Restructuring

If cramdown failures are par for the course, why are we all so fascinated with them? One thing is certain: they always provide a good teaching moment for practitioners. Marlow Manor’s chapter 11 single asset real estate case is no different. In Marlow Manor, the Ninth Circuit Bankruptcy Appellate Panel held that the bankruptcy court did not err in (i) refusing to confirm the debtor’s chapter 11 plan, which improperly classified two unsecured and impaired deficiency claims of its lender in separate classes as secured and unimpaired, and (ii) rejecting an aspect of the plan, which treated the lender as if it had made a section 1111(b)(2) election. 
Background
Marlow Manor owned a portion of a high rise in downtown Anchorage. The high rise was subdivided by a developer (the debtor’s manager, Marc Marlow into a two unit condominium project: (i) Unit A was owned by an investor and (ii) Unit B was owed by Marlow Manor. Unit B was to be converted into a senior assisted living home and was financed by a $5.4 million construction loan. In 2007, the Alaska Housing Financing Corporation (“AHFC”) refinanced the majority of the construction loan through two long term loans in the amount of $5.45 million (summarized in the chart below).
After certain Medicaid changes, it was no longer practical to use the project for assisted living, and Mr. Marlow decided to convert the Marlow Manor property to residential units offered on the open market. Thereafter, AHFC agreed to a loan modification (summarized in the chart below).

 
Mr. Marlow guaranteed both notes. The debtor later defaulted on the First Note for lack of payments, which caused the acceleration of both notes and led to Marlow Manor’s chapter 11 filing.
In the debtor’s third amended plan, the debtor classified AHFC’s various claims as follows:
Class 2 – AHFC’s First Note Claim ($3.125 million tranche). The plan treated this claim as a secured claim for $3.125 million, with interest at 5.75%, and payments in monthly installments (after a $30,000 payment on the effective date), increasing at various intervals to June 1, 2037. This claim was characterized as impaired.
Class 3 – AHFC’s First Note Claim ($1 million tranche). The plan treated this claim as a secured claim for $1 million. The plan provided that, if AHFC made an election under section 1111(b) of the Bankruptcy Code to treat such claim as fully secured and non-recourse, then this claim would receive no “separate payments.” If AHFC did not make an election under section 1111(b), then the reorganized debtor would pay this claim in accordance with the terms of the modification agreement. Because the plan proposed to pay this claim according to its terms, the plan treated this class as unimpaired and deemed to have accepted the plan.
Class 4 – AHFC’s Second Note Claim. As of the petition date, the outstanding balance owed on the Second Note was $1.325 million. The plan treated this claim as secured and stated that it would be paid in accordance with the terms of the modification agreement. This class was also described as unimpaired and deemed to have accepted the plan.
AHFC filed a motion, arguing that its claims in Classes 3 and 4 were unsecured deficiency claims that were improperly classified as secured and unimpaired. Moreover, AHFC argued that its deficiency claims should be placed with the substantially similar general unsecured claims in Class 6. General unsecured claims would receive a distribution of $20,000 on the Effective Date of the Plan, prorated in proportion to the allowed claims in this class, and would also receive prorated payments of $10,000 per calendar quarter for a period of five years. The debtor argued that the plan proposed to repay the two loans exactly as required by the loan documents, and, therefore, Classes 3 and 4 were not impaired and were not entitled to vote on the plan. Moreover, the debtor argued that the business reason for separate classification was based on the specific terms of the modification agreement, which created a separate $1 million tranche of the First Note, and the terms of the $1.325 million Second Note, neither of which required any debt service unless the property had sufficient cash flow. By limiting debt service to the debtor’s positive cash flow, the debtor argued that AHFC subordinated a total of $2.325 million of its loans to the debtor’s operating expenses and to debt service on the $3.125 million tranche of the First Note. This, the debtor argued, created a substantially different economic treatment of the loans from that of the debts owed to general unsecured creditors. The Ninth Circuit BAP was not moved by the debtor’s arguments.
Ninth Circuit BAP
The BAP affirmed the bankruptcy court, holding that AHFC’s claims under the $1 million tranche of the First Note and the Second Note were unsecured and impaired. Moreover, the BAP held that such deficiency claims were improperly classified as separate from general unsecured claims because they were substantially similar to general unsecured claims, and the debtor offered no business justification or economic reason for the separate classification.
The debtor conceded in its opening brief that the $1 million tranche of the First Note and the Second Note were unsecured under section 506(a) of the Bankruptcy Code. The BAP agreed with the bankruptcy court that The $3.125 million tranche of the First Note (Class 2) used up all of the available collateral value, and, thus, Classes 3 and 4 could not be secured. (Note, the Bankruptcy Court did not hold a valuation hearing, and appraisals were not submitted regarding the value of the property.) Accordingly, the debtor’s classification of AHFC’s unsecured claims as secured was in direct violation of section 506(a) and improperly treated AHFC as if it had made a section 1111(b) election — an election only a creditor can make — in direct contravention of section 1111(b).
Moreover, the Debtor’s argument that AHFC’s deficiency claims in Classes 3 and 4 were unimpaired under section 1124 of the Bankruptcy Code on the basis that the debtor would be making the same payments to AHFC as those required under the modification agreement rang hollow with the BAP. Under section 1124(2)(A), a class of claims is impaired and, thus, entitled to vote, unless the debtor, among other things, cures defaults (other than defaults related to the financial condition of the debtor or the bankruptcy filing). Here, the plan specifically provided that defaults would not be cured. The court, however, did not specify what defaults on the $1 million tranche of the First Note or on the Second Note needed to be cured as the only default referenced was a failure to make a payment on the $3.25 million tranche of the First Note. The court nevertheless concluded that section 1124(2)(A) was not met.
Additionally, the modification agreement entitled AHFC to aggregate annual payments on the $1 million tranche and the Second Note in an amount equal to 100% of the debtor’s available cash flow. The court did not explain how “available cash flow” was defined in the modification agreement and whether the modification agreement provided for payment of unsecured obligations before computing “available cash flow.” Because the plan provided that the debtor’s cash flow would be used to pay general unsecured creditors the court summarily concluded that the plan altered AHFC’s contractual rights under section 1124(2)(E). Accordingly, the BAP held that the bankruptcy court did not err in concluding that AHFC’s unsecured deficiency claims in Classes 3 and 4 were impaired under section 1124(2).
Applying its two-step analysis for determining whether claims have been permissibly separated into different classes, the BAP held that AHFC’s deficiency claims had no distinguishing characteristics that rendered them dissimilar to the general unsecured claims, and the debtor had pointed to no legitimate business or economic reason for the separate classification. The court found that Mr. Marlow, the guarantor of the two notes, was not a source of recovery for AHFC’s deficiency claims because he was insolvent and had multiple judgments against him. As no other special circumstances were present, the court agreed that AHFC’s unsecured deficiency claims were “garden variety” unsecured claims. Moreover, the court found that the debtor’s attempt to use the contract payment terms under the modification agreement as a distinguishing characteristic was “disingenuous at best when [the] debtor propose[d] to use its available cash flow to pay unsecured creditors rather than AHFC.” Indeed, the debtor “ha[d] all but admitted that the separate classification of AHFC’s deficiency claims as secured an unimpaired was to prevent AHFC from voting against the plan.”
Conclusion
Marlow Manor is another example of cramdown gone bad, but not without a lesson. Marlow Manor reminds practitioners to be keenly aware of possible gerrymandering objections when classifying claims in chapter 11 plans. Separately classifying two substantially similar claims might not be the nail in the coffin, but you better be sure to have a business justification for such classification. No justification, as the court found in Marlow Manor, is sure to prevent confirmation.