Third Circuit Clarifies When Subordination Agreement Can Be Ignored in Bankruptcy Cramdown

Third Circuit Clarifies When Subordination Agreement Can Be Ignored in Bankruptcy Cramdown

In In re Tribune Co the Third Circuit Court of Appeals affirmed the order confirming  Tribune Co.’s Chapter 11 bankruptcy plan over the objections of creditors who argued that they were entitled to the benefit of a debt subordination agreement. As noted by the appeals court, the Bankruptcy Code’s cramdown provision “supplants strict enforcement of subordination agreements.” Instead, “when cramdown plans play with subordinated sums, the comparison of similarly situated creditors is tested through a more flexible unfair-discrimination standard.” After acknowledging that “[u]nfair discrimination is rough justice,” the Third Circuit went on to establish its own eight-factor test for unfairness.

Bankruptcy Dispute Pits Subordination Agreement Against Cramdown Provision

The high-profile bankruptcy case involves Tribune Company (“Tribune”), which was once the largest media conglomerate in the country, owning the Chicago Tribune and the Los Angeles Times, as well as many regional newspapers, television and radio stations. The Company’s 2008 bankruptcy followed on the heels of its failed leveraged buyout (LBO), which left it with almost $13 billion of debt and a complex capital structure.

In 2012, after years of contentious proceedings, the Bankruptcy Court confirmed Tribune’s plan of reorganization (the “Plan”) over the dissenting votes of certain Senior Noteholders who had loaned Tribune unsecured debt between 1992 and 2005. Tribune had also issued two other sets of unsecured notes prior to filing for bankruptcy, which subordinated repayment to “Senior Indebtedness” or “Senior Obligations.” Also among the billions of dollars of Tribune’s debt were an unsecured $150.9 million “Swap Claim”; $105 million of unsecured claims by Tribune Media Retirees (the “Retirees”); and $8.8 million of unsecured claims by trade and miscellaneous creditors (the “Trade Creditors”).

The Plan organized Tribune’s unsecured creditors into distinct classes. The Senior Noteholders, which comprised Class 1E, argue that the Plan favored Class 1F, which was made up of the Swap Claim, the Retirees, and the Trade Creditors. The Plan paid both Class 1E and Class 1F creditors 33.6% of their outstanding claims from the initial distributions under the Plan. The Senior Noteholders argued that it allocated more than $30 million of their recovery from the subordinated notes to Class 1F when only the Senior Noteholders in Class 1E qualified as Senior Obligations, and thus they alone should benefit from those subordination agreements.

The Senior Noteholders specifically asserted that the Plan violated the Bankruptcy Code’s standards for confirmation because it did not fully enforce the subordination provisions in accordance with 11 U.S.C. § 510(a), which provides that pre-petition subordination agreements are enforceable in bankruptcy. Meanwhile, the Bankruptcy Code’s cramdown provision, 11 U.S.C. § 1129(b)(1), provides (emphasis added):

Notwithstanding section 510(a) of this title, if all of the applicable requirements of subsection (a) of this section other than paragraph (8) [for our purposes, this paragraph requires that each class of claims has accepted the plan] are met with respect to a plan, the court, on request of the proponent of the plan, shall confirm the plan notwithstanding the requirements of such paragraph [8] if 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.

The District Court affirmed a Bankruptcy Court ruling that § 1129(b)(1) did not preclude confirmation of the Plan, even though it did not fully enforce the terms of the subordination agreement.  It also agreed that the Plan did not unfairly discriminate against the Senior Noteholders.

Third Circuit’s Decision

The Third Circuit Court of Appeals also affirmed. “The Code does not compel courts reviewing cramdown plans to enforce subordination agreements strictly, though not to do so must conform with the constraints set out in the cramdown provision,” U.S. Circuit Court Judge Thomas L. Ambro wrote on behalf of the court. “The pragmatic approach taken by the Bankruptcy Court, affirmed by the District Court, reached the right result.”

The Third Circuit noted that its decision revolved around the interaction between the cramdown provision’s authority and the enforcement of subordination agreements.  It ultimately concluded that subordination agreements need not be strictly enforced for a court to confirm a cramdown plan. According to the Third Circuit, § 1129(b)(1) overrides § 510(a) because that is the plain meaning of “[n]otwithstanding.”  The court further noted that Section 1129(b)(1)’s purpose affirms its analysis. As Judge Ambro explained:

Both § 510(a) and the cramdown provision’s unfair-discrimination test are concerned with distributions among creditors. The first is by agreement, while the second tests, among other things, whether involuntary reallocations of subordinated sums under a plan unfairly discriminate against the dissenting class. Only one can supersede, and that is the cramdown provision. It provides the flexibility to negotiate a confirmable plan even when decades of accumulated debt and private ordering of payment priority have led to a complex web of intercreditor rights. It also attempts to ensure that debtors and courts do not have carte blanche to disregard pre- bankruptcy contractual arrangements, while leaving play in the joints

Next, the Third Circuit addressed the Senior Noteholders’ contention that the Plan unfairly discriminated against them. As highlighted by the Third Circuit, the Bankruptcy Code does not define “unfair discrimination.” In the absence of a statutory test, courts have relied primarily on one of four tests.

Based on its analysis of the existing tests, the Third Circuit established eight “principles” of unfair discrimination:  (1) A subordination agreement does not need to be enforced to the letter in the case of a cramdown, and subordinated amounts may be allocated to other classes not entitled outside bankruptcy to benefit from subordination agreements as long as that allocation is not presumptively unfair (and, if so, the presumption is not rebutted); (2) unfair discrimination applies only to classes of creditors that dissent; (3) unfair discrimination is determined from the perspective of the dissenting class; (4) classes must be aligned correctly; (5) a court should measure recoveries in terms of net present value of all payments or the allocation of materially greater risk in connection with the proposed distribution; (6) a court should include subordinated sums in the plan distribution when comparing recovery between classes; (7) there is a presumption of unfair discrimination where there is a materially lower percentage recovery for the dissenting class or a materially greater risk to the dissenting class in connection with the proposed distribution, and; (8) a presumption of unfair discrimination may be rebutted.

Applying the above principles, the Third Circuit agreed with the lower courts that the difference between the Senior Shareholders’ desired and actual recovery is not material. In support, the appeal court cited that the subordinated sums allocated to the Retirees and Trade Creditors comprised 11.7 percentage points toward their 33.6 percentage recovery, but only reduced the Senior Noteholders’ recovery by nine-tenths of a percent.

In reaching its decision, the Third Circuit agreed with the Senior Noteholders that a court will typically compare the recovery percentages of the dissenting and preferred classes and ask whether the difference in recovery, if any, is material. Here, the Bankruptcy Court compared Class 1E’s recovery under the Plan (33.6%) to its recovery if it and the Swap Claim were the only creditors to benefit from the subordination agreements (34.5%).

While this may not be the preferred metric, the Third Circuit found that the Bankruptcy Court did not necessarily err because “neither the text of 11 U.S.C. § 1129(b)(1) nor the rebuttable presumption test explicitly limits the unfair-discrimination analysis to only a class-to-class comparison.” According to the appeals court, in cases where a class-to-class comparison is difficult, a court “may opt to be pragmatic” and look to the discrepancy between the dissenting class’s desired and actual recovery to gauge the degree of its different treatment. “What constitutes a material difference in recovery when analyzing the effect of a plan on the dissenting class is a distinct and context-specific inquiry. We do not address the outer boundary of that inquiry here,” Judge Ambro further explained. “Wherever it may lie, the nine-tenths of a percentage point difference in the Senior Noteholders’ recovery is, without a doubt, not material.”

If you have questions, please contact us

If you have any questions or if you would to discuss the matter further, please contact me, Joel Glucksman, or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.