The Danger of Cramdown For Secured Creditors in Chapter 11 Bankruptcy

When banks and other lenders make a loan, they often obtain collateral from the borrower to secure repayment of the loan. The collateral may be a mortgage or deed of trust on real estate or a security interest in business assets such as accounts receivable, inventory and equipment. This makes the lender a secured creditor. If the borrower does not repay the loan, the secured creditor may sell the collateral to satisfy the debt.
 
American bankruptcy law provides for a procedure known as Chapter 11. The purpose of Chapter 11 is to give the borrower, now called a debtor in bankruptcy terms, an opportunity to restructure its finances and save its business or to make an orderly liquidation of its assets, usually as a going business.
 
When a debtor files Chapter 11, that immediately stops all creditors from taking action to collect their debts outside the bankruptcy by virtue of a provision in the Bankruptcy Code called the automatic stay. Bankruptcy Code §362(a). The automatic stay stops secured creditors from foreclosing on their collateral and enforcing deeds of trust and security interests.
 
In Chapter 11, the debtor proposes a plan of reorganisation. The plan divides creditors into classes. Each secured creditor is put into a separate class according to the collateral it holds. There is usually a class of unsecured creditors.
 
The plan may propose to change any of the terms of the secured debt. It may propose to lower the amount of principal, the interest rate, the maturity date, the monthly payment and any other term of the loan. Generally, the plan must provide that the secured creditor will retain its lien on the collateral. 
 
In regard to the unsecured creditors, the plan may propose to pay them 100% in cash in full on confirmation of the plan, 10 cents on the dollar in cash in full settlement of their claims, or 50% paid over time, or the plan may offer them an ownership interest in the debtor or any variation of these terms.
 
Each class votes on whether it accepts the plan. If the secured creditor is displeased with the terms for payment of its claim, it may reject the plan. If the unsecured class or any other impaired class accepts the plan, the bankruptcy court may force the terms of the plan on the secured creditor even though the lender rejects the plan. Bankruptcy Code §1129(b)(2)(A). This forcible action by the court is commonly called a "cramdown."
 
For example, suppose a lender made a loan for $1 million dollars secured with a mortgage on real estate providing for interest at 9% with monthly payments of $8,500 with the balance to be paid in full in five years.  The borrower was unable to pay the balance in full at the end of five years, filed Chapter 11, and proposed in its plan to pay the $1 million, but lower the interest rate to 5%, and lower the monthly payments to $4,800 with the full balance to become due in an additional five years.
 
The lender rejects the plan. The unsecured creditors, being happy with the proposed payment to them, accept the plan by the required two-thirds in dollar amount of the unsecured class and 51% of those voting. The debtor then requests that the court cram down the plan on the lender.
 
The lender has certain protections. For example, the plan must be fair and equitable to it, must not discriminate unfairly against the lender, must pay the lender at least a current market rate of interest, must give the lender at least as much as it would get in a liquidation of the assets and must be feasible for the debtor to perform.
 
Assuming the debtor meets these requirements, the bankruptcy court has the power to cram down the plan on the Lender and make it legally binding on the lender, superseding the previous terms of the loan. Thus, a lender, which thought it was making a five year loan at 9% interest, now has a ten year loan at 5% interest.
 
Suppose in this example that since the original loan was made, the value of the real estate, which is the collateral, has decreased and is only worth $700,000 when the bankruptcy is filed. The debtor can request that the bankruptcy court determine that the value of the property is only $700,000 and that the lender has a secured claim for only $700,000 and an unsecured claim for the $300,000 balance.
 
In that case, the lender will hold a new mortgage for only $700,000. The debtor will have to pay interest on only $700,000. The lender will receive on the $300,000 unsecured claim only the percentage which the plan provides for the unsecured creditors, which is likely to be less than 100%.
 
If the debtor obtains the required votes of the unsecured class the court can cram down this plan on the lender. Fortunately, there has been added to the bankruptcy law a provision to give the lender some protection from this result. The lender can make an election to have its claim allowed as a fully secured claim of $1 million. Bankruptcy Code §1111(b)(2).
 
The result is that the lender continues to hold a $1 million mortgage. The debtor can pay interest on only $700,000 but when the time comes for the debtor to pay off the mortgage at the end of another five years, the debtor must pay $1 million minus the total principal and interest payments the debtor has made during the five years. So in the end, the lender will receive at least its $1 million original amount of principal.
 
As  you can see, when a lender is negotiating with a borrower about a loan in default, and the borrower threatens to file bankruptcy, it is important for the lender to know what can happen to the lender in Chapter 11 and to weigh that risk in deciding what to do about the delinquent loan.           
 
Jules S. Cohen is a shareholder with Akerman Senterfitt's Bankruptcy and Reorganisation Practice Group. He has practiced Bankruptcy Law for more than 30 years. He regularly represents banks and other lenders as secured creditors in bankruptcy proceedings in all types of businesses. In addition, he represents buyers of assets from bankruptcy cases and defendants in preference suits. He has been listed in The Best Lawyers in America since its beginning 17 years ago and is Board Certified in Business Bankruptcy Law.
 
Jules S. Cohen can be contacted by phone on +1 407 423 4000 or alternatively by email at jules.cohen@akerman.com