or] contractual rights.'"); In re PG&E Corp., 46 F.4th 1047, 1063 n.11 (9th Cir. 2022) ("[A]n alteration of pre-bankruptcy rights that occurs by operation of the Code does not result in impairment."), petition for cert. filed sub nom. Pacific Gas & Electric Co. v. Ad Hoc Committee of Holders of Trade Claims, No. 22-733 (U.S. Feb. 6, 2023).

Cram-Down Confirmation Requirements

If a creditor class does not agree to impairment of the claims in...