The U.S. Court of Appeals for the Third Circuit, in a case of first impression at the appellate level, recently held that strict enforcement of subordination agreements is not mandated by the Bankruptcy Code in a “cramdown” scenario. While such agreements typically are strictly enforced in bankruptcy proceedings, the Court held in certain circumstances enforceability can be addressed through the flexible “unfair discrimination” standard.1 This addition to the long and litigious bankruptcy proceedings of the Tribune Company (“Tribune“) provides valuable guidance for debtors and creditors dealing with subordination agreements and non-consensual plans of reorganization, often called “cramdown” plans.
When Tribune filed for bankruptcy in 2008, its debt included $1.283 billion of senior unsecured notes that were contractually required to be paid before any other debt (the “Senior Notes“). Other outstanding debts included (i) $759 million in unsecured exchangeable debentures (the “PHONES Notes“), (ii) $225 million in unsecured merger financing notes (the “EGI Notes“), (iii) a $150.9 million unsecured claim relating to a swap agreement (the “Swap Claim“), (iv) $105 million of unsecured claims held by retirees, and (v) $8.8 million of unsecured claims held by trade creditors. The indentures for the PHONES Notes and EGI Notes provided that they were subordinate in payment to “Senior Obligations” (the “Subordination Agreements“).2
Competing plans of reorganization were proposed, and the plan that emerged with the most support and was eventually confirmed by the bankruptcy court (the “Plan“) placed the claims of holders of the Senior Notes (the “Senior Noteholders“) in their own class (Class 1E), the Swap Claim, retirees, and trade creditors in another class (Class 1F), and the EGI Notes and PHONES Notes in separate classes (Classes 1I and 1J). Under the Plan, Class 1E and Class 1F were both to receive initial distributions equal to 33.6% of their outstanding claims, which included, in both Classes, funds attributable to the subordination of the PHONES Notes and EGI Notes.
Bankruptcy Court Confirms the Plan
The Senior Noteholders objected to the Plan on the basis that it improperly allocated over $30 million of their recovery from the subordinated PHONES Notes and EGI Notes to Class 1F, despite the fact that the Class 1F claims were not “Senior Obligations.”3 The Delaware bankruptcy court, however, confirmed the Plan over the Senior Noteholders’ objection. Specifically, the court found that the cramdown provisions of the Bankruptcy Code do not require that subordination agreements be strictly enforced, as long as certain requirements are met, including that the plan does not “discriminate unfairly.” The bankruptcy court compared Class 1E’s recovery percentage (33.6%) to its recovery if the subordination agreements were strictly enforced (34.5%) and determined that there was not a material difference, and therefore there was no unfair discrimination to prevent confirmation.4 The bankruptcy court’s confirmation order was subsequently affirmed by the Delaware District Court and then appealed to the Third Circuit.
Third Circuit’s Analysis
On appeal to the Third Circuit, the Senior Noteholders argued, first, that the bankruptcy court erred by not strictly enforcing the Subordination Agreements and, second, in the alternative, that the bankruptcy court improperly applied the unfair discrimination analysis by failing to compare Class 1E recoveries to those of Class 1F claimholders.
On the first issue, the Third Circuit agreed with the bankruptcy court and held that the Bankruptcy Code did not require the strict enforcement of the Subordination Agreements. While section 510(a) provides that subordination agreements are enforceable in bankruptcy to the same extent that such agreements are enforceable under non-bankruptcy law, section 1129(b)(1) specifically permits a plan to be confirmed, subject to certain requirements, “notwithstanding” section 510(a). The Third Circuit determined that the plain meaning of “notwithstanding,” as used in § 1129(b)(1) is straightforward. It means: “[d]espite the rights conferred by § 510(a), if all of the applicable requirements of [§ 1129(a)] . . . are met with respect to a plan, the court . . . shall confirm the plan . . . if [it] does not discriminate unfairly, and is fair and equitable, for each impaired class that does not accept the plan.”5 The Third Circuit found that this reading was supported by § 1129(b)(1)’s purpose—allowing confirmation of a cramdown plan provided that it protects the interests of the dissenting class.6 The Third Circuit went on to note that the Code “attempts to ensure that debtors and courts do not have carte blanche to disregard pre-bankruptcy contractual arrangements, while leaving play in the joints.”7
On the second issue, the Third Circuit also agreed with the bankruptcy court and held that the allocation of the subordinated amounts to the Class 1F claimholders did not result in unfair discrimination against the Senior Noteholders.8 According to the Third Circuit, the prohibition against unfair discrimination generally “ensures that a dissenting class will receive relative value equal to the value given to all other similarly situated classes.”9 The Third Circuit also noted that in assessing a plan’s differing treatment, “a comparison between the recovery of the preferred class and the dissenting class is by far the preferred . . . approach.”10 However, the Third Circuit found that where a class-to-class comparison is difficult—as here, where the Swap Claims (57% of Class 1F) were entitled to benefit from the subordination of the PHONES Notes and EGI Notes, while the trade creditors and retirees were not—“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.”11 Although the Third Circuit stressed that “this is not the preferred way to test whether the allocation of subordinated amounts under a plan to initially non-benefitted creditors unfairly discriminates, . . . [t]here is, as is typical in reorganizations, a need for flexibility over precision.”12 Accordingly, the Third Circuit upheld the bankruptcy court’s unfair discrimination analysis which compared the Senior Noteholders’ recovery under the Plan to its recovery if strict enforcement of the Subordination Agreements were enforced, and found that a 0.9% loss in recovery was clearly immaterial.13
The decision is notable because it demonstrates that rigid enforcement of subordination clauses may take a back seat when a court believes an otherwise equitable reorganization plan hangs in the balance.
If you have questions related to the drafting or enforcement of subordination agreements, or the treatment of such agreements in a bankruptcy process, please don’t hesitate to reach out to the attorneys listed below, or your primary contact at S&K.