Subordination Agreements and Cramdown — Strict Enforcement or Rough Justice?

In the latest decision arising out of long-running disputes over confirmation of the Tribune Company’s Chapter 11 plan, the Third Circuit issued important new guidance concerning the enforceability of subordination agreements in cramdown plans, holding (1) that subordination agreements “need not be strictly enforced” in such plans, and (2) that the relevant comparison, for determining unfair discrimination, need not always be a comparison between the recovery of the preferred class and the dissenting class, but may sometimes entail a comparison between the dissenting class’s desired and actual recoveries. In re Tribune Co., -- F.3d --, 2020 WL 5035797 (3d Cir. Aug. 26, 2020). The first of these holdings, while subject to certain caveats (discussed below), threatens to limit the enforcement of subordination agreements just when senior lenders may try to argue they are needed most. The second holding — also caveated — creates the prospect of a regime under which large creditors may face more difficulty in showing unfair discrimination than small ones.

Statutory Background

Section 510(a) of the Bankruptcy Code provides that “[a] subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law.” 11 U.S.C. § 510(a). The provision, in effect, codifies pre-Code law, under which, it was observed, subordination agreements were “uniformly enforced according to their terms by bankruptcy courts.” In re Credit Industrial Corp., 366 F.2d 402, 409 (2d Cir. 1966); see also In re Leasing Consultants, Inc., 2 B.R. 165, 168 n.1 (Bankr. E.D.N.Y. 1980) (“The holding of these cases recognizing the enforceability of subordination agreements in bankruptcy cases has been codified in section 510(a) of the Bankruptcy Reform Act of 1978.”).

The enforceability pronouncement of Section 510(a), however, must be understood in the context of the Code’s further reference to subordination agreements in Section 1129(b)(1). That provision, which allows for the so-called cramdown of a Chapter 11 plan over the objection of a non-consenting class of claims, provides:

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 [i.e., the only obstacle to confirmation is the absence of consent by each voting class], the court, on request of the proponent of the plan, shall confirm the plan notwithstanding the requirements of such paragraph [8] 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.

11 U.S.C. § 1129(a)(1) (emphasis added). Whether this provision, with its reference to Section 510(a), excuses strict compliance with subordination provisions in the context of a cramdown plan, was the issue — never before addressed by a circuit court and subject to only limited case law at any level — that lay at the heart of the dispute in Tribune.

Case Background

Tribune’s capital structure included, as relevant here, certain senior debt, subordinated debt, and unsecured trade and retiree obligations. Its Chapter 11 plan (subject to nuances not relevant here) placed the senior debt in Class 1E and the trade and retiree obligations assignment in Class 1F. Both classes were slated to receive a 33.6% distribution, while the subordinated debt, by virtue of its turnover obligations, would receive nothing. The holders of the senior debt objected to this treatment on the grounds that only Class 1E (the senior debt), and not 1F (the retirees and trade), should benefit from the subordination of the junior notes.^[1]

For purposes of their dispute, the parties stipulated to the following recovery scenarios:

As the foregoing makes clear, the effect of the plan’s allocation of junior debt recoveries was materially beneficial to Class 1F, increasing its distribution by more than 11 percentage points (from 21.9% to 33.6%). On the other hand, the percentage effect on Class 1E was much more modest: Had its desired allocation prevailed, its recoveries would have increased by less than 1 percentage point (from 33.6% to 34.5%). The explanation for this was simple: The size of the senior debt pool (approximately $1.4 billion) dwarfed the size of the trade and retiree debt (some $114 million in total).

On these facts, the senior noteholders contended first, that the plan failed to accord them the full benefit of their contractual right of seniority in violation of Section 510(a), and second, that even if subordinated recoveries could permissibly be shared with other creditors, the plan still discriminated against them unfairly in violation of Section 1129(b)(1). The lower courts rejected both these contentions, and the senior noteholders appealed to the Third Circuit.

Third Circuit Opinion

The Third Circuit, in an opinion by Judge Ambro, affirmed.

The Meaning of “Notwithstanding” in Section 1129(b)(1)

As to the first issue — the relationship between Sections 510(a) and 1129(b)(1) — the Third Circuit held that “the text of § 1129(b)(1) supplants strict enforcement of subordination agreements.” Tribune, 2020 WL 5035797, at *1. Relying on the “plain meaning” of the term “notwithstanding” — defined as “in spite of” or “without prevention or obstruction from” — the court read the introductory words of Section 1129(b)(1) to mean that “despite the rights conferred by § 510(a),” cramdown is permissible so long as the plan does not discriminate unfairly and is fair and equitable. Id. at *6 (emphasis added). In so holding, the Third Circuit rejected the alternative interpretation advanced by the senior debt holders, who had argued that the “notwithstanding” clause meant that a plan could still be considered nondiscriminatory (and fair and equitable) notwithstanding that it enforced a subordination agreement.

The Third Circuit noted that its holding accorded with the “purpose” of Section 1129(b)(1). In an excerpt that may prove critical to the ultimate scope of its ruling, the court explained that:

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 pre-bankruptcy contractual arrangements, while leaving play in the joints.

Id. at *6.

The court went on to observe that its opinion aligned with one from the only other court to have addressed the issue^[2] and was consistent with legislative history. Judge Ambro acknowledged but rejected the view, advocated in an earlier article by Professor Kenneth Klee, that overriding Section 510(a) in a cramdown plan would be “anomalous” and “bizarre.” See Kenneth N. Klee, Adjusting Chapter 11: Fine Tuning the Plan Process, 69 Am. Bankr. L.J. 551, 561 (1995). Since Professor Klee had recommended deleting the reference to Section 510(a), yet Congress had not done so, the court concluded that the result compelled by the “plain language” of Section 1129(b)(1) must have been intended. Tribune, 2020 WL 5035797, at *7.

The Application of the Unfair Discrimination Test

Turning to the application of the unfair discrimination test, the Third Circuit held that the plan’s allocation of the subordinated debt recoveries was not unfairly discriminatory.

The court was confronted with two principal, and related, questions: first, whether it was appropriate to compare the senior noteholders’ desired and actual recoveries rather than compare the recoveries of Class 1E (the senior noteholders) and Class 1F (the retirees and trade); and second, whether the appropriate baseline recovery for comparison’s sake was 21.9% (the recovery prior to reallocation of amounts that otherwise would have gone to junior debt) or 33.6% (the recovery after such reallocation). The senior noteholders contended that their recovery from the estate was only 21.9% (since the rest of their distributions came from a turnover by subordinated creditors), while the trade and retiree creditors’ recovery from the estate was 33.6% (since they had no contractual right of turnover and their only source of recoveries was the plan).

The Third Circuit rejected both arguments. While the court acknowledged that a “class-to-class” comparison is typical — indeed, “nearly always” applied — there was nothing in the text of the statute that “explicitly limits the unfair-discrimination analysis to only a class-to-class comparison.” Tribune, 2020 WL 5035797, at *10, 11. Where, as here, a class-to-class comparison was difficult (since the swap claim and senior noteholder claims — both senior debt — were in different classes), it may be appropriate for a court to “opt to be pragmatic and look to the discrepancy between the dissenting class’s desired and actual recovery.” Id. at *11.

The court next rejected the senior noteholders’ contention that their “plan” recoveries were only 21.9% while the trade and retiree creditors’ “plan” recoveries were 33.6%. To adopt this reasoning would be “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 and the Swap Claim).” Id. at *12.

Applying these legal conclusions to the facts, the Third Circuit determined that the 0.9 percentage-point difference between the senior noteholders’ desired (34.5%) and actual (33.6%) recoveries was not “material” for purposes of the unfair discrimination test.^[3] Tribune, 2020 WL 5035797, at *12.

Conclusion

Tribune sheds important new light not just on Section 1129(b)(1)’s “notwithstanding” clause but also on the unfair discrimination analysis more broadly — but it raises new questions as well.

It may be tempting for some to read the opinion as holding that subordination agreements need not be complied with in cramdown. Indeed, the senior noteholders warned against just such an eventuality, pointing out that Section 510(a)’s directive of enforcement would be toothless if it could be avoided in cramdown, and that enforcement only by consent is not “enforcement” at all. There is reason to believe, however, that the Third Circuit’s ruling is more limited. While holding that the Bankruptcy Code “does not compel courts reviewing cramdown plans to enforce subordination agreements strictly,” it went on to caution that “not to do so must conform with the constraints set out in the cramdown provision.” Tribune, 2020 WL 5035797, at *12 (emphasis added). Depending on the circumstances, in other words, a plan may be determined to be unfairly discriminatory if it fails to give due weight to a subordination agreement. See, e.g., id. at *6 (noting that part of the purpose of Section 1129(b)(1) is to test “whether involuntary reallocations of subordinated sums under a plan unfairly discriminate against the dissenting class” and that the provision “attempts to ensure that debtors and courts do not have carte blanche to disregard pre-bankruptcy contractual arrangements, while leaving play in the joints”).

Similarly, while the court did not apply the usual class-to-class comparison of recoveries for purposes of evaluating unfair discrimination, this does not reflect disapproval of the typical approach. Indeed, far from it: The court, in comparing desired with actual recoveries, was careful to note that “this is not the preferred way to test whether the allocation of subordinated amounts under a plan to initially non-benefitted creditors unfairly discriminates,” but that it “may, however, be an appropriate metric (or cross-check) given the circumstances of the case.” Id. at *12. Thus, the senior noteholders’ warnings against the establishment of a “Robin Hood” system under which “large” sums may be taken from large creditor classes (who may see little percentage effect) and gifted to smaller creditor classes (who may be materially benefited), may be overstated.

In sum, the reality of the opinion is more nuanced than certain of its language, considered in a vacuum, might suggest. Unfair discrimination, as the court notes, is “rough justice” (id. at *12), and how the standard is applied remains very much flexible and fact-specific.

^[1] The senior debt comprised both senior notes and an unsecured swap claim. The swap claim was initially placed in Class 1F, but was later determined to be senior debt entitled to the same treatment as the senior notes in Class 1E.

^[2] In re TCI 2 Holdings, 428 B.R. 117, 141 (Bankr. D. N.J. 2010).

^[3] Though not discussed at length in this article, the Third Circuit spent considerable time articulating a set of eight general principles framing the unfair discrimination standard, which will undoubtedly be relevant to future cases. See Tribune, 2020 WL 5035797, at *9-11. The court applied — though it did not formally or exclusively endorse — a version of the “rebuttable presumption” test for unfair discrimination, noting that the bankruptcy court had opted to apply that test (over other alternatives) and the parties had not challenged that holding. See id. at *9 & n.16.