All’s Fair That Is Not Unfair: Third Circuit Refuses To Strictly Enforce Subordination Agreement In Cramdown
The Third Circuit Court of Appeals has affirmed the confirmation of a plan of reorganization that did not strictly enforce the subordination provisions of certain public debt issuances. The decision, In re Tribune Co., illustrates limits to the utility of subordination agreements and provides a new standard for the implementation of the “unfair discrimination” test in the context of a chapter 11 cramdown. It also may affect the pricing of public debt and is likely to lead to more litigation.
This decision, likely resolving the long-running chapter 11 proceedings of what was once the nation’s largest media conglomerate, involves a challenge by holders of senior unsecured notes to the Tribune plan of reorganization, which provided for equal distributions to various classes of unsecured creditors (including the senior noteholder class). The senior noteholders argued that subordination provisions in certain publicly issued notes required that plan payments otherwise due to the subordinated noteholders should have been allocated instead to the senior noteholders, such that the senior noteholders would receive proportionately more than other unsubordinated unsecured creditors. The Bankruptcy Court confirmed the plan over the objections of the senior noteholders, ruling that the plan satisfied the “cramdown” provisions of Bankruptcy Code section 1129(b) for confirmation of plans notwithstanding rejection of the plan by a class of creditors. Following a years-long appeals process, during which the Third Circuit held that the objections of the senior noteholders were not mooted by the substantial consummation of the plan, the District Court affirmed, and the case returned to the Court of Appeals.
The Court first addressed the applicability of Bankruptcy Code section 510(a), which generally provides for enforceability in bankruptcy of contractual subordination agreements. It ruled that section 510(a) does not govern plan allocations due to the plain language of Bankruptcy Code section 1129(b)(1), which provides that a non-consensual plan can be confirmed “notwithstanding section 510(a).”
The Court then reviewed the other requirements of section 1129(b)(1), and in particular the requirement that the plan “not discriminate unfairly … with respect to each class of claims … that … has not accepted, the plan.” It ruled that a bar on unfair discrimination implies that some discrimination is permitted. Inasmuch as there is no express definition or clarification in the Bankruptcy Code of the “unfair discrimination” standard, the Court adopted the multifaceted analysis of Professor Bruce Markell set forth in a 1998 law review article, under which a court is required to consider factors such as the expectations of parties outside of bankruptcy, contributions made to the reorganization by various parties, and the relative risks borne by various classes under a plan.
The senior noteholders argued that they were being unfairly discriminated against because, under the plan, they would receive less than they would have were the subordination provisions to have been strictly applied. The Court rejected this argument, holding that it requires a “materially lower” recovery, and that the reduction in distributions to the senior noteholders did not satisfy this materiality standard. Specifically, the Court held that the Bankruptcy Court “did not necessarily err” when it compared the 33.6% recovery provided the senior noteholders under the plan to the 34.5% recovery they sought, and found it not to be a material difference.
Notwithstanding the broad potential scope of the Court’s reasoning, what actually occurred in the case was more limited.
- The subordinated noteholders did not receive any benefit from the contested plan provisions. The plan took the share of distributions that would otherwise have been earmarked for the subordinated creditors (had they not been subordinated, and had they received distributions pro rata with other unsecured creditors) and shared those amounts with several classes of unsecured creditors rather than solely with the senior noteholders (as the senior noteholders sought). The benefitted classes included creditors that were neither subordinated nor the express beneficiaries of the subordination provisions. Tribune’s rejection of “strict subordination” is properly contrasted with the more “flexible” subordination in the confirmed plan.
- Part of the reason why the spread between what the senior noteholders received and what they sought seemed so small was that under the plan’s classification structure the senior noteholder class ($1.283 billion) was much larger than the other unsecured classes that received the benefit of the distributions the senior noteholders sought ($105 million and $8.8 million). This discrepancy was likely a consequence of the classification structure adopted by the plan proponents to facilitate confirmation and was not addressed in the decision. It is possible that the result may differ in a case where the size of the applicable classes of creditors is closer.
- The decision shows some limits to the enforceability of subordination provisions. A subordination that is not enforceable in bankruptcy may not be worth much, depending upon how much “flexibility” is employed. It will be interesting to see if Tribune affects the pricing of publicly issued debt where subordinated notes are a significant feature of the capital structure.
- There is no suggestion in the decision that there was any technical flaw in the drafting of the subordination provisions or that the subordination provisions would not be enforceable were section 1129(b)(1) not applicable. Senior unsecured lenders considering capital structure allocation should consult with counsel to consider alternatives to subordination provisions such as holding company or multi-tranche structures.
- The standard adopted by the Third Circuit in Tribune is complicated and confers considerable discretion on bankruptcy courts for application to the particular circumstances of cases. It should be beneficial to debtors and other plan proponents by enhancing the prospects for confirmation of plans. In complex cases it should have the effect of weakening the leverage of senior unsecured lenders to the benefit of other parties.
- Tribune does not present clear guidance for when and to what extent subordination provisions will be enforceable, and how much flexibility in enforcement will be permitted. As a result, parties should expect significant and possibly protracted negotiations whenever a debtor’s capital structure involves subordinated debt. The decision will likely lead to much litigation concerning its scope and contours, as plan proponents both within and outside the Third Circuit will be incentivized to aggressively seek to apply the Tribune rule to their particular cases.