Appendix — Greystone III Joint Venture v. Phoenix Mutual Life Insurance, 113 S. Ct. 72 (1992) (No. 91-1902)

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NO. OFFICE OF THE chen |

IN THE

SUPREME COURT OF THE UNITED STATES >

October Term, 1991

GREYSTONE III JOINT VENTURE.

Petitioner

Vv.

PHOENIX MUTUAL LIFE

INSURANCE COMPANY,

Respondent

ON WRIT OF CERTIORARI

TO THE FIFTH CIRCUIT

COURT OF APPEALS

APPENDIX TO

PETITION FOR WRIT OF CERTIORARI

ADRIAN M. OVERSTREET, JR., ESQ.

Counsel of Record

STEPHEN W. SATHER, ESQ.

1209 W. 5th St.

Austin, TX 78703

(512) 474-6436

ATTORNEYS FOR PETITIONER

GREYSTONE III JOINT VENTURE

INDEX TO APPENDIX

Judgment of the Court of Appeals

Opinion On Petition for Rehearing

and Suggestion for Rehearing

dated 2/27/92

Opinion of the Court of Appeais

dated 11/19/91

Order of the United States

District Court

Order of Confirmation of Debtor’s Second

Amended Plan of Reorganization

as Modified

Decision on Confirmation of Debtor's

Second Amended Plan of

Reorganization as Modified

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A-72

UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

NO. 90-8529

D.C. DOCKET NO. A-89-CA 667

In the Matter of

GREYSTONE III JOINT VENTURE, Debtor

PHOENIX MUTUAL LIFE INSURANCE COMPANY,

Appellant,

GREYSTONE III JOINT VENTURE,

Appellee.

Appeal from the United States District

Court for the Western District

Before REYNALDO G. GARZA, POLITZ and JONES,

Circuit Judges.

JUDGMENT

This cause came on to be heard on the record on

appeal and was argued by counsel.

ON CONSIDERATION WHEREOF, It is now here

ordered and adjudged by this Court that the

judgment of the District Court affirming the

bankruptcy court's confirmation of Greystone’s

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plan of reorganization is reversed, and the cause is

remanded to the District Court for further proceed-

ings in accordance with the opinion of this Court.

IT IS FURTHER ORDERED that appellee pay to

appellants the costs on appeal to be taxed by the

Clerk of this Court.

November 19,1991

ISSUED AS MANDATE: May 4, 1992

A-2

In the Matter of

GREYSTONE, III JOINT VENTURE, Debtor.

PHOENIX MUTUAL LIFE

INSURANCE COMPANY,

Appellant,

GREYSTONE III JOINT VENTURE,

Appellee.

No. 90-8529.

United States Court of Appeals,

Fifth Circuit.

Feb. 27, 1992.

Appeal from the United States District Court For

the Western District of Texas; Walter S. Smith, Jr.,

Judge.

ON PETITION FOR REHEARING AND SUGGES-

TION FOR REHEARING EN BANC

(Opinion November 19, 1991, 5th Cir., 1991, 948

F.2d 134)

Before POLITZ, Chief Judge, REYNALDO G.

GARZA and JONES, Circuit Judges.

PER CURIAM:

A majority of the panel having voted to grant

rehearing in part, the opinion of the court in dis-

posing of this appeal is as follows:

Part IV of the panel opinion, found at 948 F.2d

A-3

134, 142-44 (5th Cir.1991), is hereby withdrawn

and.deleted from the opinion. In connection with

that determination, the last paragraph of Part III

also is deleted. Further, in the first sentence of the

second paragraph of the opinion, the word "three"

is changed to “two,” and the last sentence of that

paragraph is deleted. Part V of the opinion is

renumbered to IV. In withdrawing this portion of

the panel opinion we emphasize that the bank-

ruptcy court's opinion on the “new value exception”

to the absolute priority rule has been vacated and

we express no view whatever on that part of the

bankruptcy court's decision.

Other than these revisions, the original opinion is

reinstated and the petition for panel rehearing is

DENIED. Further, no member cf the panel or

judge in active service having requested that the

court be polled on rehearing en banc, see

Fed.R.App.P. and Local Rule 35, the suggestion for

rehearing en banc is DENIED.

EDITH H. JONES, Circuit Judge, dissenting:

How one should approach issues of a statutory

A-4

construction arising from the Bankruptcy Code

has been clouded, in my view, by Dewsnup v.

Timm, --- U.S. ----, 4112 S.Ct. 773, --- L.Ed.2d ----

(1991). Nevertheless, in reaffirming what I wrote

about the "new value exception" in Part IV of the

original opinion, and therefore in voting against a

rehearing, I would hope to stand with Galileo, who,

rebuffed by a higher temporal authority, muttered

under his breath, "Eppur si muove." ("And yet it

moves.")

A-5

In the Matter of

GREYSTONE III JOINT VENTURE, Debtor

PHOENIX MUTUAL LIFE INSURANCE COMPANY,

Appellant

GREYSTONE III JOINT VENTURE,

Appellee

No. 90-8529

United States Court of Appeals

Fifth Circuit

November 19, 1991

EDITH H. JONES, Circuit Judge:

This appeal pits a debtor whose only significant

asset is an office building in the troubled Austin,

Texas real estate market against a lender who

possesses a multi-million dollar lien on the proper-

ty. After obtaining bankruptcy relief under Chap-

ter 11, Greystone III proposed a "cramdown" plan

of reorganization, hoping to force a write-down of

over $3,000,000 on the secured lender's note and

to retain possession and full ownership of the

property. Over the secured lender's strenuous

A-6

objections, the bankruptcy court confirmed the

debtor's plan. In re Greystone III Joint Venture, 102

B.R. 560 (W.D.Tex.1989). On appeal, the district

court upheld the bankruptcy court's judgment.

127 B.R. 138.

For three reasons, we must reverse. First, the

Greystone plan impermissibly classified like credi-

tors in different ways and manipulated classifica-

tions to obtain a favorable vote. Second, tenant

security deposit holders were not properly deemed

an "impaired" class under the circumstances of

this plan. Third, because we find no “new value

exception" to the absolute priority rule codified in

11 U.S.C. § 1129(b)(2)(B), that rule was violated by

Greystone’s plan.

Appellant Phoenix Mutual Life Insurance Corpo-

ration ("Phoenix") lent $8,800,000, evidenced by a

non-recourse promissory note secured by a first

lien, to Greystone to purchase the venture's office

building. When Greystone defaulted on the loan,

missing four payments, Phoenix posted the proper-

A-7

ty for foreclosure. Greystone retaliated by filing a

Chapter 11 bankruptcy reorganization petition. !

At the date of bankruptcy Greystone owed Phoe-

nix approximately $9,325,000, trade creditors

approximately $10,000, and taxing authorities

approximately $145,000. The bankruptcy court

valued Phoenix's secured claim at $5,825,000, the

appraised value of the office building, leaving

Phoenix an unsecured deficiency of approximately

$3,500,000--the difference between the aggregate

owed Phoenix and its secured claim.

As filed, Greystone’s Second Amended Plan of

Reorganization (the "Plan"), the confirmation of

which is challenged in this appeal, separately

classified the Code-created unsecured deficiency

claim of Phoenix-Mutual, See 11 U.S.C. § 1111(b),

1 No issue concerning the "good faith" of Greystone’s Chap-

ter 11 filing has been raised in the papers pertinent to this

appeal. Compare In re Humble Place Joint Venture, 936 F.2d

814 (Sth Cir.1991); In re Little Creek Dev. Co., 779 F.2d 1068

(Sth Cir. 1986).

A-8

and the unsecured claims of the trade creditors.

The Plan proposed to pay Phoenix and the trade

creditors slightly less than four cents on the dollar

for their unsecured claims, but it also provided

that Greystone’s general partner would satisfy the

balance of the trade creditors’ claims after confir-

mation of the Plan.

In a separate class, the Plan further provided for

security deposit "claims" held by existing tenants of

the office building. These claimants were prom-

ised, notwithstanding the debtor's eventual

assumption of their leases, 11 U.S.C. § 365, 25% of

the their deposits upon approval of the Plan and

50% of their deposits at the expiration of their

'- respective leases. The Pian stipulated that the

general partner would "retain its legal obligations

and... pay the [tenant]. . . creditors the balance

of their claims upon confirmation."

Finally, Greystone's Plan contemplated a

$500,000 capital infusion by the debtor's partners,

for which they would reacquire 100% of the equity

interest in the reorganized Greystone Unsurprising-

A-9

Ww ractiete SATS Oe SEEN 60 BE oy

ly, Phoenix rejected this Plan, while the trade credi-

tors and the class of holders of tenant security

deposits voted to accept it. On January 27, 1989,

the bankruptcy court held a confirmation hearing

at which the Debtor orally modified its Plan to

delete the statements that the general partner

would pay the balance of trade debt and tenant

security deposit claims after confirmation. A

Phoenix representative testified that the insurance

company was willing to fund its own plan of reor-

ganization by paying off all unsecured creditors in

cash in full after confirmation. The bankruptcy

court refused to consider this proposal and then

confirmed Greystone’s modified Plan. The district

court upheld the confirmation.

Phoenix Mutual now appeals on several grounds:

(a) the plan classified Phoenix's unsecured defi-

ciency claim separately from that of other unse-

cured creditors for no valid reason; (b) the "new

value exception" to the absolute priority rule did

not survive passage of the Bankruptcy Code: and

A-10

paired claims that could vote on the plan.”

II.

Phoenix first attacks Greystone’s classification of

its unsecured deficiency claim in a separate class

from that of the other unsecured claims against

the debtor. This issue benefits from some back-

ground explanation.

Chapter 11 requires classification of claims

against a debtor for two reasons. Each class of

creditors will be treated in the debtor's plan of

reorganization based upon the similarity of its

members’ priority status and other legal rights

against the debtor's assets. 11 U.S.C. § 1122.

Proper classification is essential to ensure that

2 Because the case is resolved on these issues, we need not

discuss appellant's further contention that additional disclo-

sure was required after the debtor orally modified its plan at

the confirmation hearing.

A-11

ee ee ere

creditors with claims of similar priority against the

debtor's assets are treated similarly. Second, the

classes must separately vote whether to approve a

debtor's plan of reorganization. 11 U.S.C.

§ 1129(a)(8),(10). A plan may not be confirmed

unless either (1) it is approved by two-thirds in

amount and more than one-half in number of each

“impaired” class, 11 U.S.C. §§ 1126(c), 11129(a)(8);

or (2) at least one impaired class approves the

plan, § 1129(a)(10), and the debtor fulfills the

cramdown requirements of § 1129(b) to enable

confirmation notwithstanding the plan's rejection

by one or more impaired classes. Classification of

claims thus affects the integrity of the voting

process, for, if claims could be arbitrarily placed in

separate classes, it would almost always be possi-

ble for the debtor to manipulate "acceptance" by

artful classification.

In this case, Greystone’s plan classified the

Phoenix claim in separate secured and unsecured

classes, a dual status afforded by 11 U.S.C. §

1111(b) despite the non-recourse nature of Phoe-

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nix's debt. Because of Phoenix's opposition to a

reorganization, Greystone knew that its only hope

for confirmation lay in the Bankruptcy Code's

cramdown provision. 11 U.S.C. § 1129(b). The

substantive impact of cramdown will be discussed

later. Procedurally, Greystone faced a dilemma in

deciding how to obtain the approval of its cram-

down plan by at least one class of "impaired"

claims, as the Code requires.* 11 U.S.C.

§ 1129(a)(10). Greystone anticipated an adverse

vote of Phoenix’s secured claim. If the Phoenix

$3.5 million unsecured deficiency claim shared the

same class as Greystone’s other unsecured trade

claims, it would swamp their $10,000 value in

voting against confirmation. The only other argua-

bly impaired class consisted of tenant security

3 An impaired claim is defined at 11 U.S.C. § 1124. For

present purposes, it suffices to say that Phoenix was im-

paired both as a secured and unsecured creditor.

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deposit claims, which, the bankruptcy court found,

were not impaired at all.

Greystone surmounted the hurdle by classifying

Phoenix's unsecured deficiency claims separately

for the trade claims, although both classes were to

be treated alike under the plan and would receive a

cash payment equal to 3.42% of each creditor's

claim. Greystone then achieved the required

favorable vote of the trade claims class.

Phoenix contends that Greystone misapplied

§ 1122 by classifying its unsecured claim separate-

ly from those of trade creditors. The lower courts

rejected Phoenix's argument in three steps. First,

they held that § 1122 of the Code does not unam-

biguously prevent classification of like claims in

separate classes. The only question is what types

of class differentiations among like claims are

acceptable. Second, Greystone’s unsecured defi-

ciency claim is "legally different" from that of the

trade claims because it arises statutorily, pursuant

to § 1111(b). Third, “good business reasons" justi-

fy the separate classification of these unsecured

A-14

claims. We must address each of these arguments. |

Section 1122 prescribes classification of claims

for a reorganization as follows:

(a) Except as provided in subsection

(b) or this section, a plan may place a

claim or an interest in a particular

class only if such claim or interest is

substantially similar to the other

claims or interests of such claims.

(b) A plan may designate a separate

class of claims consisting only of every

unsecured claim that is less than or

reduced to an amount that the court

approves as reasonable and necessary

for administrative convenience.

We observe from this language that the lower

courts’ suggestion that § 1122 does not prevent

classification of like claims in separate classes is

oversimplified. It is true that § 1122(a) in terms

only governs permissible inclusions of claims in a

class rather requiring that all similar claims be

grouped together. One cannot conclude categori-

A-15 |

cally that § 1122(a) prohibits the formation of dif-

ferent classes from similar types of claims. But if

§ 1122(a) is wholly permissive regarding the crea-

tion of such classes, there would be no need for

§ 1122(b) specifically to authorize a class of smaller

unsecured claims, a common feature of plans in

reorganization cases past and present.* The broad

interpretation of § 1122(a) adopted by the lower

courts would render § 1122(b) superfluous, a

result that is anathema to elementary principles of

statutory construction.

Section 1122 consequently must contemplate

some limits on classification of claims of similar

. Greystone has never sought to justify its separate class of

trade creditors under § 1122(b), nor did the lower courts

employ that provision in their analysis. There is no sugges-

tion in the Code, however, that a class may be created under

§ 1122(b) in order to manipulate the outcome of the vote on a

plan, rather than simply to enhance administration “the

a a Lal am Ser oN aa aN

plan.

priority. A fair reading of both subsections sug-

gests that ordinarily “substantially similar claims,"

those which share common priority and rights

against the debtor's estate, should be placed in the

same class. Section 1122(b) expressly creates one

exception to this rule by permitting small unse-

cured claims to be classified separately from their

larger counterparts if the court so approves for

administrative convenience. The lower courts

acknowledged the force of this narrow rather than

totally permissive construction of § 1122 by going

on to justify Greystone’s segregation of the Phoenix

claim. Put otherwise, the lower courts essentially

found that Phoenix's unsecured deficiency claim is

not “substantially similar" to those of the trade

creditors.

Those courts did not, however, adhere to the one

clear rule that emerges from otherwise muddled

case law on § 1122 claims classification: thou

shalt not classify similar claims differently in order

to gerrymander an affirmative vote on a reorganiza-

tion plan.

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As the Sixth Circuit observed:

[T]here must be some limit on a debt-

or’s power to classify creditors in such

amanner.... Unless there is some

requirement of keeping similar claims

together, nothing would stand in the

way of a debtor seeking out a few

impaired creditors (or even one such

creditor) who will vote for the plan and

placing them in their own class.

In re U.S. Truck Co., 800 F.2d 581, 586 (6th

Cir.1986). See also In re: Holywell Corp., 913 F.2d

873 (11th Cir. 1990); Hanson v. First Bank of South

Dakota, 828 F.2d 1316, 1313 (8th Cir. 1987); In re

Lumber Exch. Ltd. Partnership, 125 B.R. 1000,

1005-1006 (Bankr.Minn.1991); In re Waterways

Barge Partnership, 104 B.R. 776, 783-86

(N.D.Miss. 1989) (good discussion); In re Mastercraft

Record Plating, Inc., 32 B.R. 106, 108

(Bankr.S.D.N.Y.1983), rev’d on other grounds, 39

B.R. 654 (S.D.N.Y.1984). We agree with this rule,

and if Greystone’s proffered "reasons" for separate-

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a a a ee ae ee genre er ne arena ee re ee

ly classifying the Phoenix deficiency claim simply

mask the intent to gerrymander the voting process,

that classification scheme should not have been

approved. |

Greystone's reliance on Brite v. Sun Country

Development, Inc., 764 F.2d 406 (5th Cir.1985), as

an allegedly contrary rule is misplaced. That case

allowed the debtor to impair a previously unim-

paired class of creditors not for purposes of vote-

getting but because the debtor belatedly discovered

that it did not have sufficient funds to pay the

creditors’ claims in full. The court found that the

debtor's decision to reclassify previously unim-

paired creditors as impaired was necessary. Id. at.

408. Sun Country does not support Greystone’s

argument that plan proponents possess unlimited

discretion to classify unsecured claims separately.

We conclude that if § 1122(a) permits classification _

of “substantially similar" claims in different class-

es, such classification may only be undertaken for

reasons independent of the debtor's motivation to

secure the vote of an impaired, assenting class of

A-19

| ence

claims. To those proffered reasons we now turn.

Greystone contends that the "legal difference"

between Phoenix's deficiency claim and the trade

creditors’ claims is sufficient to sustain its classifi-

cation scheme. The alleged distinction between the

legal attributes of the unsecured claims is that

under state law Phoenix has no recourse against

the debtor personally. However, state law is irrele-

vant where, as here, the Code has eliminated the

legal distinction between non-recourse deficiency

claims and other unsecured claims. See 11 U.S.C.

§ 1111(b)(1)(A); In re Tampa Bay Associates, Ltd.,

864 F.2d 47 (5th Cir.1989) Hanson, 828 F.2d at

1313.°

. Greystone argues that Hanson is not controlling because

the issue there was whether it was clearly erroneous for the

bankruptcy court to deny separate classification whereas

the issue here is whether it was clearly erroneous for the

court to approve the classification. The clearly erroneous

rule has no application in this context. Whether a deficien-

A-20

The purpose of § 1111(b) is to provide an under-

secured creditor an election with respect to the

treatment of its deficiency claim. Generally, the

creditor may elect recourse status and obtain the

right to vote in the unsecured class, or it may elect

to forego recourse to gain an allowed secured claim

for the entire amount of the debt. If separate clas-

sification of unsecured deficiency claims arising

from non-recourse debt were permitted solely on

the ground that the claim is non-recourse under

state law, the right to vote in the unsecured class

would be meaningless. Plan proponents could

effectively disenfranchise the holders of such

..Continued...

cy claim is legally similar to an unsecured trade claims turns

not on fact findings but on their legal characteristics. This is

an issue of law, freely reviewable on appeal. See Richmond

Leasing Co. v. Capital Bank, N.A., 762 F.2d 1303, 1307 (5th

Cir.1985). Subsidiary fact findings however, may be entitled

to the deference of the clearly erroneous test. Id.

A-21

claims by placing them in a separate class and

confirming the plan over their objection by cram-

down. With its unsecured voting rights effectively

eliminated, the electing creditor's ability to negoti-

ate a satisfactory settlement of either its secured or

unsecured claims would be seriously undercut. It

seems likely that the creditor would often have to

“elect" to take an allowed secured claim under

§ 1111(b)(2) in the hope that the value of the col-

lateral would increase after the case is closed.®

Phoenix's $3,500.000 deficiency claim by the promised

payment of $140,000. Under the valuation process, it con-

fined Phoenix's secured claim to $5.8 million. 11 U.S.C. §

506(a). Phoenix obviously objects to this arrangement

because, in the future, it might ultimately receive more than

the written-down value of the office building in a liquidation

following foreclosure. Yet, with its voting rights effectively

eliminated by separate classification. Phoenix has no lever-

A-22

Thus, the election under § 1111(b) would be essen-

‘tlally meaningless. We believe Congress did not

intend this result.

As the bankruptcy court viewed this issue, the

debtor's ability to achieve a cramdown plan should

be preferred over the creditor's § 1111(b) election

rights because of the Code's policy of facilitating

reorganization. The bankruptcy court resorted to

policy considerations because it believed Congress

did not foresee the potential impact of an electing

creditor's deficiency claim on the debtor's aspira-

tion to cramdown a plan. We disagree with this

approach for three reasons. First, it results here in

. Continued...

age to persuade the Debtor to consider a more reasonable

settlement. Had this scenario triumphed, Phoenix's most

realistic option might have been to take an allowed secured

claim in the hope that eventually the market value of the

office building will increase by more than $140,000 over the

presently estimated value of the collateral.

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a ee

violating § 1122, by gerrymandering the plan vote,

for the sake of allegedly effectuating a § 1129(b)

cram-down. "Policy" considerations do not justify

preferring one section of the Code, much less

elevating its implicit "policies" over other sections,

where the statutory language draws no such dis-

tinctions. Second, as shown, it virtually eliminates

the § 1111(b) election for secured creditors in this

type of case. Third, the bankruptcy court's con-

cern for the viability of cramdown plans is over-

stated. If Phoenix’s unsecured claim were lower

and the trade debt were higher, or if there were

other impaired classes that favored the plan, a

cramdown plan would be more realistic. That

Greystone’s cramdown plan may not succeed on

the facts before us does not disprove the utility of

the cramdown provision. The state law distinction

between Code-created unsecured deficiency claims

and other unsecured claims does not alone war-

rant separate classification.

Greystone next argu€s that separate classification

was justified for "good business reasons." The

A-24

OO I EE ee

bankruptcy court found that the debtor “need[s]

trade to maintain good will for future operations.”

In re Greystone III Joint Venture, supra at 570. The

court further reasoned:

[I]f the expectation of trade creditors is

frustrated ... [they] have little re-

course but to refrain from doing

business with the enterprise. The

resulting negative reputation quickly

spreads in the trade community,

making it difficult to obtain services in

the future on any but the most oner-

ous terms,

Id. Greystone argues that the "realities of busi-

ness" more than justify separate classification of

the trade debt from Phoenix's deficiency claim.

This argument is specious, for it fails to distin-

guish between the classification of claims and the

separate classification of the trade claims might be

valid if the trade creditors were to receive different

treatment from Phoenix. Indeed, Greystone initial-

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1 er

ly created a separate class of unsecured creditors

that could be allowed to vote for the plan by the

promise to pay their remaining claims in full out-

side the plan. Greystone then changed course and

eliminated its promise. Because there is no sepa-

rate treatment of the trade creditors in this case,

we reject Greystone’s "realities of business" argu-

ment.

Even if Greystone’s Plan had treated the trade

creditors differently from Phoenix, the classification

scheme here is still improper. At the confirmation

hearing, none of the Debtor's witnesses offered any

reason for classifying the trade debt separately

from Phoenix's unsecured deficiency claim. There

is no evidence in the record of a limited market in

Austin for trade goods and services. Nor is there

any evidence that Greystone would be unable to

obtain any of the trade services if the trade credi-

tors did not receive preferential treatment under

the Plan. Thus, the bankruptcy court's finding

that there were good business reasons for separate

classification is without support in the record and

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—

must be set aside as clearly erroneous.

Phoenix's unsecured deficiency claim approxi-

mates $3,500,000, while the claims of the unse-

cured trade creditors who voted to accept the Plan

total less than $10,000. Greystone’s classification

scheme, which effectively disenfranchised Phoe-

nix’s Code-created deficiency claim, is sanctioned

neither by the Code nor by case law. The lower

courts erred in approving it.

III.

As a fall-back position, Greystone argues that the

office-building tenants constitute an impaired class

’ Two standards of appellate review apply to the debtor's

classification of claims. Issues such as the similarity in

priority and legal attributes and the ultimate question

whether treatment in the same or separate classes is neces-

sary, are legal issues reviewable by our court de novo. See n.

5 supra. Whether there were any good business reasons to

support the debtor's separate classification of claims is a

question of fact.

A-27

whose votes for Greystone’s Plan should have been

considered for purposes of satisfying the pre-condi-

tion of cramdown that there be one assenting,

impaired class. The bankruptcy court held that

the tenants were not an impaired class and could

not vote on the Plan because Greystone had

assumed their leases. The district court disagreed

and held that despite the Debtor's assumption of

the leases, the tenants could be counted as an

impaired accepting class. Phoenix argues this was

error.

A debtor in Chapter 11 must either assume or

reject its leases with third parties. 11 U.S.C. §

365. If the debtor does neither, the leases contin-

ue in effect and the lessees have no provable claim

against the bankruptcy estate. See Matter of

Whitcomb & Keller Mortgage Co., 715 F.2d 375,

378-79 (7th Cir. 1983); In re Cochise College Park,

Inc., 703 F.2d 1339, 1352 (9th Cir.1983). Under

the Code, only creditors are entitled to vote ona

plan of reorganization. See 11 U.S.C. § 1126(c). A

party to a lease is considered a "creditor" who is

A-28

allowed to vote, 11 U.S.C. § 1126(c}, only when the

party has a claim against the estate that arises

from rejection of a lease. In re Perido Motel Group,

Inc., 101 B.R. 289, 293-94 (Bankr.N.D.Ala. 1989).

If, however, the debtor expressly assumes a lease,

the lessee has no "claim" against the debtor under

§ 1126a). See 11 U.S.C. § § 365(g), 502(g). The

rights created by assumption of the lease consti-

tute a post-petition administration claim under

section 503(b)(1)(A) of the Code. LJC Corp. v.

Boyle, 768 F.2d 1489, 1494 n. 6 (D.C.Cir. 1985).

The holder of such a claim is not entitled to vote on

a plan of reorganization. 11 U.S.C. § 1126(a); In re

Distrigas Corp. 66 B.R. 382, 385-86

(Bankr.D.Mass. 1986).

Here, Greystone never rejected its leases with the

tenants. There is thus no support for the assertion

that the tenants’ "claims" entitled them to vote on

Greystone's Plan. The district court erred in alter-

natively permitting confirmation of the Plan based

on the tenants’ affirmative votes.

Although we must remand simply because the

A-29

Greystone Plan mis-classified creditors’ claims, it

remains possible that Greystone will propose

another plan incorporating, as did this one, the

"exception" to the absolute priority rule. For the

sake of judicial economy, we consider that possibil-

ity next.

IV.

Greystone’s Plan relied upon the "new value

exception" to the “absolute priority rule" to justify

retaining ownership of the office building notwith-

standing the plan's write-down of over 33%, or

$3.5 million, of its debt to Phoenix. Outside the

bankruptcy, such a result would be unthinkable,

for Phoenix could have foreclosed and taken back

its building for better or worse. Whether current

bankruptcy law permits this egregious alteration of

A-30

rights without the secured creditor's consent has

generated considerable controversy.® The lower

courts held in favor of Greystone. We do not.

On its face, the Code does not appear to allow the

equity owners of a bankrupt enterprise, or any

junior creditors for that matter, to retain or obtain

® In In Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 108 S.Ct.

963, 967.n. 3,99 L.Ed.2d 169 (1988), the Supreme Court expressly

declined to rule on whether a “newvalue exception" to the absolute

priority rule survived enactment of the Bankruptcy Code. The

circuit courts are divided. See, e.g., Kham & Nate's Shoes No. 2 v.

First Bank, 908 F.2d 1351 (7th Cir. 1990)(dicta)(questioning contin-

ued vitality of absolute priority rule); Inre Anderson, 913 F.2d 530,

532-33 (8th Cir. 1990)(exception exists); Inre U.S. Truck Co., 800

F.2d 581, 587-88 (6th Cir.1986). Bankruptcy courts have been

sharply divided on the issue. Compare Inre Outlook / Century, Lid.,

127 B.R. 650, 656 (Bankr.N.D.Cal. 1991) and In re Lumber Ex-

change Ltd. Partnership, 125B.R. 1000 (Bankr. Minn. 1991)(no new

value exception), with Inre Sawmill Hydraulics, Inc., 72 B.R. 454,

456 n. 1 (Bankr.C.D.IIl. 1987).

A-31

ownership and control of the debtor without the

appropriate consent of senior creditors. This

“absolute priority rule" is codified at 11 U.S.C. §

1129(b)(2)(B) as a definition of the "fair and equita-

ble" standard for plan confirmation. Thus, the

holder of any claim or interest that is junior to the

claims of an unsecured class may not receive any

property on account of its claim or interest until

the senior claims are repaid in full. Id. It is

undisputed that the right to run the reorganized

business is property. Norwest Bank Worthington v.

Ahlers, 485 U.S. 197, 108 S.Ct.963, 969, 99

L.Ed.2d 169 (1988). The purpose of this section is

to stratify creditors and equity interests so that a

cramdown, or nonconsensual, plan will not redis-

tribute a dissenting creditor's property rights to

those with a junior right or interest iri the debtor.

Such a result would be neither fair nor equitable.

In re Greystone III, 102 B.R. 574.

It was Greystone’s burden to demonstrate how its

owners’ offer to infuse $500,000.00 into the debtor.

paying off only a tiny fraction of Phoenix's deficien-

A-32

cy claim, satisfied the absolute priority rule.

Greystone’s argument proceeds in four phases.

First, before adoption of the Bankruptcy Code the

term "fair and equitable" had an established

meaning that, under certain circumstances, al-

lowed a deviation from the absolute priority rule if

equity owners agreed to put cash into the company

in exchange for an appropriate ownership interest.

See, e.g., Case v. Los Angeles Lumber Products Co..

308 U.S. 106, 121-22, 60 S.Ct. 1, 10-11, 84

L.Ed.110 (1939)(dictum). Second, because the

Code did not specifically overrule the prior judicial

understanding of the fair and equitable standard.

it must have incorporated that standard by includ-

ing the “new value exception" in § 1129(b)(2)(B).

Third, if § 1129(b)(2)(B) does not specifically codify

the "new value exception," it represents only a

partial definition of "fair and equitable" that leaves

room for one. Fourth, Greystone’s offer of

$500,000 satisfies the new value exception.

With due respect to the ingenuity of Greystone’s

Statutory construction agreement, we feel com-

A-33

: en en a 7

pelled nevertheless to paraphrase Gertrude Stein:

"There is no there there." It is not obvious, for

instance, that the Case "new value exception" is

meaningful in the context of Chapter 11's reorgani-

zation provisions, which differ markedly from the

prior law. When Case was decided, the unanimous

consent of all creditor classes was required in

addition to a fair and equitabie plan conforming to

the absolute priority rule. Case 308 U.S. at ll4n.

6, 60 S.Ct. 6, n. 6. The 1978 Bankruptcy Code,

however, permits less-than-unanimous acceptance

of a creditor class to suffice even if the absolute

priority rule is not satisfied and alternatively speci-

fies conditions for cramdown plans. 11 U.S.C. §

1129(a), 1129(b)(2). This increased flexibility

arguably renders the Case exception unnecessary

and is certainly a significant distinction from the

statutory background to that decision. In re Out-

look/Century Ltd., supra.

Greystone'’s efforts to parse the statutory language

for evidence of incorporation of the "new value

exception" are similarly unpersuasive. Greystone

A-34

relies on two phrases in § 1129(b)(2). It is con-

tended that by defining the “fair and equitable

standard” ta “include the fallawing requirements,’

ihe delinitian ia demanatrably ineamplete, leaving

HWAPHAI PAAM TAP A HOW VAIHE BxeeptiAan, Tyla

APPA VATINAIY, HRRAHAR HHP HAIRY BA ARe aah 8

VT Pe TT Ae Ae pl

THAT HAY He POAT BH VE BPR eee

Matter & FP Cana Hielibh, He, BBB Od BPA, BP

(5th Cie. 1989), The “Hew value eReeption,” by

cotitrast, dilutes the minimum requirement.

Alternatively, Greystone focuses on the condition

in § 1129(b)(2)(B)(ii) that a junior claim or interest

nay not receive or retain property on account of its

Interest until more senior parties are fully satisfied.

This argument holds that if “old equity’ infuses

Hew Mibtey tite the debtor, it 16 Hot FetA HIE te

HWHEPAHIP OH HEHE OF The Ad Batty wate

THIA 18 THREE WHEAHIAY, HRRAHAR FRY ALM Wee

1H PP RVETE REBATE TAI ERRATA Aer ety a

He PPAPRILY HY ARROHE Ot Liveyalone’s Ed

HATHA Ae AP AT PUY OPEIbutOP bo the plan

AeGo

More specifically, Greystone desired to prevent a

competitive auction of the property, at which

Phoenix cauld credit bid, precisely because al

Hpeyatane s ald equity alatua, Greystane eannat

POAH HA® SFAIHIATY JANMHage 1 ane @ aelbserving

Lah

TH PVATHHE HPP PHHERDHA TAE TP ee e

HHP PRPPRRR DP THD) A HW VATU Beeb) 1

HHEPELY THEBHHEH th PHHIAY DPReReHe Law ae de Hl

Hreonsistent with such law, THIS position al

tributes too little weight to the statutory language,

which "we are to take...seriously even when it

alters pre-Code practices." Kham & Nate's Shoes

No, 2 v. First Bank, 908 F.2d 1351 (7th

Cir. 1990)(Easterbrook, J.), citing Pennsylvania

Dept, of Welfare uv. Davenport, 495 U.S, 559, 110

S.Ot, 9196, 91900-9891, 104 1, ha. 94 Bae 11 aan

MHPRHVEE, He UHH PATH PHAR AHA Wee Hae

HHAREVEH, CHUMP RRR KIRAPLY FRIBRIRH OHARA HY

HHA PAPE RY EOTIRATA TA HAY Fe aed

HEA PPIAPLY Pule when te enaeled the bade. Gee

Hu, Ane, The Hankrpley Caniiiaaian’ a Pre

A-46

posed “Modifications” of the Absolute Priority Rule,

48 Am.Bankr.L.J. 305 (1974), Jn Outlook/Century

Lida., supra, Fram this histary ane ean infer that

Oangpeaa acted knawled@eably Wy QAMHYVINE a AH IES

AWAAII® BIAPIEY PAIR, BAR AIAHAPRY AlaR RANTS

ihe HP AV AHRAHON FAL HA HAW Valie aa BALLAD

We WAP RIY A TARTAR AT BRAT RTA A Hin Hebe

AWAHIIE DHAEIEY PL) Th he Ope atone Hh, (Ue AP

al B74, WeeAuee IE was PARE BF the precede “Tall

arid equitable" standard, Further, to the extent

that these arguments advocate equitable varia-

tions from the absolute priority rule, they conflict

with Ahlers’ observation that “whatever equitable

powers remain in he bankruptcy courts must and

eat only be exercised within the confines of the

HankHiptey Code.” Ahlers, stipra, 485 U.S, at 206,

1H & 6+, GAR-AG

in an aes HeleD, @ fed PeeedH Buea tee fat

AHR THE HRW VATE BRR HOH WHHL PEI RAE

Hed abaalule pearly Pule te HAE He ae Hime PHA

HEATH & BEATA PRAT MERA plan Hat mele

ihe debtor to te former equily awhere, ane He

Ady

“new value exception" is necessary to rein in that

potential force for self-dealing. We disagree with

the assumption that the Code permits a noncon-

APHAHAL AIAN {A “ell” the debtor to its old equity

WWHePA, Ta Hie in the face of the creditor control

HVPET PHAM AY in Chapter 11 and accepted by

Whee

He tnviy) wf Appeals may well have

Halinved | Wat petitioners or other

HHeeeuPed ppeditors would be better off

if respondents Teorganization plan was

confirmed, Put that determination is

for the creditors to make in the

manner sperified by the Code. 11

U.S.C, § 1196). -

485 U.S, at 906, 168 S.Ct. 969.

Mureaver, periitting the courts, pursuant to a

HeW VALUE eee ipn.” rather than the creditors,

HHHEP & Abbe Aayiute priority rule, to determine

He PHAM AHe At liemer equity owners’ participa-

Hit) Hi FRAP RAled debtor introduces an enor-

HAHAlY PAM PHAN factor in a carefully balanced

A-38

bargaining structure. The proposed test for the

“new value exception" is exceeding vague--requir-

ing the infusion in (a) money or money's worth of

(b) substantial (c) new value, (d) reasonably equiva-

lent to the extent of old equity's proposed partici-

pation in the reorganized debtor. and (e) necessary

to such reorganization. Amicus Brief of Prof.

Warren, at 12. If these criteria are essentially

factual, then each bankruptcy court can impose its

freewheeling view of reorganization policy without

fear of appellate reversal. Creditors and the debtor

are left to guess, not what each other's "bottom

line” position is for a consensual plan, but rather

what the particular court sees as a “bottom line”

cash contribution that will permit cramdown of an

old equity plan under the "new value exception.” It

is dubious to suppose that courts will ordinarily

possess superior foresight than the creditors

themselves concerning the creditors’ best interests.

Here. for instance, Greystone owed Phoenix $3.5

million above the value of its collateral, yet the

court, allowed it to pay $140,000 on that obligation

A-39

and retain complete ownership for a half-million

dollar capital infusion. Meanwhile, Greystone

remains obligated for only about $5.8 million on

what was originally an $8.8 million loan. If the

bankruptcy courts may implement "new value."

nonconsensual reorganization plans governed by

such amorphous standards, one wonders why

Congress bothered to frame elaborate ground rules

for achieving consensual plans. Negotiations

between creditors and the debtor against sucha

"new value exception" backdrop would be enor-

mously skewed erode the utility of the creditors’

votes.

Neither in the Code’s language, nor in the context

of a previous, different reorganization law, nor in

legislative history, nor in policy is there room for a

“new value exception" to the absolute priority rule

now defined by § 1129(b)(2)(B).

Because of this conclusion, it is unnecessary to

determine whether the lower courts properly ap-

plied a "new value exception" to the absolute priori-

ty rule. We note, however, that even though the

A-40

"standards" for that exception are most difficult to

consider effectively on appeal, the bankruptcy

court erred in refusing to consider Phoenix's

proposed equity contribution plan along with that

of former equity. There is no statutory or policy

reason why the court should have arbitrarily re-

jected a competing bid by Phoenix to infuse equity

into the debtor after the exclusivity period lapsed.

See 11 U.S.C. § 1121.

For the foregoing reasons, the judgment of the

district court affirming the bankruptcy court's

confirmation of Greystone’s plan of reorganization

is REVERSED. The case is REMANDED for pro-

ceedings consistent with this opinion.

A-41

In the Matter of

GREYSTONE III JOINT VENTURE, Debtor.

PHOENIX MUTUAL LIFE INSURANCE COMPANY.

Appellant,

GREYSTONE III JOINT VENTURE, Appellee.

Civ. A. Nos. A-89-CA-667, A-89-CA-842.

United States District Court.

W.D. Texas,

Austin Division.

July 31, 1990.

ORDER

WALTER S. SMITH, Jr., District Judge.

This is an appeal from a final order of the United

States Bankruptcy Court for the Western District

of Texas, Austin Division (Clark, J.).

I. Statement of Issues and Standard of Review

Phoenix Mutual Life Insurance Company ("Phoe-

nix Mutual" or the Appellant’) presents the follow-

ing issues:

1. Did the Bankruptcy Court err in permitting

the Debtor to separately classify the unsecured

trade creditors’ claims from Phoenix Mutual's

A-42

unsecured deficiency claim?

2. Did the Bankruptcy Court err in holding that

the Modified Plan does not violate the absolute

priority rule?

3. Did the Bankruptcy Court err in confirming

the Modified Plan without requiring new disclosure

to the Trade Creditor Class?

Under Bankruptcy Rules 7052 and 8013, the

Bankruptcy. Judge's findings of fact must be

upheld on appeal unless "clearly erroneous.” Inre

Beker Industries Corp., 89 B.R. 336, 342 n. 5

(S.D.N.Y.1988): In re Silver, 46 B.R. 772

(D.Col.1985). However, the Bankruptcy Judge's

conclusions of law are reviewed de novo. Richmond

Leasing Co. v. Capital Bank, N.A., 762 F .2d 1303

(Sth Cir. 1985).

Il. Statement of Facts and Statement of the Case

Greystone III Joint Venture (the "Debtor" or the

“Appellee") is a Texas joint venture composed of

Gerald D. Kucera, Greystone Bank Building Part-

nership and Greystone III, Ltd. The Debtor was

formed on August 30, 1983 for the purpose of

A-43

—

developing an office building located in Austin.

Texas. This project is the Debtor's primary asset.

Phoenix Mutual is the owner and holder of a

promissory note (the "Note") in the original princi-

pal amount of $8.8 million, executed by the Debt-

or, dated September 17, 1985, and due to Phoenix

Mutual. The Note is secured by a deed of trust

mortgage and assignment of rents covering the

Project. |

On April 4, 1988, the Debtor filed a voluntary

petition for relief under Chapter 11 of the Bank-

ruptcy Code. On June 13, 1988, the Debtor filed a

Plan of Reorganization and a Disclosure Statement.

On September 7, 1988, the Debtor filed its First

Amended Plan of Reorganization and its First

Amended Disclosure Statement. On September

28, 1988, the Debtor filed its Second Amended

Plan of Reorganization (the "Plan") and its Second

Amended Disclosure Statement (the "Disclosure

Statement"). Also on September 28, 1988. the

Bankruptcy Court conducted a hearing at which

the Disclosure Statement was approved. On

A-44

October 31, 1988, the Bankruptcy Court conduct-

ed a hearing on the propriety of the classification of

claims under the Plan and on the valuation of

Phoenix Mutual's secured claim under Section

506(a) of the Code. The aggregate amount of pre-

petition indebtedness owed to Phoenix Mutual

totals $9,300,773.60. The Court set the value of

the project at $5,825,000 for purposes of confirma-

tion of the Plan. Therefore, pursuant to 11 U.S.C.

ss 506(a) and 1111(b), Phoenix Mutual has a

secured claim of $5,825,000.00 and an unsecured

claim of approximately $3,500,000.00.

The Court approved the classification scheme of

the Plan, except that the Court required that two

classes of unsecured creditors, Classes 5 and 6, be

considered together for balloting. Objections to the

Plan were filed by Phoenix Mutual and the United

States Trustee ("Trustee").

On January 27, 1989, the Bankruptcy Court held

a confirmation hearing on the Plan, at which the

Debtor orally modified the Plan to satisfy certain

objections of Phoenix Mutual and the Trustee and

A-45

to clarify the Plan.

As previously noted, Phoenix Mutual's claims

were placed within different classifications under

the Plan, part secured and part unsecured. The

secured claim of Phoenix Mutual is contained in

Class 4, and provides that Phoenix Mutual would

receive the value of its secured claim at a market

interest rate in 360 monthly installments. The

Court, as previously noted, found the amount of

the secured claim to be $5,825,000. and the par-

Hes stipulated that 11 percent was a market inter-

est rate. At the confirmation hearing, the Plan was

modified to provide for a balloon payment after ten

years.

The Plan confirmed by the Bankruptcy Judge

separately classifies but identically treats the

unsecured claims of Phoenix Mutual and the

unsecured claims of trade creditors whose claims

aggregate less than $10,000 ("Classes 5 and 6" or

the "Trade Creditor Class"). The unsecured claim

of Phoenix Mutual was placed into Class 7, asa

non-recourse deficiency claim. The Plan provided

A-46

that Phoenix Mutual would receive "$200,000 (or

3.82%)" in cash on the effective date of the Plan.

The Plan further provides that Class 5/6 would be

paid 3.82 percent of their claims in cash upon the

effective date of the Plan.

Phoenix Mutual rejected the Plan as both a

secured and an unsecured creditor and did not

elect treatment under 11 U.S.C. s 1111(b)(2). The

Trade Creditor Class accepted the Plan. At the

Confirmation Hearing, a representative of Phoenix

Mutual testified that Phoenix Mutual was willing to

fund a reorganization of the Debtor that would pay

all unsecured claims in full. The Bankruptcy

Judge refused to permit Phoenix Mutual to file its

plan of reorganization for the Debtor.

On June 6, 1989, the Bankruptcy Court entered

its Decision on Confirmation of Debtor's Second

Amended Plan of Reorganization, as modified,

overruling Phoenix Mutual's objection and con-

firming the modified plan using the “cram down"

provisions of the Code. An Order of Confirmation

was entered on August 8, 1989. It is from this

A-47

confirmation that Phoenix Mutual appeals.

I{I. Discussion

A. Classification of Claims. The Appellant argues

that the Bankruptcy Court erred in separating

Phoenix Mutual's unsecured deficiency claim from

that of the claims of the other unsecured trade

creditors, asserting that there should have been

only one class of unsecured claims allowed under

the Plan.

Sections 1122 and 1123 of the Code require that

a plan of reorganization designate classes of

claims. Section 1123 provides in pertinent part:

(a) [A] plan shall--

(1) designate, subject to section 1122 of

this title, classes of claims, other than claims

of a kind specified in section 507(a)(1).

507(a)(2), or 507(a)(7) of this title, and class-

es of interests; ....

The Code expressly contemplates multiple classes

of claims. Section 1122 gives the Debtor substan-

tial freedom to establish classes of claims and

provides:

A-48

la) Except ae provided in Suleeetion (ty) af

(hie Seetan, a plan May PAGE & CLAN GF at

intereat if a PArtieulae Claee Giily Tf auen

Glali Ge (Htereat (e aubetanitially aiiiilae to

(he other claliie Ge literéate Gf eueh Class,

(hb) A plan tay designate a separate class

of claims consisting only of every unsecured

claim that is less than or reduced to an

amount that the court approves as reasona-

ble and necessary for administrative conven-

lence.

The manner in which claims are classified can

impact confirmation of a plan,

A plan may be confirmed under Section 1129(a) of

ihe Code if all classes of creditors accept the Plan

by the requisite majorities and certain other re

quirements are satisfied, However, if all of the

classes of creditors do not consent, a plan may be

confirmed under Section 1129(b) of the Code, the

so-called “cram down" section, if at least one

impaired non-insider class of creditors votes to

accept the plan and the other relevant standards of

A-49

‘

Sections 112Gla) and (hy) are met. Only the classes

ih CHAAR Whhne Fide Are pAlrEd WnAer 4 jihad

GT FEOF RATIAALION AFE GHHIER (4 Vale (a AecEnT AF

eject the pilaf, 11 UGE, @ 1186. Vatind an a

plat 18 by the Clageee He Gatablighed iH the plan A

CLASS AEEEPLS A Pla WheH tWo-thifds in dollar

amount and more than one-half in number of the

creditors in such class vote to accept the plan. 11

U.S.C. s 1126(b).

Phoenix Mutual complains that the classification

of its unsecured deficiency claim in a class sepa-

rate from that of the unsecured trade creditors was

structured purposely by the Debtor in order to

nullify Phoenix Mutual's voting rights,

Seetion 1122 of the Code prohibits the grouping

Of dissimilar claima in the same elasa, Although

Section 1122 does not specifically address the

permissibility of placing similar claims in different

classes, the pertinent legislative and case authority

support such a flexible approach. See In re U.S.

Truck Co., Inc., 800 F.2d 581, 585 (6th Cir. 1986).

Section 1122 allows a claim or inter-

A-50

eat to he placed in a parteular cage

only if eueh claim te eubetanttally

wlilag (6 (he GHEE Claliie Ge Titer eate

af auéh élaga, Th dee Hat FeqQutre thal

aiiilae GClageee HE AeGuUpEd Lamethet

Hut merely (hat any BrGup be hartiage

HeGUS,

We find unpersuasive the current line

of cases that hold Congress intended

all unsecured claims of a similar

nature to be grouped within one class

unless a separate classification is

established under Section 1122(b) A

eritieal review of those cases attempts

io create a statutory requirement

where none exists and a relianee on

pre-code law and Aet statutory re

quirements

In re Ag Consultants Grain Division, Inc,, 77 B.R,

665, 674 (Bankr.N.D.Ind. 1987) (citations omitted).

See also, Matter of Jersey City Medical Center, 817

F.2d 1055, 1060-61 (3rd Cir.1987); Barnes v.

A-51

Whelatt, OYA F.2d 193, 201 (D.C.Cir.1982).

(if 6@UF8E “the classification in a plan should not

4 @UHatAHHAL violence to any claimant's interest."

Hriileley i Clase Manhattan Mortgage and Realty

rust (Matter of LeBlanc), 622 F.2d 872, 879 (Sth

Cin L@BQ)

The plan should not arbitrarily clas-

sify or discriminate against creditors.

The fact that bankruptcy courts are

courts Of equity, however, allows

exceptions to any strict rules of classi-

fications of claims. A bankruptcy

court ean permit discrimination when

the faets of the case justify it.

Aa noted, Phoenix Mutual claims that the classifi-

eation was arranged for the purpose of denying its

voting rights and, as such, is in violation of the

“good faith" requirement of Section 1129(a)(3). So

long as a plan is proposed with the legitimate and

honest purpose to reorganize and is not otherwise

prohibited by law, it is a plan which satisfies this

A-52

section. Matter of Sun Country Development, Inc..,

764 F.2d 406, 408 (5th Cir. 1985).

The Bankruptcy Judge is, of course, in the best

position to determine whether a particular classifi-

cation is made in "good" or “bad" faith. In the

present case, Judge Clark determined that the

classification was proper because the legal "nature"

of Phoenix Mutual's deficiency claim was different

from that of the trade creditors, and that separate

treatment was justified for good business reasons.

These factual findings by the Bankruptcy Court are

not clearly erroneous, nor has the Court discovered

any error of law. Accordingly, the Appellant's first

ground of error is overruled.

B. Absolute Priority Rule. As previously noted.

two alternatives under the Code exist for the con-

firmation of a plan: confirmation under Section

1129(a) and confirmation under Section 1129(b). If

an impaired class of claims votes to reject a plan,

then the plan can only be confirmed pursuant to

the provisions of Section 1129(b). See 11 U.S.C. s

1129(a)(8). In this regard, Section 1129(b) pro-

A-53

vides, in pertinent part:

(b)(1) 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 notwith-

standing the requirements of such

paragraph if the plan does not discrim-

inate unfairly, and is fair and equita-

ble, with respect to each class of

claims or interests that is impaired

under, and has not accepted, the

plan.

The absolute priority rule

“provides that a dissenting class of

unsecured creditors must be provided

for in full before any junior class can

receive or retain any property [under a

reorganization] plan." The rule had its

genesis in judicial construction of the

A-54

undefined requirement of the early

bankruptcy statute that reorganization

plans be "fair and equitable." The rule

has since gained express statutory

force, and was incorporated into

Chapter 11 of the Bankruptcy Code

adopted in 1978. Under current law,

no Chapter 11 reorganization plan can

be confirmed over the creditors’ legiti-

mate objections (absent certain condi-

tions not relevant here) if it fails to

comply with the absolute priority rule.

Norwest Bank Worthington v. Ahlers, 485 U.S. 197,

108 S.Ct. 963, 967, 99 L.Ed.2d 169 (1988).

An exception to this rule developed which allowed

confirmation of a reorganization plan over a credi-

tor's objections when there has been an "“infusion-

of-‘money-or-money’s-worth’ " by a junior interest

holder. Case v. Los Angeles Lumber Products Co..,

308 U.S. 106, 60 S.Ct. 1, 84 L.Ed. 110 (1939). The

Appellant argues that the Case exception has been

A-55

Eee te ee a a ee

replaced by the 1978 amendments to the Code.

specifically by Section 1129(b) which provides that

an interest holder may not receive or retain any

interest under a plan unless senior claimants are

paid in full. The Appellant further argues that the

continued vitality of the exception has been ques-

tioned by the Supreme Court in Norwest Bank

Worthington v. Ahlers, 485 U.S. 197, 108 S.Ct. 963.

99 L.Ed.2d 169 (1988).

The Court agrees with the Bankruptcy Judge's

determination that the Case exception remains

vital. Neither the Code nor the Supreme Court has

expressly repudiated the exception. The "fair and

equitable" standard was incorporated into the Code

when adopted in 1978. As cited above. Section

1129(b)(1) specifically refers to confirmation when

the plan "does not discriminate unfairly, and is fair

and equitable with respéct to each of class of

claims or interests that is impaired...."

The Norwest court expressly declined to make a

determination as to whether the Case exception had

been overruled by the 1978 passage of the Code.

A-56

Norwest Bank Worthington v. Ahlers, supra, 108

S.Ct. at 967, n. 3. The case authority prior to the

Norwest opinion weighed in favor of the survival of

the contribution exception. See In re Green, 98

B.R. 981 (9th Cir. BAP 1989); Matter of Yasparro,

100 B.R. 91 (Bankr.M.D.Fla.1989); In re Snyder,

99 B.R. 885 (Bankr.C.D.II1.1989); In re Henke, 90

B.R. 451 (Bankr.D.Mont.1988). Contra, In re

Winters, 99 B.R. 658 (Bankr.W.D.Penn. 1989).

Additionally, the equitable considerations that

mandated the creation of this exception have not

diminished. The rule is a logical extension of the

notion that an equity reorganization should, in all

respects, be “fair and equitable".

Circumstances may exist where the

success of an undertaking requires

that new money be furnished and

where the former stockholders are the

only or more feasible source of the new

capital. In such instances, the court

may recognize as fair and equitable a

plan which includes contributions of

A-57

new money by stockholders, provided

it satisfactorily appears that full recog-

nition has been given to the value of

the creditors’ claims against the

property.

Case v. Los Angeles Lumber Products Co., 308

U.S. 106, 121 n. 15, 60 S.Ct. 1, 10 n. 15, 84 L.Ed.

110, quoting In re Dutch Woodcraft Shops, 14

F.Supp. 467, 471, 30 Am.Bankr.Rep. 351

(D.C.Mich.1935).

As the Court has determined that the Bankruptcy

Court did not err in applying the exception to the

absolute priority rule, the question becomes

whether the exception was correctly applied.

The Case exception serves the narrow purpose of

affording the debtor the capital necessary to sur-

vive, and should be narrowly and precisely applied.

There must be a rigorous showing that the cash

infusion is necessary under the circumstances and

is substantial. Case v. Los Angeles Lumber

Products Co., 308 U.S. at 121, 60 S.Ct. at 10. This

is essential in order to assure that a debtor's equity

A-58

holders will not eviscerate the absolute priority rule

by means of gratuitous, token cash infusions

proposed primarily to "buy" cheap financing.

Group of Institutional Investors v. Chicago, Milwau-

kee, St. Paul & Pacific Railroad Co., 318 U.S. 523,

570, 63 S.Ct. 727, 751-52, 87 L.Ed. 959 (1943).

In the present case, the debtor's general partners

proposed to advance $500,000 in additional cash.

The Appellant does not dispute that the $500,000

cash infusion is substantial; rather, the Appellant

argues it is not necessary. Appellant argues that

the contribution of new money must be “essential

to the success of the undertaking," and that to be

essential, there must be no other sources of fund-

ing. Phoenix Mutual offered to advance $155,000

to pay off the unsecured creditors and complete

tenant "finishing out" obligations, and argues,

therefore, that the old interest holders’ contri-

bution is unnecessary.

The Court does not agree that there must be no

other source of funding before the exception ap-

plies. The authority cited by Appellant does not

A-59

support its contention that the former stockholders

be the only source from which additional funding

is to come. In the Case opinion, as cited by Appel-

lant, the Court notes:

Circumstances may exist where the

success of an undertaking requires

that new money be furnished and

where the former stockholder are the

only or most feasible source of the new -

capital.

Case, 308 U.S. at 121, n. 15, 60 S.Ct. at 10. n.

15 (emphasis added). Similar language is used in

the Seventh Circuit case cited by Appellant:

... if the creditors challenge a plan as

not "fair and equitable" because the

new capital is not necessary or the

shareholder is not the most feasible

source, then the court must make

such a finding....

Official Creditors’ Committee v. Potter Material

Service, Inc. (In re Potter Material Service. Inc.), 781

A-60

F.2d 99, 102 (7th Cir.1986). The opinion of the

Bankruptcy Judge establishes that the most feasi-

ble source of funding was from the current owners

of the partnership, rather than from Phoenix

Mutual. This factual determination is not clearly

erroneous, and Appellant's second ground of error

is without merit.

C. Requirement of New Disclosure to the Trade

Creditor Class. The Appellant asserts that the

Bankruptcy Court erred in confirming the Modified

Plan without requiring new disclosure to the Trade

Creditor Class, apparently on the basis that the

Trade Creditor Class was the only impaired class

which could vote to accept the plan.

At the confirmation hearing, the Debtor orally

offered to modify the Plan to remove the require-

ment of payment of the balance of the trade claims

by the general partner within thirty days of confir-

mation. The effect of the modification was that the

Modified Plan no longer promised that the Trade

Creditor Class would be fully paid on the effective

date and that the Trade Creditor Class would only

A-61

receive 3.82% on their claims under the Modified

Plan. The Bankruptcy Judge allowed the oral

modification and directed the Debtor to resolicit

and provide disclosure of its Modified Plan. since

the modification represented a "substantial modifi-

cation” to the Plan. However, the opinion and

order by the Bankruptcy Judge confirming the

Plan does not refer to the requirement of resolicita-

tion or new disclosure.

Section 1129(a) provides in pertinent part:

(a) The court shall confirm a plan--

(10) If a class of claims is impaired under

the plan, at least one class of claims that is

impaired under the plan has accepted the

plan, determined without including any

acceptance of the plan by any insider.

Appellant argues that as Phoenix Mutual's claims

are impaired, the Plan should not have been con-

firmed as the Debtor failed to obtain the accept-

ance of at least one impaired class of creditors,

exclusive of insiders. The basis of Appellant's

A-62

argument is that Classes 4, 5, 6, and 7 were the

only potential impaired classes for purposes of s

1129; that Phoenix Mutual was the only creditor

in Classes 4 and 7 and rejected the Plan; and that

Class 5/6 was not impaired within the meaning of

s 1124.

Appellee asserts that Class 5/6 was impaired

both before and after the modification and that it

was not the only possible class which could have

voted to accept the plan as Class 2 was also an

impaired accepting class.

Appellee argues further that Appellant has no

standing to assert this ground of error and that the

Bankruptcy Judge's determination that no further

disclosure was required was not clearly erroneous.

The record indicates that Class 2, the class of

tenant security deposits, was also an impaired

class of claims which did vote to accept the Plan.

Class 2 was not an "artificial class", as alleged by

Appellant, but had actual "claims" against the

Debtor which were "impaired", as those terms are

defined in the Bankruptcy Code. Section 101(4)

A-63

defines a claim as:

(a) Right to payment, whether or not

such right is reduced to judgment,

liquidated, unliquidated, fixed, contin-

gent, matured, unmatured, disputed,

undisputed, legal, equitable, secured

or unsecured; or

(b) Right to an equitable remedy for

breach of performance if such breach

give rise to a right to payment, whether

or not such right to an equitable

remedy is reduced to judgment, fixed,

contingent, matured, unmatured,

disputed, undisputed, secured or

unsecured.

Section 1124 defines when a claim is impaired,

and provides, in pertinent part:

Except as provided in section

1123(a)(4) of this title, a class of claims

or interests is impaired under a plan

unless, with respect to each claim or

A-64

interest of such class, the plan--

(1) leaves unaltered the legal, equi-

table, and contractual rights to which

such claim or interests entitles the

holder of such claim or interest;

(2) .... OF

(3) provides that, on the effective

date of the plan, the holder of such

claim or interest receives, on account

of such claim or interest, cash equal

to--

(A) with respect to a claim, the al-

lowed amount of such claim....

Because the Plan guarantees only payment of 75

percent of the deposits paid to Debtor pre-petition, it

does not leave unaltered the legal, equitable and

contractual rights to which the deposit holders

were entitled. Therefore, Class 2 was an impaired

class within the meaning of the Code and the

acceptance by Class 5/6 was unnecessary.

A-65

oe re eee

Additionally, the Bankruptcy Judge's implied

finding.that no further disclosure was required has

not been established to have been clearly errone-

ous. Accordingly, Appellant's third ground is also

without merit.

In light of the foregoing, it is ORDERED that the

opinion of the Bankruptcy Court is hereby AF-

FIRMED.

W; rS. Smi Jr.

WALTER S. SMITH, JR.

U. S. DISTRICT JUDGE

Ne Oh WN el lan Ns i ile

IN THE UNITED STATES BANKRUPTCY COURT

FOR THE WESTERN DISTRICT OF TEXAS

AUSTIN DIVISION

IN RE: §

GREYSTONE § Bankruptcy

Ill § No. 88-10968

JOINT VENTURE § (CHAPTER 11)

RDER OF I N ON DE R'S SECOND

N P RGANIZATION

FIE

Came on to be considered the Debtor's Second

Amended Plan of Reorganization. The Debtor

requested confirmation pursuant to 11 U.S.C.

Section 1129(b). The Court having considered the

evidence received and the argument of counsel

finds this as follows:

1. The Debtor should be permitted to modify the

Plan to delete the affirmative statement that gener-

al partners will satisfy the balance of trade debt

claims, to reduce the term of repayment for the

secured claim of Phoenix Mutual Life Insurance

Company from 30 to 10 years with a balloon

payment at the end of 10 years, to provide for

payment of U.S. Trustee fees under 28 U.S.C. §

1930(a)(6), and to delete the provision that the

automatic stay will remain in effect after confirma-

tion.

2.No further disclosure is required for these

modifications.

3. A market interest rate for the Class 4 secured

claim of Phoenix Mutual Life Insurance Company

is 11%. The Court has previously valued the Class

4 claim at $5,825,000.00. The Court re-affirms

this finding.

4.The Plan complies with the requirements of

Section 1129(a), except for Section 1129(a)(8).

5. Counsel for the Debtor has filed his Certificate

of Compliance With Bankruptcy Rule 3020, repre-

senting that the $500,000.00 cash infusion re-

quired by the Plan has been deposited in his Trust

Account.

6. The Plan does not discriminate unfairly, is fair

and equitable and thus complies with the re-

quirements of Section 1129(b) with respect to each

A-68

bei

class of claims or interests that is impaired under

and has not accepted the Plan.

7. The Second Amended Plan of Reorganization as

Modified should be confirmed.

8. The objections of Phoenix Mutual Life Insur-

ance Company should be overruled.

9. The findings and conclusions contained in this

Court's Decision on Confirmation are incorporated

herein by reference.

It is, therefore, ORDERED, as follows:

1. The Debtor’s Second Amended Plan of Reorgan-

ization is hereby modified as follows:

(a) The first sentence of the final paragraph

on page 6 of the Second Amended Plan of Reorgan-

ization is modified to read:

"The Class 4 allowed claim will be paid

in one hundred twenty (120) equal

monthly installments in an amount

sufficient to repay the claim in three

hundred and sixty (360) equal monthly

installments beginning thirty (30) days

after the effective date of the Plan; the

A-69

remaining balance shall be due and

payable ten (10) years after the effec-

tive date of the Plan."

(b) The Plan's description of Classes 5 and 6 on

pages 7 and 8 of the Second Amended Plan of

Reorganization is modified to delete the language:

“and will honor its obligations within

30 days of confirmation".

modified to provide that the Debtor-in-Possession

shall pay all fees required under 28 U.S.C. Section

1930(a)(6) as they come due.

(d) The Second Amended Plan of Reorganization is

modified to delete Art. II(A)(4) pertaining to the

automatic stay.

2. The interest rate for the Class 4 secured claim

shall be 11%. The amount of the Class 4 secured

claim is $5,825,000.00.

3. The Second Amended Plan of Reorganization as

modified, is hereby confirmed.

4. The objections of Phoenix Mutual Life Insur-

A-70

ance Company are hereby overruled.

SIGNED this 5th day of Aug., 1989.

/s/ Leif M, Clark

LEIF M. CLARK

U. S. BANKRUPTCY JUDGE

In re GREYSTONE III JOINT VENTURE, Debtor.

Bankruptcy No. 88-10968.

ss United States Bankruptcy Court,

W.D. Texas,

Austin Division.

June 6, 1989.

DECISION ON CONFIRMATION OF

DEBTOR'S SECOND AMENDED PLAN

AS MODIFIED

LEIF M. CLARK, Bankruptcy Judge.

CAME ON for hearing the Second Amended Plan

of Reorganization of Debtor (as modified) together

with the objection thereto by Phoenix Mutual Life

Insurance Company ("Phoenix"). This decision

focuses on those critical issues on which the par-

ties focused at the hearing and in their post-

submission briefs. The court finds that the bal-

ance of the findings required to confirm a plan

under Section 1129 of the Bankruptcy Code have

been successfully established by the debtor and

will be set out in detail in the confirmation order.

I. THE FACTS AND POSTURE OF THE CASE

The plan proposes to pay both trade debt of

approximately $10,000 and the Code-cre-

ated deficiency claim of Phoenix Mutual (approxi-

A-72

mately $3,475,000) slightly over three (3) cents on

the dollar. The plan also proposes to pay 1987 ad

valorem taxes in excess of $108,000, and to assure

payment of 75% of tenant security deposit claims.

The partnership currently has on hand approxi-

mately $101,000, more than enough to pay off the

trade in full, though nowhere near enough to pay

even the remaining taxes, much less Phoenix’ defi-

ciency claim.

Absent bankruptcy, Phoenix is a nonrecourse

creditor and would have no claim at all beyond its

secured claim against either the partnership or its

general partners. The trade debt and the tenants,

on the other hand, have recourse under Texas law

against both the partnership and the general

partners, and the plan does not purport to restrict

or eliminate that recourse. Texas Uniform Part-

nership Act, Tex.Rev.Civ.Stat.Ann., Art. 6132b, s

40 (West pamphl. ed. 1988); see Republic Supply

Co. v. Shoaf, 815 F.2d 1046 (5th Cir.1987) (plan's

discharge of nondebtor entity withstood collateral

attack under principles of res judicata where credi-

A-73

tor failed to timely object to plan). The debtor's

partners intend to retain their equity interest in

the venture with a capital infusion of $500,000, to

be used both to fund payments to creditors and for

future operations.

All creditors other than Phoenix have supported

the plan. The plan was amended at the confirma-

tion hearing to delete the affirmative statement

that general partners would satisfy the balance of

trade debt claims ! and to reduce the term of

repayment for Phoenix’ secured claim from thirty

to ten years, with a balloon at the end.

Phoenix still objects to the plan, contending that

(1) the plan is either not proposed in good faith

The Debtor urged that the statement in the plan was

intended to be nothing more than a restatement of Texas law.

In fact, the general partners were not parties to the plan.

other than in their capacity as equity investors, so the plan

could not purport to bind them to an obligation to which they

had not affirmatively consented anyway.

A-74

because the plan improperly classifies the trade

debt as a separate impaired class or, alternatively,

unfairly discriminates by “artificially impairing" the

trade debt and (2) the plan cannot be forced upon

Phoenix over its objections anyway because it is

not fair and equitable with respect to Phoenix’

deficiency claim. The debtor responds that the

Code contemplates flexibility in classification, so

that making use of the tools afforded by the Code

cannot, by definition, be anything other than good

faith as that term is used in Section 1129(a)(3).

The debtor adds, in the same vein, that its treat-

ment of the trade is intended to come within the

rule of law announced by this court in In re

Meadow Glen, Ltd., 87 B.R. 421, 425

(Bankr.W.D.Tex. 1988), in order to avoid a finding

that the plan “unfairly discriminates." Finally, the

debtor argues that the capital infusion of $500,000

proposed by the partnership's partners brings the

plan within the exception announced in Case v.

Los Angeles Lumber Products Co., 308 U.S. 106, 60

S.Ct. 1, 84 L.Ed. 110 (1939).

A-75

II. ANALYSIS OF THE LAW

Phoenix argues that this debtor's plan takes

improper advantage of Chapter 11, and subverts

the intent of Congress in the process. Phoenix

complains that the plan impermissibly silences

Phoenix, by putting the trade debt into a separate

class which has enthusiastically accepted the plan.

This, Phoenix urges, subverts the "clear intentions"

of Congress in enacting Section 1129(a)(10).

Meanwhile, the debtor's principals are "buying"

their way back in ostensibly under the exception to

the absolute priority rule announced in Case v. Los

Angeles Lumber Products Co., 308 U.S. 106, 60

S.Ct. 1, 84 L.Ed. 110 (1939), undermining the

"veto" which Phoenix believes Congress intended to

confer on undersecured nonrecourse lenders by

virtue of Section 1129(b)(2)(B).

According to Phoenix, the debtor has taken advan-

tage of creative classification, then "artificially

impaired" that class in order to give the debtor an

accepting class, avoiding domination by Phoenix’

Code-created deficiency claim. The cash infusion

A-76

meanwhile skirts the absolute priority rule of Section

1129(b)(2)(B) that the objecting unsecured class

either be paid in full or that junior interests retain

or get nothing under the plan. Phoenix is vocifer-

ous in urging that the debtor's tactics circumvent

the structure of the Code. The argument presup-

poses, however, that Congress intend the secured

lender in cases such as this to have the final say

over whether a plan should be confirmed. That

presupposition gives more credit to Congress and

its intentions than Congress appears to be due,

however.

A. An Historical Perspective on the Role Envi-

sioned for Secured Creditors in Single-Asset Real

Estate Cases under the Bankruptcy Code

Prior to the passage of the Bankruptcy Reform

Act in 1978, single asset real estate debtors,

employing Chapter XII of the Bankruptcy Act,

could “write down" their secured debt while the

market was low, then enjoy the appreciation real-

ized in excess of the written-down mortgage when

the market rebounded. See Great National Life

A-77

Insurance Co. v. Pine Gate Associates, Ltd., 2 B.C.D.

1478 (Bankr.N.D.Ga.1976) (hereinafter Pine Gate).

According to the Pine Gate court,

Nowhere in Chapter XII is there any

exclusion of the benefit of Chapter XII

to a debtor having only one secured

creditor. The history of the creation of

Chapter XII, which was to provide a

remedy to property owners to avoid

foreclosure under distressed economic

conditions indicates otherwise.... [T]he

contract rights of a secured creditor in

the property of which a debtor is the

legal or equitable owner may be modi-

fied or altered even without the con-

sent of such secured creditor so long

as the secured creditor receives

adequate protection under Section 461

to realize the value of its lien. Reten-

tion of property is the statutory

scheme of Section 461(11)(c) and

adequate protection, rather than

A-78

consent. of the secured creditor is its

keystone.

Id. at 1487: see also Matter of Accousti, 2 B.C.D.

1093 (Bankr.D.Conn.1976); Matter of Marietta

Cobb Apartments, 3 B.C.D. 720

(Bankr.S.D.N.Y.1977); Matter of Hobson Pike

Associates, Ltd.., 3 B.C.D. 1205

(Bankr.N.D.Ga.1976).

These cases construing Chapter XII (which until

the early 1970's had fallen into disuse) arose even

as Congress was undertaking a major overhaul of

the bankruptcy laws. See generally “Report of the

Commission on the Bankruptcy Laws of the United

States." H.R.Doc. No. 137, 93rd Cong, lst Sess

(1973). By 1977, the House had completed its final

proposed draft of a new Bankruptcy Code, H.R.

8200. which combined former reorganization

chapters X, XI, and XII into a single chapter

(Chapter 11), optimistically designed to be flexible

enough to meet all the needs for which the three

chapters were created in the Chandler Act of 1938.

124 Cong Rec H11117, 95th Cong, 2d Sess (daily

A-79

ed. Sept. 28, 1978) (remarks of Rep. McClory). The

House version adopted many of the recommenda-

tions of the Bankruptcy Commission, and took a

liberal approach in its provisions which decidedly

favored reorganization. H.R.Rep. No. 595, 95th

Cong, lst Sess 220 (1977), U.S.Code Cong. &

Admin.News 1978, p. 5787. In its confirmation

section, the House version permitted confirmation

over the objections of dissenting secured creditors

so long as their claim was essentially "adequately

protected," (cf. 11 U.S.C. (repealed) s 861), and

over the objections of dissenting impaired unse-

cured classes of creditors so long as no junior

classes received property on account of their junior

claims (a modified version of the Chandler Act's

“fair and equitable" standard, codified and pre-

served in Chapter X of the Bankruptcy Act). H.R.

8200, s 1129, 95th Cong, Ist Sess (1977). Section

506(a) of the proposed bill defined a secured claim

in terms of the value of the collateral securing the

debt, as had Chapter XII of the Bankruptcy Act.

Section 502, meanwhile, provided that claims

A-80

would be disallowed if unenforceable against the

debtor for any reason. One such unenforceable

claim would, of course, be a “deficiency” claim

asserted by a nonrecourse lender. Under the

House version, a plan could conceivably be con-

firmed even though no impaired class voted in

favor of the plan, because there was no antecedent

to current Section 1129(a)(10) in H.R. §200. Under

the House version, then, a Chapter XII-type reor-

ganization would be permitted under new Chapter

11 as well. See Matter of Marietta Cobb Apart-

ments. 3 B.C.D. 720 (Bankr.S.D.N.Y.1977); Matter

of Hobson Pike Associates, Ltd., 3 B.C.D. 1205

(Bankr.N.D.Ga. 1976) (single asset real estate cases

with only one creditor--the secured creditor --con-

firmed over the objections of that creditor).

By the next year, the Senate came up with its

own, somewhat more conservative version of the

Bankruptcy Code. S. 2266, 95th Cong, 2d Sess

(1978). In its reorganization sections, the Senate

version preserved many of the provisions of Chap-

ter X of the Act, at least for publicly held compa-

A-381

nies. S. 2266, ss 1128, 1130, 95th Cong, 2d Sess

(1978). It also contained a specific section severely

restricting how real estate liens could be treated. ”

2 (a) Notwithstanding any other provision of this chapter or

section 506(a) of this title, the claim or interest of a creditor

secured by a lien upon or security interest in property of the

estate which is real estate, chattels real, leasehold estates in

real property, or fixtures, to the extent that such claim or

interest was incurred for the purchase or improvement of

such property, may be altered or modified in the plan only in

the following manner: (1) where a default in payment of an

installment claim or interest is existing the claim or interest

of the creditor may be reinstated whether or not reinstate-

ment would be permitted under otherwise applicable law with

all payments then in default to be amortized equally over the

life of the reinstated loan at the same rate of interest; or

(2) the claim or interest of the secured party may be extended

as to payment on a reasonable, equitable and practicable

basis as long as the value of the claim or interest as extended

would be the indubitable equivalent of the claim or interest if

reinstated under subsection (l)above.

A-82

Finally, in an evident reaction to these two then-

recent cases. S. 2266 required that at least one

class of creditors, exclusive of insiders, must have

accepted the plan in order for it to be confirmed.

S. 2266. s 1130(a)(12), 95th Cong, 2d Sess

(1978).°

ae aeeeeeenweewomweeweeeeo”

. continued...

ee ae an

| S. 2266. s 1130(a), 95th Cong.2d Sess (1978).

3 The two cases came out within a few weeks of each other

in September 1977. while the Senate version was undergoing

drafting. See Matter of Marietta Cobb Apartments, 3 B.C.D.

720 (Bankr.S.D.N.Y.1977); Matter of Hobson Pike Associates,

Ltd.. 3 B.C.D. 1205 (Bankr.N.D.Ga.1976). In each case, the

bankruptcy judge, construing Section 461(11) of Chapter XII

of the Bankruptcy Act. found no prohibition on confirma-

tion of a plan involving only one creditor, the secured credi-

tor, over that creditor's objections, so long as the plan provi-

sions themselves afforded adequate protection of the value of

the secured creditor's lien interest. Both decisions were well-

reasoned and correctly refuted the continuing application ofa

A-83

...-cContinued...

judicial gloss to the contrary that had its genesis in cases

which predated changes to Chapter XII made in 1952. Matter

of Hobson Pike Associates, Ltd., 3 B.C.D. at 1211-1214; see

In re Herweg, 119 F.2d 941 (7th Cir.1941); see also Dole,

“Judicial Gloss," The Chapter XII Cram-Down Provisions, 82

Comm.L.J. 197-204 (June 1977). Both courts noted a

congressional policy favoring cram-down as a way of achiev-

ing reorganization values over the objections of recalcitrant

creditors whose property rights were satisfactorily addressed

in the adequate protection scheme of the statute. Matter of

Marietta Cobb Apartments, 3 B.C.D. at 724; Matter of Hobson

Pike Associates, Ltd., 3 B.C.D. at 1210. Finally, both cases

underlined just how nonsensical it was for a secured creditor

to complain that there were no other impaired creditors in

favor of the arrangement. Said Judge Babbitt in Marietta

Cobb Apartments, quoting a then-recent commentator:

... It is not terribly difficult for the enterprising

real estate debtor to incur other creditor obli-

gations, perhaps even resulting in secondary

and mechanics or materialmen's liens on the

A-84

_,.Continued...

property. The reorganization plan can propose

payment of all or part of these claims in cash,

assuring the favorable vote of those classes.

In re Marietta Cobb Apartments Co., 3 B.C.D. at 724, quoting

Lifton. Real Estate in Trouble, 31 Bus.Law. 1927, 1968

(1976). Even more acerbic was Judge Norton in Hobson Pike

Associates:

The true design of ... Chapter XII is not

whether there are creditors to accept the plan

in writing, but whether the plan provides the

necessary “adequate protection"... ... Should

the Herweg ... view prevail, contrary to the

strong Chapter XII rehabilitation intent, that

view would seem to offer an invitation to

debtors and attorneys practicing in the bank-

ruptcy field to create some secured or unse-

cured debt on the eve of the Chapter XII filing

in order to acquire some creditor acceptance of

the plan.... It has been observed by bankrupt-

cy attorneys to this court that unsecured

A-85

} ...continued...

debt ... is easy to produce just prior to filing if

unsecured debt is a prerequisite to enjoyment

by the debtor of the statutory privileges [of

reorganization].... Such fabrication of unse-

cured debt to meet the criticism of Herweg ...

would be difficult for courts to recognize, if

_ indeed, to do so would defeat jurisdiction or

remove availability to this debtor relief chapter

[sic]....

[H]Jow many unsecured creditors and/or how

much debt other than the secured debt must

be found to assent in order to allow a plan to

be confirmed? ... Will one creditor for a

$1.00, $10,00, $100.00, $1,000.00 debt suf-

fice to sustain the required acceptances?

Must the accepting creditor class be signifi-

cant in number and/or amount in comparison

to the objecting creditor? If so, what amount,

how many? Surely such a statutory construc-

tion is an unsatisfactory result not intended

A-86

The two versions thus represented two philosoph-

ically inconsistent positions insofar as how single

asset real estate cases might fare under the

Bankruptcy Code. The House version would have

continued the rehabilitation-oriented policies of

Chapter XII, while the Senate version apparently

gave ear to the complaints of secured creditors who

had been burned under that very chapter. Not

until the floor managers for each bill met in confer-

ence was there any effort to reconcile the incon-

sistencies. Unfortunately, the legislative history is

largely unilluminating as to what precisely tran-

spired in those meetings, and we have only the

comments of the floor managers in the Congres-

sional Record to give any hint to their thinking on

the subject.

What we do know is that Congress retained the

House version's cram-down powers and rejected “as

unnecessary" the restrictions on real estate lien

treatment found in the Senate version, "in light of

the protection given a secured creditor under

Section 1129(b) of the House amendment." 124

Cong Rec H11115, 95th Cong, 2d Sess (daily ed.

Sept. 28, 1978)(remarks of Rep. Edwards). * To

mollify the concerns raised by secured creditors as

a result of the Pine Gate decision, the floor manag-

...Continued...

by Congress.

Id. at 1210, 1213-14.

Congress ended up tilting in favor of the House version,

a bent acknowledged by the Supreme Court subsequently:

By permitting reorganization, Congress antic-

ipated that the business could continue to

provide jobs, to satisfy creditors’ claims, and to

‘ail a return for its owners. H.R.Rep. No.

95-595, p. 220 (1977). Congress presumed

that the assets of the debtor would be more

valuable if used in a rehabilitated business

than ‘if sold for scrap.’ Ibid.

United States v. Whiting Pools, Inc., 462 U.S. 198, 203. 103

A-88

ers devised a new subsection (b) for Section 1111.

This complicated little provision was designed to

achieve two basic tasks. First of all, it gave under-

secured nonrecourse creditors a Code-created

deficiency claim, solely for use in Chapter 11

reorganizations, overriding the general provision in

Section 506(a) which would otherwise allow : onre-

course secured creditors a claim only to the extent

of the value of their collateral. See 11 U.S.C. s

506(a). Second, it allowed such secured creditors

to “opt-out” of recourse treatment, in which case

the plan would have to "allow" the secured claim in

an amount equal to the amount of the value of

secured creditor's debt, rather than the secured

creditor's collateral. ° Section 1111(b) thus gave

..continued...

S.Ct. 2309. 2312. 76 L.Ed.2d 515 (1983), quoted in M.

Bienenstock, Bankruptcy Reorganization, p. 1 n. 2 (PLI 1987).

5 Under the latter scenario, in a cram-down, the plan

would have to allow the claim in an amount equal to the

A-89

the nonre-course lender both a voice and a choice.

In the words of a respected commentator,

Section 1111(b) protects the legiti-

mate expectation of the secured lender

that the bankruptcy laws will be used

only as a shield to protect debtors and

not as a sword to enrich debtors at the

expense of secured creditors.

5 Collier on Bankruptcy, P 1111.02[1], p. 1111-

14 et seq. (15th ed. 1985).

In addition to adding Section 1111(b), the confer-

ees also tried to beef up Section 1129(b), expressly

using the terms of art “fair and equitable" and

“unfairly discriminates" in s 1129(b)(1). Each of

these terms carried their own judicial baggage into

the cram-down portion of Section 1129.

The floor managers also carried into the joint

..Continued...

debt, but the payment stream used to pay the claim need

only have a present value equal to the value of the property.

Then, in the event of a post-confirmation default, the secured

A-90

draft the Senate's provision that at least one class

of creditors, exclusive of insiders, would have to

accept the plan before it could be confirmed. They

did so without explanation or comment, and

apparently without consideration of either that

section's relationship or impact upon the cram-

down provisions brought into the draft from the

House version. ®

_.Continued...

creditor would have full recourse against the collateral up to

the amount of its debt, enjoying any appreciation in the value

of the collateral since confinmation.

6 Recall that the Senate version had the requirement of at

least one accepting class even though it did not have a

“cram-down" provision. Its inclusion first in the Senate

version and ultimately in the final version as enacted is

probably traceable to the then-recent decisions in Hobson

Pike and Marietta Cobb Apartments, discussed supra, and not

to any interplay with cram-down. See 5 Collier on Bankrupt-

cy, P 1129.02{10], p. 1129-36.10 (15th ed. 1987). - In floor

remarks, the floor manager of the bill in the Senate com-

A-91

.. Continued...

mented with regard to the new cram-down provisions that

Section 1129(b) is new. Together with sec-

tion 1111(b) and section 1129(a)(7)(C), this

section provides when a plan may be con-

firmed, notwithstanding the failure of an

impaired class to accepi the nlan under sec-

tion 1129(a)(8).

124 Cong Rec S17420, 95th Cong, 2d Sess (daily ed. Oct. 6,

1978) (remarks of Sen. DeConcini). In the context of these

remarks, Section 1129(a)(10) is noticeable by its absence.

While the policy it serves is questionable and undoubtedly

leads to unfortunate “gaming” on the part of debtors, Section

1129(a)(10) nonetheless clearly evinces an apparent belief on

the part of Congress that the scenario played out in Hobson

Pike Associates and Marietta Cobb Apartments (i.e., confirma-

tion of a plan accepted by no one and over the objections of

the only affected creditor) is not an appropriate use of the

bankruptcy powers. For better or worse, therefore, unless

some disinterested, impaired third class of claims (other than

the debtor and the affected secured creditor) favors the

A-92

The conferees apparently gave no particular

thought to the impact of Section 1122 on the cram-

down provisions of the Code, not anticipating how

so-called "creative classification" schemes might

affect a debtor's ability to gain access to the cram-

down powers.’ Both versions of the draft enact-_

ment contained nearly identical provisions regard-

ing classification, and the legislative history only

confirms that Congress did not envision any par-

..continued...

proposed reorganization, reorganization under the Bankrupt-

cy Code, no matter how salutary or equitable, will simply not

be available to the debtor. See Anderson Oaks (Phase 1)

Limited Partnership, 77 B.R. 108, 111 (Bankr.W.D.Tex. 1987).

Apart from overruling the odious result in Hobson Pike

Associates and Marietta Cobb Apartments, however, Section

1129(a)(10) appears to serve no other function particularly

related to cram-down. But see 5 Collier on Bankruptcy, P

1129.02{10] at p. 1129.36.10 (15th ed. 1987).

A-93

ticular restrictions on the creative use of the classi-

fication powers, other than that (1) dissimilar

claims could not be forced into the same class and

(2) an impaired and dissenting class could not be

treated differently than another class of equal

dignity. 11 U.S.C. ss 1122(a), 1129(b); H.R.Rep.

No. 595, 95th Cong, Ist Sess 406, 414-15 (1977).

Congress thus adopted an unclear middle posi-

tion on the question of single asset real estate

cases in bankruptcy. It could have given secured

creditors veto power over reorganizations had it

enacted the Senate version. It could also have

effectively gagged the secured creditor had it set-

tled solely on the House version. Instead, Con-

gress made sausage and, as a result, courts and

practitioners are left with a reorganization chapter

which, when applied to single asset real estate

cases, is rife with inconsistencies.

For example, Section 1111(b) “ungags" the se-

cured creditor by giving it an unsecured claim

which the drafters no doubt contemplated would

dominate the unsecured class, forcing a donny-

brook at eram-down over whether the debtor could

retain any interest in the estate without paying off

the Code-created deficiency. By happenstance,

that same deficiency claim will, in the usual real

estate case, because it dominates the unsecured

class, threaten the debtor's plan under Section

1129(a)(10). By equal happenstance, however, the

flexibility of Section 1122 seems to permit the

debtor to easily circumvent that pitfall by simply

preserving, impairing, and separately classifying

trade debt. See Hobson Pike Associates, Ltd., 3

B.C.D. at 1213. The only limitation on that tactic

apparent on the face of the Code is the require-

ment that, as between the trade and the deficiency

claim, the plan not unfairly discriminate. A credi-

tor "victimized" by such tactics will be quick to

point to Section 1129(a)(3), which requires the plan

to have been proposed “in good faith," but that

position is tenable only if one first assumes that

the purpose of Section 1129(a)(10) was to assist in

preventing debtors from obtaining access to the

cramdown provisions, an assumption which this

court finds is suspect. As we shall see below, the

"good faith" argument is undercut by the expansive

and flexible classification and impairment sections

of the Bankruptcy Code, the use of which will in

most cases also satisfy the technical requirements

of Section 1129(a)(10). If any purpose can be

divined from the Code's structure, it is that, in real

estate cases such as this, the ultimate confronta-

tion will take place over whether the plan can satis-

fy the stringent requirements of cram-down im-

posed by Section 1129(b), not whether it can satis-

fy the hyper-technical (and largely impractical)

requirements of Section 1129(a)(10). This court

cannot find any particular congressional intent,

either expressed or implied in Congress’ sausage-

making exercise, that compels this court to read

together the various Code provisions in such a way

as to confer on secured creditors in cases such as

these the veto power for which Phoenix now lob-

bies.

By the same token, however, the debtor's powers

are not unrestricted. We thus explore those restric-

tions in light of this plan. We first look at the

classification question, then examine the Case

exception. If the classification and treatment

scheme pass muster, we will then turn to whether

the Case exception is available to overcome the

absolute priority rule and, if so, whether it is avail-

able to this debtor in this case.

B. THE CLASSIFICATION QUESTION

1. The flexibility of classification permitted by

Section 1122

Collier's advises that a debtor enjoys considerable

flexibility in the manner in which it classifies

claims:

Since Congress obviously intended

that the proponent of a plan have the

flexibility to separately classify certain

general unsecured claims and thereby

leave such claims unimpaired if such

treatment was advantageous to the

debtor, the argument that all claims of

the same legal nature must be includ-

ed within one class is not persuasive.

5 Collier on Bankruptcy, P 1122.04, p. 1122-18

(15th ed. 1985). Some cases since the Code’s

enactment have been less certain about that flexi-

bility, however, often responding to factual scena-

rios which a given court found offensive or abusive.

See Granada Wines, Inc. v. New England Teamsters

and Trucking Industry Pension Fund, 748 F.2d 42

(1st Cir.1984); In re S. & W Enterprise, Inc., 37 B.R.

153 (Bankr.N.D.IIL. 1984); In re Mastercraft Record

Plating, Inc., 32 B.R. 106, 108

(Bankr.S.D.N.Y.1983), rev’d on other grounds, 39 |

B.R. 654 (S.D.N.Y.1984); In re Pine Lake Village

Apartment Co., 19 B.R. 819, 831 (Bankr.S.D.N.Y.

1982). These cases condemn the practice of creat-

ing a separate class for a given group of unsecured

creditors apart from other unsecured creditors,

finding in the tactic an attempt to "gerrymander" in

order to satisfy the "one accepting class" require-

ment of Section 1129(a)(10). ® They support a more

...Continued... |

Floor comments note the interplay of Sections 1111(b),

A-98

Se ale Sl dt in

restrictive "read" of Section 1122 by relying on Act

cases which construed Section 197 of the Bank-

ruptcy Act. 9 See In re Los Angeles Land & Invest-

ments, Ltd., 282 F.Supp. 448, 453 (D.Hawaii 1968),

affd, 447 F.2d 1366 (9th Cir.1971); In re Scherk v.

Newton, 152 F.2d 747 (10th Cir.1945). By their

interpretation, these cases hold that all claims of

similar legal status vis-a-vis their entitlement to

..Continued...

1129 and 1124 (relating to what constitutes an impaired

class), but make no reference to Section 1122. 124 Cong Rec

H11103, 95th Cong, 2d Sess (daily ed. Sept. 28,1978)

(remarks of Rep. Edwards).

8 If nothing else, the practice and the uproar it has created

bears out Judge Norton's criticism of imposing such a re-

qvirement as a precondition to confirmation. Matter of

Hobson Pike Associates, Ltd., 3 B.C.D. at 1213; see note 3,

supra.

9 That section, which was part of Chapter X, read as fol-

lows, in pertinent part:

For the purposes of the plan and its accept-

A-99

saree

estate assets must be placed within the same

class. '° These cases also point to the reference in

the legislative history to a codification of "existing

case law surrounding the classification of claims

and equity securities." S.Rep. No. 989, 95th Cong,

2d Sess 118 (1978), U.S.Code Cong. & Admin.News

1978, p. 5904.

Other cases have criticized this rigid interpreta-

tion of Section 1122. The Sixth Circuit, for exam-

ple, pointed out that both the legislative history

. Continued...

ance, the judge shall fix the division of credi-

tors and stockholders into classes according to

the nature of their respective claims and

stock....

11 U.S.C. (repealed) s 597 (1976).

hd One concern of Act cases was the possibility that

claimants with the claims of equal dignity against a particu-

lar item of property might be separately classified, thereby

depriving one group of claimants of valuable lien rights. See

Seidel v. Palisades-on-the-Desplaines (In re Palisades-on-the-

Desplaines), 89 F.2d 214, 217 (7th Cir.1937) ("all creditors of

A-100

and prior case law are inconclusive because Sec-

tion 1122 is the successor not only to former Sec-

tion 197 (part of Chapter X under the Act) but also

to former Section 351 (part of Chapter XI under the

Act). In re U.S. Truck Co., Inc., 800 F.2d 581, 585

(6th Cir.1986). The latter section states only that

For the purposes of the arrangement

and its acceptance, the court may fix

the division of creditors into classes

and, in the event of a controversy, the

court shall after hearing upon notice

summarily determine such controver-

Sy.

11 U.S.C. (repealed) s 751 (1976). Because under

Chapter XI, only unsecured claims could be ad-

justed, former Section 351 opened the door to

multiple classes of claims similar in legal nature.

Section 1122 on its face did not incorporate the

more restrictive language of former Section 197

and the Sixth Circuit found no reason to re-insert

such a restriction just because of a passing refer-

ence in the legislative history. Id. at 586-87.

Other circuits have agreed with the Sixth Circuit's

conclusion. Matter of Jersey City Medical Center,

817 F.2d 1055, 1061 (3rd Cir.1987); Hanson v.

First State Bank of South Dakota, N.A., 828 F.2d

1310, 1313 (8th Cir.1987); see Matter of LeBlanc,

622 F.2d 872 (5th Cir.1980) (construing a Chapter

XII Bankruptcy Act case); In re AOV Industries,

Inc., 792 F.2d 1140 (D.D.C.1986).

Other bankruptcy courts have also rejected a

restrictive reading of Section 1122. See, e.g., In re

Ag Consultants Grain Div., Inc., 77 B.R. 665, 670-

76 (Bankr.N.D.Ind.1987); In re Northeast Dairy

Coop Federation, Inc., 73 B.R. 239, 249

(Bankr.N.D.N.Y.1987); In re Mason & Dixon Lines,

Inc., 63 B.R. 176, 181 (Bankr.M.D.N.C.1986); In re

Huckabee Auto Co., 33 B.R. 132, 137

(Bankr.M.D.Ga.1981). The court in Ag Consultants

pointedly notes that even the reliance on Bank-

ruptcy Act cases may be misplaced, as many

of those cases did permit flexible classification,

often at least in part because it would contribute to

confirmation of the plan. See In re Ogden Apart-

ment Building Corp., 90 F.2d 712 (7th Cir. 1937);

see also Seidel v. Palisades-on-the- Desplaines (in re

Palisades-on-the-Desplaines), 89 F.2d 214 (7th

Cir. 1937); Brockett v. Winkle Terra Cotta Co., 81

F.2d 949 (8th Cir.1936); In re Dudley v. Mealey,

147 F.2d 268 (2d Cir.1945). At the very ieast,

these Act cases placed their emphasis on the prac-

ticalities of a given case, with an eye toward favor-

ing rehabilitation, and the Ag Consultants court

wisely observed that even the oft-cited Scherk v.

Newton case holds only that creditors of equal rank

with claims against the same property should be

placed in the same class, not that they must be. In

re Ag Consultants Grain Division, Inc., 77 B.R. at

674, citing Scherk v. Newton, 152 F.2d at 751.

Finally, Ag Consultants reminds us that a court's

first duty is to interpret a given statute as itis

written,

unless it is demonstrably at odds with

the intentions of the statute's drafters.

Griffin v. Oceanic Contractors, Inc., 458

U.S. 564, 571, 102 S.Ct. 3245, 3250,

...Continued...

| ) A-103

Id.

This court joins with Ag Consultants and the

73 L.Ed.2d 973 (1982).

We find no ambiguity in 11 U.S.C. s

1122. Section 1122 allows a claim or

interest to be placed in a particular

class only if such claim is substantial-

ly similar to the other claims or inter-

ests of such class. It does not require

that similar classes be grouped togeth-

er but merely that any group be

homogeneous. [citations omitted].

above-cited circuit court authority in finding

...-Continued...

unpersuasive the current line of cases

that hold that Congress intended all

unsecured claims of a similar nature

to be grouped within one class.... A

critical review [reveals that] those

cases attempt[ ] to create a statutory

requirement where none exists and a |

reliance on pre-Code law and Act

statutory requirements.

A-104

Id. at 675. Section 1122 authorizes flexibility in

classification in furtherance of the rehabilitative

intentions of Chapter 11.

2. The propriety of the classification scheme

The flexibility to “classify around" a secured credi-

tor’s Code-created deficiency claim is not unbri-

dled, however. The Fifth Circuit has noted that

As a general rule the classification in

a plan should not do substantial vio-

lence to any claimant's interest. The

plan should not arbitrarily classify or

—— — discriminate against creditors. The

fact that bankruptcy courts are courts

of equity, however, allows exceptions

to any strict rules of classifications of

claims. A bankruptcy court can

permit discrimination when the facts

of the case justify it.

Brinkley v. Chase Manhattan Mortgage and Reality

Trust (Matter of LeBlanc), 622 F.2d 872, 879 (Sth

Cir. 1980).

Examining the propriety of the classification

..-Continued...

| A-105

scheme focuses on the peculiar equities of each

case, leading a court to exercise its equitable

powers in the interests of forwarding the reorgani-

zation policy which underlies the Bankruptcy

Code. United States v. Whiting Pools, Inc., 462 U.S.

198, 203, 103 S.Ct. 2309, 2312, 76 L.Ed.2d 515

(1982); H.R.Rep. No. 595, 95th Cong, Ist Sess 220

(1977).

Phoenix contends however that there must be a

good reason to separately classify the trade in this

case. Phoenix argues that the separate classifica-

tion of the trade coupled with their unjustified

impairment represents blatant "gerrymandering"

which, if nothing else, violates the "good faith"

requirement imposed by Section 1129(a}(3).

Phoenix thus tries to bring itself within the facts of

Pine Lake Village, supra. In that case, separate

classification of a mortgage deficiency was not

permitted because the sole purpose, according to

the court, was to permit the plan to satisfy Section

1129(a)(10), which requires the acceptance of at

least one class of impaired creditors. A single class

of unsecured creditors there, as here, would have

been dominated by the deficiency claim of the

secured creditor. Pine Lake Village Apartment Co.,

supra. As we have indicated above, however, the

underpinnings of Pine Lake Village are shaky. So

also is the logic that Section 1129(a)(10) operates

as a Statutory gatekeeper to bar access to cram-

down. !! Finally, there is Fifth Circuit authority

..continued...

equal rank with claims against the same property should be

placed in the same class"); Scherk v. Newton, 152 F.2d 747,

751 (10th Cir.1945) ("all creditors of equal rank with claims

against the same property should be placed in the same

class").

11 As noted supra, there is nothing in the legislative hunters

to indicate that Congress intended to "link" Section

1129(a)(10) with the cram-down powers. To the contrary, the

provision was in the Senate version, which did not have a

cram-down provision. See discussion supra at note 3.

Congress’ response to the cram-down power incorporated

i A-107

that, so long as a plan is proposed with the legiti-

mate and honest purpose to reorganize and is not

otherwise prohibited by law, it is a plan which

satisfies the "good faith" requirement of Section

1129(a)(3). Matter of Sun Country Development,

Inc., 764 F.2d 406, 408 (5th Cir.1985). }?

.-Continued...

from the House bill was Section 1111(b), which merely as-

sured that, if a debtor tried to force a plan onto a non-

recourse lender, the plan would have to pass muster under

the modified absolute priority rules of Section 1129(b) both

with respect to the secured claim (echoing Section 461(1 1) of

the Bankruptcy Act) and to the Code-created unsecured

claim (echoing the “fair and equitable” standard of Chapter X

of the Bankruptcy Act). It seems not to have occurred to

Congress that Section 1129(a)(10) might be used to bar

access to the cram-down powers. Even if it had, the section's

utility was undercut by the generous classification and

A-108

By the same token, however, recent cases have

felt constrained to “draw the line" on the extent to

which a plan can creatively classify creditors,

though they have had some difficulty in articulat-

ing precisely why. For example, in U.S. Truck, the

Sixth Circuit observed that

In this case, U.S. Truck is using its

classification powers to segregate

dissenting (impaired) creditors from

assenting (impaired) creditors (by put-

ting the dissenters into a class or

classes by themselves) and, thus, it is

assured that at least one class of

impaired creditors will vote for the

plan and make it eligible for cram

...Continued... |

impairment provisions of Chapter 11. 11 U.S.C. ss 1122,

1123(a). 1124; see discussion infra.

12 First, Brite’s claim that the unsecured creditors’ status

was changed to effectuate the cram down does not go to

whether the purpose of Sun Country's proposed plan is to

reorganize is whether the plan has a reasonable hope of

A-109

A bie re nh Dat SRI: -

ETS a

‘down consideration by the court. We

agree with the Teamsters Committee

that there must be some limit on a

debtor's power to classify creditors in

such a manner. The potentia! for

abuse would be significant otherwise.

Unless there is some requirement of

keeping similar claims together, noth-

ing would stand in the way of a debtor

seeking out a few impaired creditors

(or even one such creditor) who will

vote for the plan and placing them in

their own class.

In re U.S. Truck Co., Inc., 800 F.2d 581, 586 (6th

Cir.1986); In re Jersey City Medical Center, 817

F.2d 1055, 1061 (3rd Cir.1987) (citing U.S. Truck);

Hanson v. First’Bank of South Dakota, N.A., 828

F.2d 1310, 1313 (8th Cir. 1987) (finding no justifi-

cation for separate classification in this case); In re

Northeast Dairy Coop Federation, Inc., 73 B.R. 239,

250 (Bankr.N.D.N.Y.1987).

If we take as a given that some independent

reasonable grounds for separate classification

must be found in order to authorize the proposed

classification scheme, then one recognized ration-

ale is a demonstrated economic need to treat cer-

tain otherwise similar claims differently. In U.S.

Truck Co:, Inc., 800 F.2d 581, 586 (6th Cir. 1986);

In re Jersey City Medical Center, 817 F.2d 1055,

1061 (3rd Cir.1987); In re Ag Consultants Grain

Div., Inc., 77 B.R. 665, 676 (Bankr.N.D.Ind. 1987).

The legal character of a claim may also itself justify

both disparate classification and treatment under

the authority of a number of Act cases.

Unsecured creditors may, under

special circumstances, be divided into

separate classes where the legal

character of their claims is such as to

accord them a status different from

other unsecured creditors.

In re Los Angeles Land of Investments, Ltd., 282

F.Supp. 448, 453 (D. Hawaii 1968), affd, 447 F.2d

1366 (9th Cir.1971); Scherk ‘: Newton, 152 F.2d

747, 751 (10th Cir. (1945) (classification is simply

a method of recognizing difference in rights which

call for difference in treatment); see also Seidel v.

Palisades-on-the-Desplaines (in re Palisades-on-the-

Desplaines), 89 F.2d 214 (7th Cir.1937). The facts

of this case justify disparate classification of the

trade debt on both grounds.

First of all, trade creditors are not of equal legal

status with Code-created deficiency claims. They

have an independent claim against the general

partners which the deficiency claim does not enjoy,

because Section 1111(b) does not confer a com-

parable right. The "recourse claim" is only good

against the debtor's estate in the Chapter 11 case.

Section 1111(b) does not purport to create a claim

cognizable under state partnership law against the

partners.

The transformation of nonrecourse claims into

recourse Claims is for distribution purposes only in

a Chapter 11 reorganization cases where the

debtor has been given the power to retain encum-

bered property (over the objection of the secured

creditor) for use in its plan of reorganization. "It

was obviously not intended by according recourse

[status] to non-recourse claims that the holders of

these claims would be given any additional rights

under state law." 3 Norton Bankr.L. & Prac. s

57.02

... conversion of non-recourse claims

to recourse claims is the "price" the

debtor pays to use encumbered

property in its reorganization over the

objection of the secured creditor. If

the property is voluntarily or involun-

tarily returned to the secured creditor,

the non-recourse secured creditor is no

longer entitled to this preferred status.

Matter of DRW Property Co., 57 B.R. 987, 992,

993 (Bankr.N.D.Tex. 1986).

Indeed, the estat® in Chapter 11 has no claim

against the partners, at least not via bankruptcy

law. See I-37 Gulf Ltd. Partnership, 48 B.R. 647,

649 (Bankr.S.D.Tex.1985); see also 5 Collier on

Bankruptcy P 1111.02[2], p. 1111- 22 (15th ed.

...Ccontinued...

A-113

ee nee oe

ee LY ee ee ee ne

1985). What is more, in a Chapter 7 case, while

the estate has a claim against the partners, Phoe-

nix’ Code-created deficiency claim is no longer part

of the estate's liabilities. 11 U.S.C. ss 723,

1111(b). The legal "nature" of Phoenix’ deficiency

claim is thus subtly different from that of the trade

debt.

In this plan, the debtor "directs" the trade to the

general partners, who are anticipated to pay their

claims in satisfaction of their liability under the

Texas Uniform Partnership Act. The trade are thus

being treated somewhat differently, in recognition

of their unique legal rights against the partners,

rights which a Code-created deficiency claim can

not enjoy. |

Good business reasons also justify separate

| treatment, as the partnership and its partners

need the trade to maintain good will for future

operations. Trade debt simply does not extend

credit to an entity such as this based on that enti-

ty’s long-term ability to pay the debt back, but on

the entity's short-term cash flow. If those expecta-

a ae ee ee ee ee 7 ee te

tions are frustrated, creditors holding such debt

have little recourse but to refrain from doing

business with the enterprise.

The resulting negative reputation quickly spreads

in the trade community, making it difficult to

obtain services in the future on any but the most

onerous terms. These simple realities of business

more than justify separate classification of the

trade debt from the obviously unrelated Code-

created deficiency claim.

3. Classification and “artificial impairment."

We are still left with Phoenix’ argument that the

debtor could have paid the trade in full but left it

to the partners instead, so that the debtor would

have at least one impaired class to vote for the

plan. Is this permitted? The Fifth Circuit’s answer

seems to be in the affirmative. Matter of Sun

Country Development opined that taking advantage

of the power of cram down is not ipso facto bad

faith. 764 F.2d at 408. In that case, the debtor

impaired a relatively small class of unsecured

claims. The creditor there (as here) complained

A ee rn

that there was no independent justification for that

impairment other than to “open the gates" to the

cramdown provisions. '* The Fifth Circuit rejected

.-Continued...

success. Congress made the cram down available to debtors:

use of it to carry out a reorganization cannot be bad faith.

Id. at 408 (emphasis added). Similar logic carries over to

debtors’ using the classification mechanism, which’ was made

available to debtors by Congress, to carry out a reorganiza-

tion.

" The case in Sun Country was filed prior to the 1984

amendments to the Bankruptcy Code which made explicit a

judicial gloss that read in the word “impaired” into the re-

quirement of one accepting class in Section 1129(a)(10).

There was thus considerable doubt whether the judicial gloss

was justified, in light of the express terms of the pre-1984

version of Section 1129(a)(10), and so some doubt whether

the accepting class had to even vote, much less be impaired,

due to the operation of Section 1126(f.

The debtor's first plan treated the unsecured creditors as

A-116

the notion that the debtor's tact was improper,

given that the Code provisions were available and

the debtor was simply using them. Id. at 408.

What is more, nothing in Sections 1123 or 1124

either expressly or impliedly prohibits “intentional”

impairment. See H.R.Rep. No. 595, 95th Cong, Ist

Session 406, 408 (1977). '* To the contrary, the

. Continued...

unimpaired, but was later amended to give them a short-term

note instead of cash on confirmation. Evidence taken by the

district court confirmed that the debtor had an independent

justification for the impairment, as the notes were subse-

quently redeemed at a discount after the debtor received its

tax refund. The issue of so-called “unjustified" impairment

was not therefore directly before the Circuit court.

. The plan must designate classes of

claims and interests and specify, by class, the

claims or interests that are unimpaired under

the plan.... The plan must provide the same

treatment for each claim or interest of a par-

ticular class ...

A-117

only "brake" on impairment appears to be the re-

quirement in Section 1129(b) that the plan not

“unfairly discriminate" against a dissenting class of

creditors. In re Meadow Glen, Ltd., 87 B.R. 421,

425 (Bankr.W.D.Tex. 1988). We turn owir attention,

then, to that provision.

4. Classification and “unfair discrimination."

The argument that the debtor’s tactic unfairly

discriminates in all cases is not persuasive. See In

re Pine Lake Village Apartment, Co., 19 B.R. 8 19,

831 (Bankr.S.D.N.Y.1982): In re Northeast Dairy

Cooperative Federation, Inc., 73 B.R. 239, 249

(Bankr.N.D.N.Y.1987); In re Meadow Glen, Ltd., 87

B.R. 421, 425 (Bankr.W.D.Tex.1988). The re-

quirement that a plan not “unfairly discriminate"

with respect to a dissenting class parallels the

requirement that all creditors within a given class

must be treated the same. Indeed. the phrase is a

term of art, with a specialized mean

» « «CORE I aved...

H.R.Rep. No. 595, supra at 406 (discussing s 1123),

A-118

ing consistent with the operation of Section

1122(a). '5 In the words of Collier 's,

Reducing discrimination to its bare

essentials, a dissident class ... must ...

) receive treatment which allocates value

to the class in a manner consistent

with the treatment afforded to other

classes with similar legal claims

against the debtor.

5 Collier on Bankruptcy, P 1129.03[3], p. 1129-

50 (15th ed. 1981): see H.R.Rep. No. 595, 95th

Cong, lst Sess 416-17 (1977); see also In re

Meadow Glen, Ltd., 87 B.R. 421, 425

(Bankr.W.D.Tex. 1988). In this case, the debtor has

. .Continued...

U.S.Code Cong. & Admin.News 1978, p. 6362.

This section is new. It is designed to indi-

cate when contractual rights of creditors or

interest holders are not materially affected.

The section specifies three ways in which the

plan may leave a claim or interest unimpaired.

Id. at 408 (discussing s 1124), U.S.Code Cong. & Admin.

A-119

assiduously accorded its trade debt precisely the

same dividend as it has its Code-created deficiency

claim and, in so doing, has satisfied the technical

specifications of Section 1129(b) that the plan not

“unfairly discriminate" against the dissenting class.

'§ The two classes have the same relative legal

priority of claim upon the estate's assets and are

accorded the same percentage of payment out of

those assets.

. Continued...

News 1978, p. 6364.

‘2 Cf. 11 U.S.C. s 1322(b)(1) (plan may designate a class

of unsecured claims as provided in Section 1122. but may

not discriminate unfairly against any class so designated).

Chapter 13 combines the concept of unfair discrimination

with the classification issue, a connection not directly made

in Chapter ll cases.

a The sponsors of the Code remarked that the proscrip-

tion on unfair discrimination was merely included “for

Clarity," adding that the provisions of the House Report

Stated correctly the appropriate nterpretation of the phrase

A-120

Phoenix contends that, because the estate has

more than enough in cash with which to pay off

the trade, there is no just cause for failing to do so,

so that the structure of the plan unfairly discrimi-

nates. In fact, however, it is the very proscription on

unfair discrimination that mandates that the trade

not be paid off, for nothing would then be left of

those assets to pay the Code-created deficiency

and the plan would prima facie “unfairly discrimi-

nate" against Phoenix:

From the perspective of unsecured

trade claims, there is no unfair dis-

crimination as long as the total con-

sideration given all other classes of

equal rank does not exceed the

amount that would result from an

exact aliquot distribution.

H.R.Rep. No. 595 at 416, U.S.Code Cong. &

Admin.News 1978, p. 6372. In re Meadow Glen,

Lid., 87 B.R. 421, 425 (Bankr.W.D.Tex. 1988). !

The upshot then is that this plan does not unfairly

discriminate against Phoenix’ Code-created defi-

ciency claim, nor is the classification scheme

inappropriate given the marked legal and economic

differences between that claim and the trade debt.

The court rejects the notion Suggested first in

Meadow Glen that this plan represents a case of

“artificial impairment," as such a conclusion

exceeds the intent of Congress in enacting the

“unfair discrimination" language. If there isa

rational justification for separate classification, the

- -Continued...

as used in this portion of the Bankruptcy Code. 124 Cong

Rec H11104 (daily ed. Sept. 28, 1978) (remarks of

Rep.Edwards); 124 Cong Rec $17420 (daily ed., Oct. 6,

1978) (remarks of Sen DeConcini). The House Report, in

turn, states that a plan avoids unfair discrimination so long

as it provides for “exact aliquot distribution."

H.R.Rep. No. 595 at 416. U.S.Code Cong. & Admin.News

1978, p. 6372.

Phoenix’ real frustration is that the plan deprives

A-122

debtor is entitled to exploit the parameters of the

Code to get a plan confirmed. This court therefore

holds that the plan passes muster with respect to

its classification and treatment of Phoenix’ Code-

created deficiency claim.

C. THE CASE EXCEPTION

We turn now to whether the plan is “fair and

equitable," i.e., whether the plan satisfies the

absolute priority rule. Collier 's has commented

gloomily that

In the real estate limited partnership

context, if the partnership's sole asset

is a building which does not generate

sufficient income to service debt, it is

highly unlikely that the debtor can

sustain its burden of proof under

section 1129(b)(2)(B) that the debtor

can provide full payment of the claims

of unsecured creditors including the

mortgagee's deficiency claims. Once it

is clear that the debtor is unable to

pay the unsecured deficiency claims in

full, the only way that the cram down

powers can be successfully used is if

the former equity interests are elimi-

nated.

5 Collier on Bankruptcy, P 1111.02[2], p. 1111-

20 (15th ed.1985).

The debtor argues that all is not lost, however,

because the Supreme Court long ago recognized an

“exception.to the absolute priority rule, giving it

expression in a series of cases culminating in Case

v. Los Angeles Lumber Products Co., 308 U.S. 106,

60 S.Ct. 1, 84 L.Ed. 110 (1939). Phoenix responds

that the vitality of the exception under the current

Bankruptcy Code was questioned in Norwest Bank

Worthington v. Ahlers, 485 U.S. 197, 108 S.Ct. 963,

99 L.Ed.2d 169 (1988), and that this court should

rule that the exception is no longer available to

permit debtors to "buy" their way back in to their

own cases. !® If it is indeed no longer availab!e,

then this plan (and virtually all real estate bank-

..Continued...

Phoenix of the veto to which it believes it is entitled by virtue

of its large deficiency claim. As we have seen, however, that ,

expectation is unwarranted. Congress gave creditors such

as Phoenix the Code-created deficiency claim as an antidote

to cram-down, not as a vaccine. The deficiency claim merely

permits Phoenix to invoke the absolute priority rule, forcing

the debtor's owners to negotiate a way to satisfy the claim or

risk losing their ownership interest.

18 In Ahlers, Justice White suggested in a footnote that

our decision should not be taken as any

comment on the continuing vitality of the Los

Angeles Lumber exception--a question which

has divided the lower courts since passage of

the Code in 1978. Compare, e.g., In re Saw-

mill Hydraulics, Inc., 72 BR 454, 456, and n. 1

(Bkrtcy CD II] 1987) with, e.g., In re Pine

Village Apartment Co., 19 BR 819, 833 (Bkrtcy

SDNY 1982).

Rather, we simply conclude that even if an

| A-125

ruptcy cases in this part of Texas) must fail as a

matter of law. If it survives, then the facts of this

case must be tested against the exception to see if

this case fits. If this case does not, then this case

fails but others may follow with greater success.

1. The history and development of the "exception"

Case advised that a junior interest holder might

retain an interest in the enterprise even though

senior classes were not fully paid provided the

junior interest holder had made a cash infusion

which was both necessary under the circum-

stances and substantial.

Case v. Los Angeles Lumber Products Co., 308 U.S.

106, 121, 60 S.Ct. 1, 84 L.Ed. 110, 122 (19389). }9

..-Continued...

“tnfusion-of-'money-or-money’s-worth’ " excep-

tion to the absolute priority rule has

Survived .lm3

the enactment of s 1129(b), respondents’ proposed contribu-

tion to the reorganization plan is inadequate to gain the

benefit of this exception.

Case law had developed that promulgatcd a "fixed

principle” that plans must be “fair and equitable,"

i.e., that equity reorganizations were required to

adhere to an absolute priority in their payment

scheme, enforceable as a matter of law by the

court, regardless whether anyone eise objected.

[T]he stockholder's interest in the

property is subordinate to the rights of

creditors; first of secured and then of

unsecured creditors.... [A]ny arrange-

ment of the parties by which the

subordinate rights and interests of

stockholders are attempted to be

secured at the expense of the prior

rights of either class of creditors comes

within judicial denunciation.

Louisville Trust Co. v. Louisville, N.A. & C.R. Co.,

174 U.S. 674, 19 S.Ct. 827, 43 L.Ed. 1130 (1899):

see Northern P.R. Co. v. Boyd, 228 U.S. 482, 33

S.Ct. 554, 57 L.Ed. 931 (1913); Kansas City

Terminal R. Co. v. Central Union Trust Co., 271 U.S.

445, 46 S.Ct. 549. 70 L.Ed. 1028 (1926). This

“fixed principle" was incorporated into Section 77B

of the Bankruptcy Act by the inclusion of a re-

quirement that plans be "fair and equitable," the

term of art for the absolute priority rule. Case,

supra, 308 U.S. at 119, 60 S.Ct. at 9. However,

early cases also recognized that. due to practical

considerations, the rule had to have an exception.

In Kansas City Terminal. Supra, the Court had

noted that

[When necessary, [creditors] may be

protected through other arrangements

which distinctly recognize their equi-

table right to be preferred to stock-

holders against the full value of all

property belonging to the debtor corpo-

ration, and afford each of them fair

opportunity, measured by the existing

circumstances, to avail himself of this

right.

Generally, additional funds will be

essential to the success of the under-

taking, and it may be impossible to

obtain them unless stockholders are

permitted to contribute and retain an

interest sufficiently valuable to move

them. In such or similar cases, the

chancellor may exercise an informed

discretion concerning the practical

adjustment of the several rights.

Kansas City Terminal R. Co. v. Central Union Trust

Co., 271 U.S. at 454-55, 46 S.Ct. at 551-52. But

for this exception, a perfectly sensible reorganiza-

tion might founder for lack of capital infusion from

the equity holders, who could hardly be expected

to pump new money into a venture if they could

not in the process retain an interest in the venture.

Case acknowledged the continuing vitality of the

court-fashioned exception to the absolute priority

rule:

It is, of course, clear that there are

circumstances under which stockhold-

ers may participate in a plan of reor-

ganization of an insolvent debtor....

Especially in [Kansus City Terminal] did

this Court stress the necessity, at

times, of seeking new money "essential

to the success of the undertaking"

from the old stockholders. Where that

necessity exists and the old stockhold-

ers make a fresh contribution and

receive in return a participation rea-

sonably equivalent to their contribu-

tion, no objection can be made.

Case v. Los Angeles Lumber Products Co., 308

U.S. at 121, 60 S.Ct. at 10. For the exception to

lie, the circumstances of the case must first dictate

the necessity of a capital infusion. Then, the par-

ticipation given in return for the infusion must be

“reasonably equivalent." The exception was thus

carefully cabined, lest the absolute priority rule

itself be eviscerated.

The Court went on to underscore the underlying

importance of preserving the creditors’ "full right of

priority against the corporate assets," however:

If that were not the test, then the

creditor's rights could be easily diluted

by inadequate contributions by stock-

holders. To the extent of the inade-

quacy of their contributions the stock-

holders would be ... “in the position of

mortgagor buying at his own sale."

In view of these considerations, we

believe that to accord “the creditor his

full right of priority against the corpo-

rate assets" where the debtor is insol-

vent, the stockholder’s participation

must be based on a contribution in

money or in moneys’ worth, reasonably

equivalent in view of all the circum-

stances to the participation of the

stock holder.

Case, supra at 122, 60 S.Ct. at 10. Case thus

reaffirms the paramount importance of preserving

absolute priority, even though a new capital infu-

sion might be required for the plan's success. The

“exception” was thus carefully circumscribed.

2. The continuing vitality of the “exception”

Alhlers's inference that Case did not survive the

enactment of the Bankruptcy Code can probably

be traced to the Code’s fundamental change in

structure from the Bankruptcy Act. Under the Act,

courts were required to enforce the absolute priori-

ty rule as a matter of law in Chapter X reorganiza-

tions. 11 U.S.C. (repealed) s 621(2) (1976). The

Code, by contrast, permits consensual plans which

need not comport with absolute priority, i.e., senior

debt may voluntarily surrender rights to recovery

out of the estate's assets to junior debt holders. 11

U.S.C. s 1129(a)(7), (8). Absolute priority is pre-

served as a prerequisite to confirmation only in the

narrow circumstance of "cram-down," or confirma-

tion over the objection of a dissenting class of

creditors, and then only from the dissenting class

down. 11 U.S.C. s 1129(b)(2)(B); H.R.Rep. No.

595, 95th Cong, lst Sess 413 (1977). The reten-

tion of the "fair and equitable" standard in cram

down situations serves the equitable end that a

creditor class should only be forced to accept a

plan over its objection upon assurance that it will

»« COB Ree...

A-132

not, in the process, be forced to surrender its

rights to satisfaction of its claims out of the assets

of the estate to junior interests. To reiterate the

Supreme Court in Boyd, it would be neither fair

nor equitable to visit such a result on classes of

creditors whose claim on the assets of the enter-

prise is clearly superior. Northern P.R. Co. v. Boyd,

228 U.S. at 503, 33 S.Ct. at 559.

The Case exception does not undercut the protec-

tive equitable function of the absolute priority rule

even as resurrected in Section 1129(b) of the Code.

In fact, it is probably a misnomer to call it an

exception at all. It is, rather and more accurately,

a logical expansion on the notion that an equity

reorganization should, in all respects, be “fair” and

"equitable." The Case court quoted with approval

an earlier bankruptcy case to that very effect: - -

Circumstances may exist where the

success of an undertaking requires

that new money be furnished and

where the former stockholders are the

only or most feasible source of the new

capital. In such instances, the court

may recognize as fair and equitable a

plan which includes contributions of

new money by stockholders, provided

it satisfactorily appears that full

recognition has been given to the value

of the creditors’ claims against the

property.

In re Dutch Woodcraft Shops, 14 F.Supp 467, 471,

30 Am.Bankr.Rep. 351 (D.C.Mich. 1935) (emphasis

added), quoted at Case, supra at 308 U.S. 121 n.

15, 60 S.Ct. at 10 n. 15. An infusion of new capi-

tal may well be necessary to the success of the

venture. To the extent that it is, and to the extent

that persons willing to invest in the reorganized

entity receive a participation in the enterprise

commensurate with their investment, and no more.

it cannot be said that the participation granted the

investor renders the plan either unfair or inequita-

ble. Kansas City Terminal R. Co. v. Central Union

Trust Co., 271 U.S. 445, 455, 46 S.Ct. 549, 70

L.Ed. 1028 (1926): Case v. Los Angeles Lumber

Products Co., 308 U.S. 106, 121-22, 60 S.Ct. 1, 10-

11, 84 L.Ed. 110, 122-23 (1939). There is nothing

about the structure of the Code that alters this

fundamental recognition of the practicalities of all

enterprises. It still takes cash to run any enter-

prise and the cash flow of the enterprise is fre-

quently inadequate to the task. The same equita-

ble considerations that motivated the recognition of

the "exception" in Kansas City Terminal, and reaf-

firmed its vitality under Section 77B in Case,

commend its preservation under the Bankruptcy

Code, to assure that an overstrict application of the

“fair and equitable" standard does not strangle the

debtor and leave the reorganization stillborn.

This court thus holds that, notwithstanding the

precautionary note in Ahlers, the Case “exception”

is still good law, as it represents nothing more than

an extension of the fair and equitable concept to

embrace the need for new capital for the venture.

To the extent the “fair and equitable"

concept has been brought forward into the Code,

therefore, so also has the expansion on that con-

cept enunciated in Case. There is nothing peculiar

about real estate reorganization cases that suggest

that the need for new capital in such cases is any

less compelling than in any other venture, so Case

should be available in such cases, provid.pa

ed it is precisely applied. 2°

3. Applying the "exception"

...Continued...

Id. at 485 U.S. at ---- n. 3, 108 S.Ct. at 966-67 n. 3, 99

L.Ed.2d at 177 n. 3.

19 The actual cash infusion in Case was rejected because

it failed the second prong of the test. Id. 308 U.S. at 121-22,

60 S.Ct. at 11, 84 L.Ed. at 123. First and foremost, the

capital infusion was not cash. Second, the consideration

retained by the stockholders was disproportionate relative to

the infusion.

20 ‘It is fair to assume that Congress was aware of Case

when it passed the Bankruptcy Code. That Congress did not

expressly codify Case's holding should be of no moment, as

the term of art carried with it the judicial glosses that had

been placed upon it. What does matter is that the Bankrupt-

cy Code did not expressly repudiate Case. It is a time-hon-

A-136

When applying Case under the Bankruptcy Code,

a court should first be sensitive to its antecedents.

The exception serves the narrow purpose of afford-

ing the debtor the capital necessary to survive. It

is not intended as a device by which pre-filing

owners can buy their way back into the venture,

much less preserve their ownership interest. Such

a read would amount to a perversion of what

Justice Douglas clearly intended to be a limited

and narrow extension. Close attention must be

paid not only to the letter of the exception but also

to the spirit in which it was promulgated. Requir-

ing a rigorous showing of both necessity and sub

stantiality will assure that a debtor's equity holders

will not eviscerate the absolute priority rule by

means of gratuitous, token cash infusions pro-

posed primarily to “buy” cheap financing. Group of

Institutional Investors v. Chicago, Milwaukee, St.

Paul & Pacific Railroad Co., 318 U.S. 523, 570, 63

S.Ct. 727, 751, 87 L.Ed. 959, 1010 (1943).

If a cash infusion is not necessary to the reorgan-

ization effort, the debtor will have failed to have

raised the predicate equitable concern that moti-

vated resort to the exception in Kansas City Termi-

nal and Case in the first place and the court

should not allow the capital infusion and concomi-

tant equity participation without the consent of the

senior interests. We only entertain the Case

extension to the absolute priority rule in those

situations in which the enterprise needs the capital

investment in the first place. Otherwise, the gener-

al concerns that animate the "fair and equitable"

standard still predominate and prohibit use of the

extension merely as a device to retain an interest

in the venture.

If (and only if) the cash infusion is needed. it

must be actual money or money's worth, paid not

merely promised, and the participation accorded

the equity interests in exchange for this cash infu-

sion must be commensurate, reasonably equiva-

lent. The equity interests will be allowed back into

the venture only to the extent of their new contri-

bution, in order to preserve creditors’ full rights of

priority in the estate's assets:

Whenever assessments are demand-

ed, they must be adjusted with the

purpose of according to the creditor

his full right of priority against the

corporate assets, so far as possible in

the existing circumstances.

Kansas City Terminal R. Co. v. Central Union Trust

Co., 271 U.S. at 456, 46 S.Ct. at 552; Northern

P.R. Co. v. Boyd, 228 U.S. at 504, 33 S.Ct. at 560.

With these preliminary considerations in mind,

we turn to the facts and posture of this case.

a. The "necessity" prong

The debtor has enough cash to pay off all trade

debt in full, but not the deficiency claim. Because

of the strictures of Section 1129(b), which prohibit

“unfair discrimination," the debtor cannot pay off

the trade debt without jeopardizing the entire plan

in the process. The debtor needs cash to pay the

deficiency claim as well as the trade, in accordance

with plan terms.

In answer to this need, the debtor's general part-

ners propose to put in $500,000 in additional

cash, some of which will be used to pay the debt-

or’s portion of the trade, some of which will pay

precisely the same percentage to Phoenix on its

deficiency claim. 7! The debtor cor ends that the

cash infusion is both necessary and substantial as

those terms are used in Case, so that the plan

should be found to be fair and equitable despite its

technical noncompliance with Section

1129(b)(2)(B).

The office complex is well managed, with a good

occupancy. The net operating income is close to,

but not quite, sufficient to service the plan's debt.

While the building is relatively new, it can antici-

pate a certain amount of maintenance in the fu-

ture. The cash flow analyses of both appraisal

experts as well as the projections of the debtor

..Continued...

ored principle of statutory construction that legislators are

presumed to be aware of judicial glosses placed on prior

Statutory enactments, and that subsequent amendments and

codifications are presumed to have been carried into the new

A-140

confirm that, eventually, the debtor's anticipated

cash flow will be insufficient to satisfy both debt

service and the escrows needed for taxes and

insurance. The total infusion of cash by the part-

ners will cover these shortages and future needs,

and will also pay off the claims of all but one class.

Without this cash, the plan would not be feasible.

See 11 U.S.C. s 1129(a)(11); see also In re Murel,

35 F.2d 941 (2d Cir.1935) (setting the standard for

adequate protection of a secured creditor's interest

in collateral over the life of a plan at "indubitable

equivalence").

The cash will come from the current owners of the

partnership, for which they are to receive 100% of

the ownership interest in the venture. In the

current economic climate, with banking institu-

tions chastened by the extraordinary number of

bank failures over the last five years, even well-run

commercial real estate ventures should not expect

to find working capital available from banks or

Savings and loan associations. Phoenix’ own

witness testified that there is no financing current-

ly available for commercial properties in Texas, and

the debtor's general partner confirmed that it has

not been able to attract new equity outside of its

existing partners, both general and limited.

Phoenix has indicated that it would be happy to

advance $155,000 to pay off the unsecured credi-

tors and complete tenant finish out obligations. It

has not, however, indicated any willingness to fund

future operations unless it can take over owner-

ship of the property, a condition precedent inimical

to the reorganization. It therefore does not repre-

sent a viable alternative source of working capital

for the future of the entity. 22

.-Continued...

Statute unless expressly repudiated. The Bankruptcy Code

did not repudiate Case, so the long-standing equitable

expansion of the absolute priority rule should be presumed

to still be good law.

Case recognized that new money was commonly neces-

Sary in equity reorganizations not only to provide new work-

A-142

The proposed capital infusion from the existing

owners of the partnership is, in this court's view,

“essential to the success of the undertaking,” and

so satisfies the “necessity” predicate for the invoca-

tion of the capital infusion exception to the abso-

lute priority rule. Kansas City Terminal R. Co. v.

Central Union Trust Co., 271 U.S. at 455, 46 S.Ct.

at 551-52: Case v. Los Angeles Lumber Products

Co., 308 U.S:-at 121, 60 S.Ct. at 10.

b. The “substantiality" prong

We turn, then, to the question of substantiality.

As noted above, this part of the Case extension has

..Continued...

ing capital but also to pay dissenting creditors. Case, supra

at 308 U.S. 121 n. 15, 60 S.Ct. at 10 n.15.

22 It is important to emphasize that, due to the nature of

the Case capital infusion exception, it is inappropriate to

approach the problem as though the ownership of the enter-

prise were up for sale. That is simply not the issue at all.

Instead, the question is whether there is an available source

of capital to fund the plan. By the time one gets to the Case

A-143

two facets.

First, the contribution must be "substantial" in

the sense that it must be “money or money’s

worth." Items such as reputation, standing in the

community, financial wherewithal, and manage-

ment expertise, while perhaps important to the

question of a plan's feasibility, have no place

whatsoever in the calculus for what constitutes a

“substantial contribution." Case, supra, 308 U.S.

at 122, 60 S.Ct. at 10, Ahlers, supra, 485 U.S. at

---- n. 3, 108 S.Ct. at 966-67 n. 3, 99 L.Ed.2d at

177 n. 3.

Second, the participation or consideration ac-

corded to those making the capital infusion must

be commensurate with or reasonably equivalent to

the capital infusion, to discourage current owners

from buying up the venture for a relatively modest

investment and to preserve the absolute priority

rule. The essence of the absolute priority rule is

that creditors have a prior right to the corporate

assets which may not be undermined even in the

interests of furthering the reorganization. Once

bankruptcy is filed, the role of the equity interests

in the continuation of the enterprise is fundamen-

tally altered. In the words of the Court in Case,

the equity interest owner, upon filing,

... invokes that jurisdiction risking all

of the disadvantages which may flow to

him as a consequence, as well as

gaining all of the benefits. One of

those disadvantages from the view-

point of the debtor and its stockhold-

ers is the approval of a plan of reorgan-

ization which eliminates them com-

pletely.

Case v. Los Angeles Lumber Products Co., 308

U.S. at 127, 60 S.Ct. at 12.

In this case, the debtor proposes to retain 100%

of the ownership of the enterprise with a new

equity infusion of $500,000. Is the proposed par-

ticipation reasonably equivalent to the capital

contribution? The question contains within itself a

preliminary issue, how to measure “reasonable

equivalence." The Supreme Court in Northem P.R.

Co. v. Boyd, in evaluating whether existing equity

might retain an interest in a railroad, commented

that

If the value of the road justified the

issuance of stock in exchange for old

shares, the creditors were entitled to

the benefit of that value, whether it

was present or prospective, for divi-

dends or only for purposes of control.

In either event, it was a right of

property out of which the creditors

were entitled to be paid before the

stockholders could retain it for any

purpose whatsoever.

Northern P.R. Co. v. Boyd, 228 U.S. 482, 508, 33

S.Ct. 554, 561, 57 L.Ed. 931 (1913) (emphasis

added). Again, the Supreme Court in Kansas City

Terminal reiterated that

when necessary, [creditors] may be

protected through other arrangements

which distinctly recognize their equi-

table right to be preferred to stock-

holders against the full value of all

property belonging to the debtor corpo-

ration, and afford each of them fair

opportunity, measured by the existing

circumstances, to avail himself of this

right.

Kansas City Terminal R. Co. v. Central Union Trust

Co., 271 U.S. at 454-55, 46 S.Ct. at 551-52

(emphasis added). Finally, the Supreme Court in

Ahlers has recently reaffirmed that equity owner-

ship has value, independent of the fair market

value of the enterprise, for purposes of applying

the absolute priority rule:

We join with the overwhelming

consensus of authority which has

rejected this "no value" theory. Even

where debts far exceed the current

value of assets, a debtor who retains

his equity interest in the enterprise

retains “property.” ... Indeed, even ina

sole proprietorship, where “going

concern" value may be minimal, there

may still be some value in the control

of the enterprise; obviously, also at

issue is the interest in potential future

profits of a now-insolvent business.

And while the Code itself does not

define what "property" means as the

term is used in s 1129(b), the relevant

legislative history suggests that Con-

gress’ meaning was quite broad.

“"[PJroperty’ includes both tangible

and intangible property."

See H.R.Rep. No. 595 at 413.

Norwest Bank Worthington v. Ahlers, 485 U.S.

197, ----, 108 S.Ct. 963, 969, 99 L.Ed.2d 169, 180

(1988) (emphasis added). We thus see that, in

terms of the absolute priority rule, the enterprise

first "belongs" to its unsecured creditors. 2°

..-Continued...

extension, one is already beyond whether the plan itself is

otherwise proper. In other words, the issue of where to get

the cash to make the plan work is not an opportunity to

A-148

A ili

By the same token, the capital infusion concept is

grounded on the assumption that any investor,

even a former owner, is entitled to compensation in

exchange for investing new capital into the ven-

ture. Case v. Los Angeles Lumber Products Co.,

supra, 308 U.S. at 123, 60 S.Ct. at 11; In re U.S.

Truck Co., 800 F.2d 581, 588 (6th Cir.1986); In re

Potter Material Service, Inc., 781 F.2d 99, 103 (7th

Cir.1986); In re Toy & Sports Warehouse, Inc., 37

B.R. 141, 148 (Bankr.S.D.N.Y.1984); In re Jartran,

Inc., 44 B.R. 331, 367 et seq. (Bankr.N.D.III. 1984).

..Continued...

undermine the plan. Instead, if the plan fails, then another

party in the case with standing may propose an alternative

plan. At confirmation, the court is not at liberty to “conduct

an auction" of the equity. The court's limited role is to decide

whether the plan as proposed should or should not be con-

firmed. The consequences of that decision are for the parties

to work out, not the court.

“os Under the absolute priority rule as

articulated in Case, claimants were entitled to

have their relative values respected in full,

A-149

Many of these cases, including U.S. Truck, Potter

Material Service, and Jartran, emphasize the risk

associated with the investment, thereby justifying

allowing a 100% ownership interest in exchange for

a relatively modest capital infusion. 24

The true balance needs to be struck between a

recognition of this risk/reward analysis on the one

hand and the creditors’ entitlement to control over

the venture by virtue of the operation absolute

priority rule. Cases such as Jartran, U.S. Truck,

and Potter Material Service do not give sufficient

...-Continued...

according exactly to their nonbankruptcy

entitlements. The fact that there was a going-

concern surplus to the assets as a whole was

irrelevant. This represented part of the value

of the debtor's assets that the creditors had a

right to over shareholders outside bankruptcy,

and the absolute priority rule respected that

right inside of bankruptcy.

Jackson, "Reconsidering Reorganization," The Logic and Limits

A-150

ear to the overriding function of the absolute prior-

ity rule, which is to assure that, to paraphrase

Boyd, to the extent that the value of a given ven-

ture justifies the issuance of new equity in ex-

change for new capital. the creditors are entitled to

the benefit of that value, whether it is present or

prospective, for dividends or only for purposes of

control. This is why the participation accorded the

investor must be “reasonably equivalent." Case v.

Los Angeles Lumber Products Co., 308 U.S. at 122,

60 S.Ct. at 10. A court applying Case must evalu-

ate not only the value of the equity in the enter-

prise being acquired by way of the capital infusion

but also the “value” of senior rights threatened by

the capital infusion. Note the comment of the

Supreme Court in Consolidated Rock Products

regarding how senior interests ought to be com-

pensated in the face of a retention of values by

junior interests:

Thus, it is plain that while creditors

may be given inferior grades of securi-

ties, their “superior rights" must be

recognized.... They must receive ...

compensation for the senior rights

they are to surrender. If they receive

less than that full compensatory

treatment, some of their property

rights will be appropriated for the

benefit of stockholders without compen-

sation. That is not permissible.

Consolidated Rock Products, Co. v. DuBois, 312

U.S. 510, 528-29, 61 S.Ct. 675, 686, 85 L.Ed. 982,

995 (1941).

In order to evaluate whether the participation

proposed to be afforded the equity investor is

commensurate with the capital infusion, the

bankruptcy court must be prepared to value all

aspects of the enterprise. In some cases that will

prove easier than in others. Compare In re Potter

Material Service, Inc., 781 F.2d at 103 with In re

Jartran, Inc., 44 B.R. at 367-79. These courts and

others have adopted as their starting point Consol-

idated Rock Products, Co. v. DuBois, 312 U.S. 510,

61 S.Ct. 675, 85 L.Ed. 982 (1941). The Supreme

Court there held that a "capitalization of prospec-

tive earnings" was essential in order to evaluate the

relative distribution of property proposed:

The criterion of earning capacity is

the essential one if the enterprise is to

be freed from the heavy hand of past

errors, miscalculations or disaster,

and if the allocation of securities

among the various claimants is to be

fair and equitable. Since its applica-

tion requires a prediction as to what

will occur in the future, an estimate,

as distinguished from mathematical

certitude, is all that can be made. But

that estimate must be based on an

informed judgment which embraces all

facts relevant to future earning capaci-

ty and hence to present worth, includ-

ing, of course, the nature and condi-

tion of the properties, the past earn-

ings record, and all circumstances

which indicate whether or not that

...-Continued...

: A-153

record is a reliable criterion of future

performance. A sum of values based

on physical factors and assigned to

separate units of the property without

regard to the earning capacity of the

whole enterprise is plainly inadequate.

Id., 312 U.S. at 526, 61 S.Ct. at 685, 85 L.Ed. at

993-94. Neither party presented any direct evi-

dence on capitalized future net revenues, but the

appraisals of both parties reflect, inter alia, a

discounted cash flow analysis that supports the

valuations of the allowed secured claim. Nothing

remains in excess of that claim, apart from the

$101,000 currently on hand, and the $500,000 to

be invested. The debtor's general partner stated he

did not expect a return on the investment, so

much as a mitigation of the some one million dol-

lars already invested in the project. He does not

anticipate recovering $5.8 million (the amount of

the allowed secured claim in the plan) in the near

term, but believes that eventually, the market will

recover and with it, the value of this property.

Based upon projected revenues, it is not likely that

the investors will recover on their investment for

the ten year term of the plan.

Looking at the valuation of the enterprise itself as

a going concern, relying on the discounted cash

flows even of Phoenix’ expert, the court finds that

the investment justifies a 100% ownership of the

enterprise, all other things being equal. See In re

Potter Material Service, Inc., 781 F.2d 99, 103 (7th

Cir.1986); In re Toy & Sports Warehouse, Inc., 37

B.R. 141, 148 (Bankr.S.D.N.Y.1984). The debtor's

investors as “buying” the future risk of return,

postponed in this case for ten years, for $500,000.

Leaving that much money at risk for that long, in

exchange for 100% of the reward at the end of that

term is not at all unreasonable and full ownership

under the circumstances is therefore justified given

the long-term deferral of any reward for the in-

vestment relative to the risk of loss being shoul-

dered.

We turn next to whether the senior interests will

receive “compensatory treatment" consistent with

...-Continued...

. A-155

the absolute priority rule. We must first decide

just what senior rights, if any, are being "taken" by

virtue of this proposed capital infusion. In this

case, the "senior right" in question is the Ahlers-

acknowledged right of an unsecured creditor class

not being paid in full to control the enterprise to

the exclusion of current ownership, a right other-

wise conferred on Phoenix by operation of Section

1111(b), which gave Phoenix an unsecured claim

entitled to control to the exclusion of junior inter-

ests under Section 1129(b)(2)(B).

It is not an easy task to evaluate the relative

value of Phoenix’ "loss of control" occasioned by the

proposed capital infusion. 2° It is not even certain

...Continued...

of Bankruptcy Law, 213 (Harvard University Press 1986).

“4 The Jartran case takes this concept to its logical (and

perhaps impermissible) extreme, noting that, where a

company is insolvent, any equity infusion at all will entitle

the investor ipso facto to 100% of the equity of the company.

In re Jartran, Inc., 44 B.R. at 379 ("inasmuch as the share-

A-156

whether the value can be quantified, or that, if it

can be, whether it need be compensated with

money. Compensation “will be dependent on the

facts and requirements of each case." Consolidat-

ed Rock Products, Co. v. DuBois, 312 U.S. at 529-

..Continued...

holders’ equity is valueless, any contribution by Hall will

necessarily be equal to or greater than the value of its

100% .lm3

ownership interest").

“2 Recall that Ahlers stated that

[i]JIndeed, even in a sole proprietorship, where

‘going concern’ value may be minimal, there

may still be some value in the control of the

isibliiinaiait obviously, also at issue is the

interest in potential future profits of a now-

insolvent business.

Norwest Bank Worthington v. Ahlers, 485 U.S. at ----, 108

S.Ct. at 969, 99 L.Ed.2d at 180.

A-157

cial note should be made in this case that the

senior right which occupies the court here arises

only in bankruptcy. 11 U.S.C. s 1111(b); see

discussion supra. It is not as though this creditor

had contracted for a deficiency claim prior to

bankruptcy. It only has a Code-created deficiency

to assure it of a voice in the proceeding.

Nonetheless, the Code-created deficiency must be

given equal voice and dignity with nonbankruptcy

recourse claims, in order to honor the intent of

Congress in enacting Section 1111(b) in the first

place. Nonrecourse debt is treated as recourse, for

purposes of bankruptcy, precisely in order to trig-

ger the operation of the absolute priority rule. 124

Cong Rec H11103-11104, 95th Cong, 2d Sess

(daily ed. Sept. 28, 1978) (remarks of Rep. Ed-

wards). No distinction should thus be drawn when

evaluating the value of the particular senior right

conferred by way of Section 1111(b), namely,

control over the enterprise to the exclusion of

equity interests.

Here, the holder of this deficiency claim could

either prevent confirmation or at the least would

enjoy whatever upside gain the enterprise might

enjoy should the market in Austin return to health,

but for the capital infusion. Phoenix’ unsecured

claim would, in the absence of the cash infusion,

give it a measure of control over the very building

which also stands as collateral for its secured debt.

These are valuable rights indeed, though they are

difficult to quantify. 2?” On the other hand, Phoe-

nix would not have the capital infusion proposed

under this plan and the enterprise itself would be

$500,000 poorer without it, but for the equity

infusion.

In order to compensate Phoenix, the debtor may

have to confer certain offsetting rights, such as an

ownership participation, an option to purchase, or

some other such device “dependent on the facts

. Continued...

s6 The Court observed that the mechanism to be em-

ployed “in the case of a solvent company ... will be dependent

on the facts and requirements of each case." Id. There is no

logical reason for the rule to be any different in the case of an

insolvent entity into which current equity intends to infuse

A-159

and requirements of each case." Consolidated Rock

Products, Co. v. DuBois, 312 U.S. at 529-30, 61

S.Ct. at 686-87, 85 L.Ed. at 995. On the other

hand, the facts of a given case may well satisfy the

need for full compensation without further adjust-

ment. In this case, for example, current manage-

ment is deemed by all to be superior, the plan's

duration is relatively short, and all of the capital

contributed goes into the operation and mainte-

nance of the very asset which secures Phoenix’

secured claim. Under these circumstances, it is

difficult to find that the rights which Phoenix

enjoys by virtue of its Code-created deficiency

require further compensation than they already

have, in deference to Justice Douglas’ advise that

[p]ractical adjustments are necessary.

The method of effecting full compensa-

tion for senior claimants will vary from

case to case.

Consolidated Rock Products, Co. v. DuBois, 312

U.S. at 529-30, 61 S.Ct. at 686-87, 85 L.Ed. at

995. 8 For these reasons, the court believes the

proposed plan should be approved as it stands.

| III. CONCLUSION

For all of the foregoing reasons, the court finds

and concludes that the debtor's plan as currently

proposed should be approved and confirmed. An

order consistent with this opinion will be entered.

So ORDERED.

SIGNED June 5, 1989.

if M.Clark

LEIF M. CLARK

U. S. BANKRUPTCY JUDGE

. Continued...

new capital in exchange for an ownership interest which will,

by definition, deprive the senior unsecured creditors of some

or all of their control over the venture. See Group of Insti-

A-161

Te ee TT |

...Continued...

tutional Investors v.Chicago, Milwaukee, St. Paul & Pacific

RailRoad Co., 318 U.S. 523, 570, 63 S.Ct. 727, 751, 87 L.Ed.

959, 1010 (1943).

The evidence at trial strongly suggests that the lender

does not know what's good for it, as the value of the property

is likely to deteriorate in the hands of the lender, based upon

its past history with properties it has re-acquired.

a6 In another case, a court might require further provi-

sions on the lines of equity participations, back-in owner-

ships, profit particip

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