IN RE D W REALTY CORP., (S.D.N.Y. 1994)

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Docket Number

No. 93 Civ. 6161 (JSM).

Attorney(S)

Davidoff Malito, Stuart Perlmutter and Rachel Warren, New York City, for Barclays Business Credit, Inc. Hertzog, Calamari Gleason, Steven Schwartz, New York City, for Federal Home Loan Mortg. Corp. Backenroth Grossman, Mark Frankel, New York City, for D W Realty Corp.

Judges

John S. Martin

Acts

Bankruptcy — Creditors, The Debtor, And The Estate — Creditors And Claims — Determination Of Secured Status
Bankruptcy — Reorganization — The Plan — Classification Of Claims Or Interests

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Smart Summary

Factual and Procedural Background

This case arises from an appeal of a decision approving the disclosure statement filed by the bankrupt, D W Realty Corporation ("D W" or the "Debtor"). The Debtor classified the unsecured portion of its debt to the secured creditor Barclay's Business Credit Corp. ("Barclay's") separately from other unsecured creditors in its plan of reorganization. Barclay's challenged this classification, contending it was done solely to manipulate voting and guarantee approval of the Plan. The underlying bankruptcy involved a single asset real estate case where the Debtor owns an office building valued at $3.1 million but encumbered by a $5.6 million first mortgage held by Barclay's, resulting in a secured claim of $3.1 million and an unsecured deficiency claim of approximately $2.5 million. Other unsecured claims total about $1,295,000. The Bankruptcy Court approved the separate classification, and this appeal challenges that decision.

Legal Issues Presented

Whether the unsecured deficiency claim of an undersecured creditor may be separately classified from other unsecured claims in a debtor’s plan of reorganization under 11 U.S.C. § 1122.
Whether separate classification of such deficiency claims is permissible absent a legitimate business or Code-based reason, or if it constitutes impermissible "gerrymandering" to manipulate creditor voting.
Whether the Bankruptcy Court erred in holding that Barclay's unsecured deficiency claim could not be classified with other unsecured claims based on the creditor’s right to make an election under 11 U.S.C. § 1111(b)(2).

Arguments of the Parties

The opinion does not contain a detailed account of the parties' legal arguments.

Table of Precedents Cited

Precedent	Rule or Principle Cited For	Application by the Court
In re John Hancock Mutual Life Ins. Co., 987 F.2d 154 (3rd Cir. 1993)	Separate classification of substantially similar claims is impermissible if done solely to manipulate voting or "gerrymander" classes.	Used to establish that separate classification must have a legitimate business or Code-based justification and must not offend due process or fair play.
In re Greystone III Joint Venture, 995 F.2d 1274 (5th Cir. 1991), cert. denied	Separate classification solely to affect voting is improper; § 1111(b) election purpose and implications for voting rights of undersecured creditors.	Quoted extensively to emphasize the purpose of § 1111(b) election and the problems with requiring separate classification of deficiency claims.
In re One Times Square Associates Limited Partnership, 159 B.R. 695 (Bankr. S.D.N.Y. 1993)	Separate classification must be justified by legitimate reasons and not used to manipulate voting.	Reinforced the principle that separate classification must be for legitimate reasons, not just to create an impaired class for voting purposes.
In re Bryson Properties, XVIII, 961 F.2d 496 (4th Cir. 1992), cert. denied	Requirement of legitimate business justification for separate classification.	Supported the Court’s conclusion that separate classification must be justified beyond mere voting manipulation.
In re Lumber Exchange Bldg. Ltd. Partnership, 968 F.2d 647 (8th Cir. 1992)	Legitimate reasons required for separate classification of claims.	Used to affirm the need for legitimate justification under § 1122 for separate classification.
In re 500 Fifth Ave. Associates, 148 B.R. 1010 (Bankr. S.D.N.Y. 1992), aff'd 1993 WL 316183 (S.D.N.Y.)	Clarification that the § 1111(b) election cannot be exercised by the unsecured deficiency claim portion; voting power considerations.	Supported the Court’s interpretation that the § 1111(b) election belongs to the secured portion and that the unsecured deficiency claim cannot exercise it or be separately classified on that basis.

Court's Reasoning and Analysis

The Court analyzed the classification of Barclay's unsecured deficiency claim in light of the Bankruptcy Code provisions and relevant case law. It noted that 11 U.S.C. § 1122 requires claims classified together to be substantially similar but does not mandate that all substantially similar claims be in the same class. However, case law prohibits separate classification for the sole purpose of manipulating voting ("gerrymandering"). The Court found that the Bankruptcy Court erred in concluding that Barclay's unsecured deficiency claim could not be classified with other unsecured claims due to the right of election under 11 U.S.C. § 1111(b)(2).

The Court explained that the § 1111(b)(2) election right belongs only to the secured portion of a claim, not the unsecured deficiency portion, because the deficiency claim is unsecured by definition and lacks an interest in the property. Therefore, the concern that other unsecured creditors would interfere with Barclay's election was unfounded.

Further, the Court held that secured and unsecured claims of the same creditor are dissimilar, so they cannot be grouped together in one class unless the creditor elects to treat the entire claim as secured. Since Barclay's did not intend to make such an election, the Bankruptcy Court's reasoning was flawed.

The Court also reasoned that requiring separate classification of unsecured deficiency claims would render the § 1111(b)(2) election meaningless in most single asset real estate bankruptcies, effectively disenfranchising undersecured creditors and undermining their ability to negotiate.

Lastly, the Court noted that allowing arbitrary classification would negate the administrative convenience provision of § 1122(b) and violate principles of statutory interpretation that require all parts of a statute to have meaning.

Although classifying Barclay's deficiency claim with other unsecured claims may allow Barclay's to dominate voting, the Court found that separate classification to avoid this outcome would unfairly empower small unsecured creditors and violate the fairness and nondiscrimination requirements of § 1129(b)(1). It would also permit debtors to undermine secured creditors' foreclosure rights through bankruptcy classification tactics, contrary to congressional intent.

Holding and Implications

The Court REVERSED the Bankruptcy Court's order approving the disclosure statement that permitted separate classification of Barclay's unsecured deficiency claim from other unsecured claims.

The Court held that separate classification of unsecured deficiency claims and other unsecured claims is not required and may only be permitted for legitimate business or Code-based reasons, which were not present in this case. The disclosure statement was found to violate the rule against separate classification motivated solely by an attempt to create an impaired class of creditors to approve the Plan.

The case was remanded to the Bankruptcy Court for further proceedings consistent with this decision. The decision directly affects the classification and voting rights of unsecured deficiency claims in single asset real estate bankruptcies but does not establish new precedent beyond reaffirming the limitations on separate classification and the proper interpretation of § 1111(b)(2).

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In re D W REALTY CORPORATION.

OPINION

MARTIN, District Judge:

This is an appeal from a decision approving the disclosure statement filed by the bankrupt, D W Realty Corporation ("D W" or the "Debtor"), in which D W classified the unsecured portion of its debt to the appellant-secured creditor Barclay's Business Credit Corp., 156 B.R. 140. ("Barclay's") separately from its debts to other unsecured creditors. Appellant contends that the sole reason for this separate classification is to manipulate the voting with respect to the Debtor's plan of reorganization (the "Plan") and guarantee that at least one impaired class of creditors will vote to approve the Plan.

DISCUSSION

This is a single asset real estate bankruptcy case. The Debtor's sole business is owning and operating an office building in Wilkes-Barre, Pennsylvania (the "Property"). The Property has a present value of $3.1 million, and is encumbered by a first mortgage held by Barclay's in the amount of approximately $5.6 million. Thus, pursuant to 11 U.S.C. § 506(a), Barclay's has a secured claim in the amount of $3.1 million, and an unsecured deficiency claim in the amount of approximately $2.5 million. All other unsecured claims total approximately $1,295,000. Thus, Barclay's unsecured claim is substantially greater in amount than the total value of all of the other unsecured claims taken together, and, if classified together with those claims, would dominate in the voting of that class of claims.

Classification is governed primarily by 11 U.S.C. § 1122, which, read closely, requires only that claims that are classified together must be substantially similar. It does not actually require that all substantially similar claims be placed in the same class. However, the case law makes clear that substantially similar claims may not be placed in separate classes for the sole purpose of affecting or "gerrymandering" the voting with respect to the debtor's proposed plan of reorganization under § 1129(a) of the Bankruptcy Code. See In re John Hancock Mutual Life Ins. Co., 987 F.2d 154, 158 (3rd Cir. 1993); In re Greystone III Joint Venture, 995 F.2d 1274, 1278-79 (5th Cir. 1991), cert. denied, ___ U.S. ___, 113 S.Ct. 72, 121 L.Ed.2d 37 (1992); In re One Times Square Associates Limited Partnership, 159 B.R. 695, 703 (Bankr.S.D.N.Y. 1993). In other words, separate classification must not offend due process and fair play. In re One Times Square at 703. Thus, separate classification must be justified by a legitimate business reason or some legitimate difference in the treatment of creditors that are classified separately under a debtor's plan of reorganization. In re John Hancock, 987 F.2d at 159-60; In re Bryson Properties, XVIII, 961 F.2d 496, 502 (4th Cir.), cert. denied, ___ U.S. ___, 113 S.Ct. 191, 121 L.Ed.2d 134 (1992); In re Lumber Exchange Bldg. Ltd. Partnership, 968 F.2d 647, 649-50 (8th Cir. 1992). Otherwise, "if claims could be arbitrarily placed in separate classes, it would almost always be possible for the Debtor to manipulate `acceptance' by artful classification." In re Greystone, 995 F.2d at 1277.

Here, no business reason or other Code-based difference has been proffered in support of separate classification of Barclay's deficiency claim. In fact, the Plan contemplates giving exactly the same treatment to the deficiency claim and the class of other unsecured claims. Nevertheless, in this case, the Bankruptcy Court held not only that Barclay's deficiency claim could be classified separately from the other unsecured claims, but went further and held that it could not be classified together with the other unsecured claims. Decision at 2. The Court supported this holding by reasoning that since § 1111(b)(2) permits the inadequately secured creditor to elect as to whether its deficiency claim will be treated as fully secured rather than as an unsecured claim pursuant to § 506(a), the deficiency portion could not be placed in a class of unsecured claims, the other members of which have no right to make such an election and should have no vote as to whether the inadequately secured creditor will exercise its § 1111(b)(2) election to opt out of § 506(a). Decision at 9. This reasoning, however, is flawed in several respects.

First, the § 1111(b) right of election does not belong to the unsecured portion of the secured creditor's claim or to the class of unsecured creditors of which the deficiency claim would be a member, absent either exercise of the election or separate classification. It belongs instead to the secured portion of the claim, and to the class of which the secured portion of Barclay's claim is a member. On its face, section 1111(b)(1)(A) of the Bankruptcy Code clearly refers to "[a] claim secured by a lien on property of the estate". Since, by definition, the deficiency claim is not secured by a lien, § 1111(b) presumably is not concerned with the rights of that portion of the secured creditor's claims. Furthermore, § 1111(b)(1)(B)(i) provides that "[a] class of claims may not [exercise the 1111(b)(2) election] if the interest on account of such claims in such property is of inconsequential value." The "interest . . . in . . . property" of an unsecured deficiency claim, being nonexistent, obviously is of "inconsequential value". See In re 500 Fifth Ave. Associates, 148 B.R. 1010, 1016 (Bankr.S.D.N.Y.), aff'd, 1993 WL 316183 (LJF) (S.D.N.Y. May 21, 1993) (If a lien has no value, the holder of that claim cannot make the § 1111(b) election); 5 Collier on Bankruptcy, ¶ 1111.02 (1992). Thus, it is only the secured claim and the class of which it is a member that may exercise the 1111(b) election, and the problem of improper interference with the election posited by the Bankruptcy Court in its Decision simply does not exist.

Furthermore, the Court below stated that it "[found] no reason why the mortgagee's secured and unsecured claims cannot and should not be treated together in a single class." Decision at 12. This clearly is incorrect, unless Barclay's elects to treat its entire claim as secured pursuant to § 1111(b)(2). Section 1122(a) states that "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 class." Manifestly, a secured claim and an unsecured claim, even those of the same creditor, are about as dissimilar as two claims can be. Since Barclay's has stated that it does not intend to exercise its right under § 1111(b)(2) to have its entire claim treated as secured, Decision at 3, its two claims clearly cannot be grouped together in one class of dissimilar claims.

In addition to the foregoing problems with the Bankruptcy Court's decision, a rule that requires the unsecured deficiency claim of an inadequately secured creditor to be classified separately from the other unsecured claims against the debtor would render the § 1111(b)(2) election meaningless in most single asset real estate bankruptcy cases. As the Fifth Circuit stated in In re Greystone,

The purpose of § 1111(b) is to provide an undersecured 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 classification 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 claims by placing them in a separate class and confirming the plan over their objection by cramdown. With its unsecured voting rights effectively eliminated, the electing creditor's ability to negotiate a satisfactory settlement of either its secured or unsecured claims would be seriously undercut. It seems likely that the creditor would have to `elect' to take an allowed secured claim under § 1111(b)(2) in the hope that the value of the collateral would increase after the case is closed. Thus, the election under § 1111(b) would be essentially meaningless. We believe Congress did not intend this result.

995 F.2d at 1280. Thus, a requirement that an unsecured deficiency be classified separately from the other unsecured claims would effectively withdraw one option given by the Code to the inadequately secured creditor, who would reap no advantage by opting not to elect fully secured status pursuant to § 1111(b).

Finally, if a debtor could classify unsecured claims in any fashion that it pleased, irrespective of their treatment under its Plan of reorganization, there would be no need for the administrative convenience provision of § 1122(b). Such a result, therefore, would run afoul of the maxim that, if possible, a statute is to be interpreted so as to give meaning to all of its parts. In re Greystone, 995 F.2d at 1278-79.

While it is true that classification of an unsecured deficiency claim together with the other unsecured claims against the debtor will permit the inadequately secured creditor to dominate the voting of the sole unsecured class in most single asset real estate bankruptcy cases, a rule that routinely permits, let alone requires, separate classification would give unsecured creditors who hold a very small proportion of the unsecured debt the ability to control the voting process and "cram down" a plan over the objection of a creditor who has a much greater interest in the assets of the debtor. To give a small group of unsecured creditors voting power that is so disproportionate to their interest in the bankruptcy estate does not comply with the § 1129(b)(1) requirement that a Plan does not discriminate unfairly and is fair and equitable. See In re John Hancock, 987 F.2d at 158. Such a result also undermines the democratic process that is intrinsic to Chapter 11. Id. at 159; In re 500 Fifth Ave. Associates, 148 B.R. at 1020. Moreover, such a rule would allow virtually any owner of a single property that is encumbered by debt that exceeds the property's present value to unilaterally take from the secured creditor the right to foreclose simply by filing a petition in bankruptcy under Chapter 11. Foreclosure is a legal right for which the secured creditor bargained when it lent the debtor money and took a lien on the Property. There is no indication that Congress intended that Chapter 11 generally, and classification in particular, should be used routinely to achieve such a result.

CONCLUSION

The Order of the Bankruptcy Court approving D W's disclosure statement is reversed. This Court holds that separate classification of unsecured deficiency claims and other unsecured claims is not required. Such separate classification may be permitted only for legitimate business or Code-based reasons. Here no such reasons have been preferred. Thus, the disclosure statement violates the basic rule that separate classification is impermissible if motivated solely by an attempt to create an impaired class of creditors that will assent to confirmation of the Plan. This matter is remanded to the Bankruptcy Court for further proceedings in light of this decision.