Restructuring

Contributed by Victoria Vron
When are projections so optimistic that a chapter 11 plan cannot be confirmed?  As the debtor in In re Friendship Dairies found out the hard way, when the projections start faltering right out of the gate.  In our continuing series on valuation issues, we examine the perils of highly optimistic projections in business plans.
Background
In Friendship Dairies, the debtor was a dairy producer whose chapter 11 plan was premised on a complete revamping of its dairy operations.  During the chapter 11 case, the debtor started moving its operations to a more intensive milking and complementary farming operation, with the hopes that the more modernized operations would generate sufficient income to pay its creditors in full over a period of several years and at rates that accorded its creditors the present value of their respective claims.  The proposed chapter 11 plan sought to pay the many classes of secured and priority claims in installments, with certain classes receiving balloon payments at the end of the installment period.  All but one of the impaired classes accepted the plan.  The debtor’s largest secured creditor, AgStar, rejected the plan.  (Apparently, the debtor’s relationship with AgStar was the topic of much of the litigation during the chapter 11 case as well.  AgStar sought liquidation of the debtor and did not have any interest in agreeing to a plan that contemplated an ongoing relationship with the debtor.)  The debtor’s second largest secured creditor thought the plan would work, as evidenced by its purchase of some of AgStar’s liens and its agreement to purchase (at a discount) claims of willing unsecured creditors under the plan.
AgStar objected to confirmation of the plan on multiple grounds.  Although the court noted that some of AgStar’s objections (which included a conspiracy theory) were not “without some tilting at windmills,” the court held that two of the objections had merit and each on its own justified denial of confirmation.
Applicable Statutory Standard
A chapter 11 plan may be confirmed only if the requirements set forth in section 1129 of the Bankruptcy Code are met.  Among the numerous confirmation requirements is section 1129(a)(11), which requires that confirmation of the plan not likely be followed by the liquidation, or the need for further financial reorganization, of the debtor (also referred to as the feasibility standard).  In addition, section 1129(a)(8) requires that each impaired class of claims or interests accept the plan.  If an impaired class of claims rejects the plan, section 1129(b)(1) provides that the plan may nevertheless be confirmed if it does not discriminate unfairly, and is fair and equitable, with respect to such class (also referred to as cramdown).  With respect to an impaired class of secured claims that rejects a plan, section 1129(b)(2)(A)(i) provides that a plan is fair and equitable if it allows holders of such claims to retain their liens and receive payments on account of such claims in deferred cash payments totaling at least the allowed amount of such claims, of a value, as of the effective date of the plan, of at least the value of such holders’ interests in the estate’s interest in the property subject to the liens.
Feasibility
The court’s primary ground for denying confirmation of the plan was feasibility.  The debtor’s expert performed an analysis of the debtor’s operations going forward and prepared projections that were included in the plan.  The first year of the projections commenced during the chapter 11 case and ended after the anticipated effective date of the plan.  The projections did not factor in the required payments to creditors under the plan, but showed that available cash existed for plan payments and to fund reserve accounts for future contingencies.  Unfortunately for the debtor, as of the confirmation hearing, the debtor already had failed to meet the projections.  In addition, shortly before the confirmation hearing, the debtor failed to pay two required adequate protection payments to one of its non-objecting secured creditors.  Due to a shortfall resulting from operations, the debtor also did not have any reserves left.
In determining whether the plan was feasible, the court looked at whether the debtor had shown, by a preponderance of the evidence, the existence of a reasonable possibility that a successful rehabilitation could be accomplished within a reasonable period of time.  A reorganization plan is successful when it is not likely to be followed by liquidation, or the need for further financial reorganization.  As the court noted, the success of a debtor’s plan need not be guaranteed, but it should have a reasonable assurance of commercial viability. As the court noted, courts should closely scrutinize plans that are more visionary than realistic, pragmatic approaches to the debtor’s financial problems.  Even under a “visionary” plan, though, if secured creditors are fully protected in the event of the plan’s failure, the court still may confirm the plan so long as it has at least a marginal prospect of success.
The court then outlined various factors that may be considered in determining whether a plan is feasible (any of which could be weighed, or even ignored, in a court’s discretion): the debtor’s capital structure, the earning power of the business, economic conditions, the ability of debtor’s management, the probability of continuation of management, and any other related matter.  As to a debtor’s capital structure, the court pointed out that courts should be wary of any plan that provides for virtually all of the income of the reorganized debtor to go to making plan payments, without a sufficient buffer to weather economic storms.  As to earning power of the business, the court noted that projections should be concrete and not speculative and that failure to meet projections during a test-run (absent a legitimate, fixable excuse) is an indication of the unreliability and lack of soundness of a debtor’s projections.  The court also noted that when a plan provides for balloon payments, the court will have to be satisfied that the balloon payments themselves are feasible, which likely means a showing of a successful sale of the business to a likely or known buyer or the ability to refinance the debt from a likely or known refinancer before the balloon payments become due.
Having analyzed each of these factors with respect to the debtor, the court determined that the debtor’s plan was not feasible.  As the court stated, the problem is that the debtor stumbled at the starting line by failing to meet its own projections.  In fact, it did not even have enough cash on hand to pay administrative expenses on the effective date.  The debtor tried to argue, unsuccessfully, that it either had or would get agreements from administrative claimants to defer effective date payments and that the unavoidable delays in resolving claims would allow the debtor essentially to put off plan payments until a time at which its operations generated sufficient revenues.  The court found that failure to prove that the debtor could make the initial round of payments under the plan signaled an impending crisis.  Moreover, the debtor failed to provide evidence of how the balloon payments under the plan (which were significant) would be paid, and in the court’s words, was asking the court to “take yet another leap of faith” that such payments would be satisfied through deferrals or refinancings.  Thus, in light of the debtor’s struggles during the case, its crushing debt load, and lack of capital or cushion of any sort, the court concluded that the plan would not work.
Fairness & Equitableness
The court held that the chapter 11 plan was not confirmable for one additional, independent reason.  Section 506(b) of the Bankruptcy Code provides that oversecured creditors may add reasonable and necessary attorneys’ fees to their claims as long as such fees do not exceed the excess collateral value, and such fees are provided for under the agreement or the state statute under which the claim arose.  The debtor’s plan, however, allowed attorneys’ fees of secured creditors to be paid without interest through installment payments, which would commence only after the underlying secured claim was paid off.  In AgStar’s case, this would mean that its attorneys’ fees (if otherwise allowed) would only start to be paid in installments after the balloon payment on the underlying secured claim in 2028.  The court held that the failure to capitalize the attorneys’ fees in such circumstance meant that AgStar would receive much less than the present value of its claim under the plan, making the plan not fair and equitable under section 1129(b) of the Bankruptcy Code.
Conclusion
Aside from highlighting the obvious perils of missing projections out of the gate, Friendship Dairies demonstrates the difficulties debtors may face when making drastic changes to their operations during the chapter 11 case in an effort to rehabilitate themselves and premising their chapter 11 plan on the success of such operational changes.  With more and more chapter “22”s and even chapter “33”s being filed, it is not surprising that courts may scrutinize feasibility of chapter 11 plans more closely.