A Ninth Circuit B.A.P. case from 2012 addressed an issue in a Chapter 11 “single asset” real estate case where the debtor sought to confirm its plan over the objection of an undersecured lender.  The case was In Re Loop 76 v. Wells Fargo Bank, na (465 B.R. 525 (9^th Cir. B.A.P. 2012)).  The key issue in the case was whether the bankruptcy court could consider a “third party” source of payment (in this case, a guarantor), when deciding whether unsecured claims are substantially similar under 11 U.S.C. §1122(a).  Basically, the debtor wanted a large unsecured claim (a guarantor claim on a secured debt) to be classified separately from other unsecured creditors, so that the anticipated “no” vote on confirmation would not taint the acceptance of the plan by the other unsecured creditor class.

Often in real estate cases there are very large unsecured claims, possibly arising out of deficiency claims.  If such a deficiency claim were placed in the same class as the other general unsecured creditors, it might negate the acceptance of that class.  However, if such a debt were placed in a separate class, it might give the debtor more flexibility in confirming a plan over the objection of the creditor.

Loop 76 was a commercial real estate developer which had obtained a commercial loan of about $23 million from Wells Fargo Bank.  The loan was secured against an office complex.  There were also personal guarantees for the loan, signed by the principals of Loop 76.  Loop 76 eventually defaulted on the loan, due to the collapse of the real estate market in 2008-2010.  A Chapter 11 petition was eventually filed by Loop 76.  Since the property in question was only worth about $17 million, there was a large deficiency claim held by Wells Fargo.  The proposed plan attempted to classify the deficiency claim separately from the other unsecured creditors.

Wells Fargo objected to this treatment, believing that they should be lumped in with all the other unsecured creditors.  They were, according to Wells Fargo, “substantially similar” to the other unsecured creditors such that separate classification was not justified.  The attempt to create a separate class was, argued the creditor, nothing more than an attempt to “gerrymander” acceptance of the plan by needlessly creating a separate class of creditor.  Wells Fargo also continued to pursue the guarantors of the real estate loan in state court.

The bankruptcy court, weighing the issues, ruled against Wells Fargo.  Examining the history and intent of Section 1122(a) and Section 1129(a)(10), the court found that Wells Fargo had an alternate source of repayment, what it called a “third party” repayment source.  Such a creditor is different from a creditor who has no such alternate source of repayment.  Wells Fargo could provide no evidence that the guarantors themselves were insolvent or that they were no longer pursuing the guarantors.  Thus, the court found that there was a legitimate basis for putting Wells’s deficiency claim in its own class.

Wells Fargo appealed the decision to the 9^th Circuit B.A.P.  The B.A.P. affirmed, noting that Wells had a third-party repayment source, unlike any of the other general unsecured creditors.  Thus, there was a compelling reason to put it in its own class.  Having a guarantor was a situation that no other unsecured creditor had.  A court can consider third party sources of repayment, the B.A.P. held, when trying to decide if unsecured claims are substantially similar under Section 1122(a).

Furthermore, it caught the B.A.P.’s attention that, if Wells’s claim were placed in the same class as all the other unsecured creditors, it would have dwarfed all the other unsecured claims, since it was such a large dollar amount.  It would have controlled the class and have been able to veto the acceptance of the proposed plan.  In the interests of fairness, it made sense to put Wells’s claim in its own class, segregated from the other unsecured claims. The Bankruptcy Code permits the creation of separate voting classes of creditors, provided that there is a rational basis for it and the claims are not “substantially similar.”  Not surprisingly, this issue can become a litigated one, if voting on plan confirmation turns on the acceptance or rejection of such a class.

Read More:  Classification Of Claims And Interests In Chapter 11 Bankruptcy