The Third Circuit of Appeals resolves the Issue of Subordination Agreement Enforcement and Non-Consensual Cramdown Plan

In a remarkable judgment, the Third Circuit of Appeals In Re Tribune Co., allowed the enforcement of subordination agreements when the same might jeopardize a bankruptcy plan.

To provide a context, under Section 510 (a) of the Bankruptcy Code, subordinate agreements are enforceable in a bankruptcy in the same manner as those enforceable under non-bankruptcy law. However, another provision of the Code, Section 1129 (b) (1) provides for a cramdown provision and allows a Chapter 11 plan to be confirmed along with imposes certain limitations to Section 510 (a). Due to the simultaneous reading of these two provisions, an issue usually arises in a bankruptcy scenario, which is whether a bankruptcy court can disallow enforcement of a subordinate agreement when the same would hinder a plan proponent’s ability to confirm an enforceable Chapter 11 plan. As no precedent existed on the issue, the Third Circuit of Appeals has provided a guiding light.

In the matter of In re Tribune Co., the court upheld the Bankruptcy Court’s order, whereby Tribune Company’s Chapter 11 plan was confirmed, even though certain creditors pushed to enforce a subordination agreement entered before the bankruptcy filing. The court found that the cramdown provision provided under Section 1129 (b) (1) “supplants strict enforcement of subordination agreements”. It further held that “when cramdown plans play with subordinated sums, the comparison of similarly situated creditors is tested through a more flexible unfair-discrimination standard.” Section 1129 provides for confirmation of plan and sub-section (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.” The court interpreted the word “notwithstanding” to mean that even though enforcement rights are conferred by Section 510 (a) to subordination agreements, bankruptcy courts must confirm to the bankruptcy plan over the objection of a non-consenting class of creditors if Section 1129 (a) comes into play, as long as the plan does not discriminate unfairly, and is instead fair and equitable for each class which does not consent to the plan.

Another exceptional aspect of the judgment is that the court established eight factors to assess unfair discrimination in the above stated context. The first factor is that the subordination agreements need not be strictly enforced in the case a cramdown and thereby creditors holding claims with the same priority can be treated differently as long as the discrimination is not unfair. The second factor is that the unfair discrimination applies only to classes of dissenting creditors and not individual creditors. As per the third factor, the unfair discrimination is to be determined from the perspective of the dissenting class. For the fourth factor, the court said that the classes are to be aligned correctly to enable bankruptcy court to assess whether the cramdown plan discriminates unfairly. The fifth factor is that the bankruptcy courts should look into the plan’s payment provision for each creditor’s recovery measured in terms of the net present value of all payments or the allocation of materially greater risk in connection with its proposed distribution. The sixth factor states that the bankruptcy court must first determine the pro rata baseline for the recovery of creditors sharing the same priority and then should compare the baseline against the percentage distribution that claimants in the dissenting class would have otherwise been entitled to receive under full enforcement of their subordination agreement under Section 510 (a), but did not get under the plan. The seventh factor states that a presumption exists in favour of unfair discrimination where there is a lower percentage recovery for the dissenting class or a materially greater risk to the dissenting class in connection with the proposed distribution. Lastly, as per the eight factor the presumption of unfair discrimination is rebuttable.

The judgment passed by the Third Circuit of Appeals has provided a much-needed guiding light regarding interplay between the provision of enforcement of subordination agreement and non-consensual cramdown plans. Further, the court also laid down the “eight factor” test to determine unfair discrimination which would allow the bankruptcy courts to disregard the rigid enforcement of subordination provisions.

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