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Rough Justice: Third Circuit Issues Important Decision on Unfair Discrimination

“Unfair discrimination is rough justice. It exemplifies the Code’s tendency to replace stringent requirements with more flexible tests that increase the likelihood that a plan can be negotiated and confirmed,” announced Judge Thomas Ambro of the United States Court of Appeals for the Third Circuit on August 26, 2020.[1] Though limited to an explication of Section 1129(b)(1)’s prohibition on unfair discrimination against a class of dissenting creditors, Judge Ambro’s “rough justice” remark will echo in all areas of bankruptcy law among practitioners who prioritize pragmatism over perfectionism.

In its latest Tribune decision, the Third Circuit considered an appeal from a group of bondholders who alleged that a plan that fails to strictly enforce subordination agreements among creditors in accordance with Section 510(a) of the Bankruptcy Code is ineligible for confirmation under Section 1129(b)(1) of the Bankruptcy Code.  In the alternative, they argued that the relative recoveries of senior and subordinated creditors resulted in “unfair discrimination” prohibited by the Code.[2] Writing for a three-judge panel, Judge Ambro rejected both arguments.

First, in response to the senior noteholders’ contention that the Bankruptcy Court should not have confirmed the Plan because it did not strictly enforce subordination agreements among the parties, the Court looked to the text of the statute. Section 510(a) says that a “subordination agreement is enforceable [in bankruptcy] to the same extent that such agreement is enforceable under applicable nonbankruptcy law.”[3] But, Section 1129(b)(1) states that:

Notwithstanding section 510(a) of this title, if all of the applicable requirements of subsection (a) of this section other than paragraph (8) 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 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.[4]

Accordingly, section “1129(b)(1) overrides [section] 510(a) because that is the plain meaning of ‘[n]otwithstanding.’”[5] Judge Ambro further observed that this resolution of the interplay between Sections 510(a) and 1129(b)(1) is harmonious with the legislative intent that girds the cramdown section of the Code. 

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 prebankruptcy contractual arrangements, while leaving play in the joints.[6]

Next, the senior noteholders argued that the Plan unfairly discriminates against them.  Judge Ambro identified several different tests to identify unfair discrimination, but settled on a “rebuttable presumption” test proposed by Professor Bruce Markell that had been accepted by the parties in this case.

A rebuttable presumption of unfair discrimination exists when there is (1) a dissenting class; (2) another class of the same priority; and (3) a difference in the plan’s treatment of the two classes that results in either (a) a materially lower percentage recovery for the dissenting class (measured in terms of the net present value of all payments), or (b) regardless of percentage recovery, an allocation under the plan of materially greater risk to the dissenting class in connection with its proposed distribution.[7]

Applying the test, Judge Ambro concluded that “the Bankruptcy Court did not necessarily err when it compared the Senior Noteholders’ desired recovery . . . (34.5%) to their actual recovery under the Plan (33.6%),” and that the “nine-tenths of a percentage point difference in the Senior Noteholders’ recovery is, without a doubt, not material.”[8] He thus concluded that “[a]lthough the Plan discriminates, it is not presumptively unfair when understood, as ruled above, that a cramdown plan may reallocate some of the subordinated sums.”[9]

[1] In re: Tribune Company, et al., __ F.3d __ (3d. Cir. August 26, 2020) (“Tribune”).

[2] Specifically, the senior noteholders alleged that the plan “allocated more than $30 million of their recovery from [subordinated creditors] to Class 1F [a class of trade and other unsecured creditors alleged not to be entitled to the benefits of subordination] when only the Senior Noteholders in Class 1E . . . should benefit from . . . subordination.” Id. at 9.

[3] 11 U.S.C. §510(a).

[4] 11 U.S.C. § 1129(b)(1) (emphasis added).

[5] Tribune at 16.

[6] Id. at 16-17.

[7] Id. at 23 citing Bruce A. Markell, A New Perspective on Unfair Discrimination in Chapter 11, 72 Am. Bankr. L.J. 227, 227–28 (1998). However, the presumption “may be overcome if the court finds that a lower recovery for the dissenting class is consistent with the results that would obtain outside of bankruptcy, or that a greater recovery for the other class is offset by contributions from that class to the reorganization. The presumption of unfairness based on differing risks may be overcome by a showing that the risks are allocated in a manner consistent with the prebankruptcy expectations of the parties.”  Id. 

[8] Id. at 29, 30.  Judge Ambro’s observation that the Bankruptcy Court “did not necessarily err” is hardly a ringing endorsement.  But it was a necessary predicate to framing the dispute as one between 34.5% and 33.6%, a mere 0.9% difference.  The senior noteholders’ view was that the Bankruptcy Court “should have compared their recovery from the estate absent subordination (21.9%) to the Trade Creditors’ recovery under the Plan with the reallocated subordination payments (33.6%).”  Id.  But the Court disagreed: “To measure discrimination this way is to ignore that the Plan brought into the Tribune estate not only the subordinated sums distributed to non-beneficiaries of that subordination, but all payments from the subordinated creditors (and indeed it allocated the overwhelming majority of those sums to the Senior Noteholders [. . .])”). Id.

[9] Id. at 30.