Plan Proponents Beware of “Death Trap” Traps in Chapter 11 Plans and Disclosure Statements
A topic that receives relatively little attention is the practice of plan proponents to include “death trap” provisions in chapter 11 plans. A death trap provision can provide for a distribution, or a larger distribution, to an impaired class in exchange for a favorable vote on the plan. Although such a provision can be an extremely useful tool in achieving confirmation of a Chapter 11 plan, courts are reluctant to approve such provisions if they deviate from a certain standard, forcing the parties back to the drawing board and causing them to incur significant costs and delays in connection with the plan confirmation process.
Pursuant to 11 U.S.C § 1129 of the Bankruptcy Code, a court may only confirm a plan if, among other things, each class of claims or interests (a) accepts the plan or (b) is not impaired under the plan. § 1129(a)(8). If the requirements of § 1129(a)(8) are not met, the plan may be “crammed down” on an impaired class that does not accept the plan, but only under the condition that the plan does not “discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.” § 1129(b).
Cramdown hearings can be costly and time-consuming. In order to prevent a cramdown fight, a plan proponent may include in the plan a “death trap” provision that will incentivize an impaired class to vote for the plan by providing a distribution, or a larger distribution than it otherwise would receive. Courts tend to approve disclosure statements and plans that contain such provisions if certain criteria are met.
For example, in In re Zenith Elecs. Corp., Judge Walrath overruled the objection of the equity committee with respect to the treatment of certain bondholders under the plan. 241 B.R. 92, 105 (Bankr. D. Del. 1999). The plan contained a provision that provided for bondholders to receive nothing if they voted against the plan, but for a pro rata distribution of $50 million of new 8.19% Senior Debentures if they voted for the plan. Id. The equity committee asserted that such a treatment was unfair because, under the valuation conducted in that case, if correct, bondholders would not receive anything. Id. In addition, the equity committee argued that the plan was unfair because it did not provide for a similar treatment of shareholders. Id. Judge Walrath disagreed holding that “[t]here is no prohibition in the Code against a Plan proponent offering different treatment to a class depending on whether it votes to accept or reject the Plan.” Id. (citing In re Drexel Burnham Lambert Group, Inc., 140 B.R. 347, 350 (Bankr. S.D.N.Y. 1992). The Court continued explaining that such a disparate treatment can be justified in that it can save the plan proponent the “expense and uncertainty of a cramdown fight” which, in turn, furthers the Bankruptcy Code’s overall policy of “fostering consensual plans of reorganization . . . .” Id.; see also In re MPM Silicones, LLC, No. 14-22503-RDD, 2014 WL 4637175 (Bankr. S.D.N.Y. Sept. 17, 2014) (explaining that “[s]uch fish-or-cut-bait, death-trap, or toggle provisions have long been customary in Chapter 11 plans . . . [they] offer a choice to avoid the expense and, more importantly, the uncertainty of a contested cramdown hearing.”).
Courts, however, tend to disapprove death trap provisions if they deviate from the standard articulated by Zenith and other courts. For example, in In re Mcorp Fin., Inc., the court rejected a “death trap” provision that not only implicated the treatment of one class under the plan, but also the treatment of other classes. 137 B.R. 219, 236 (Bankr. S.D. Tex. 1992). In that case, the plan provided for a possible distribution to all equity classes (Classes 15, 16, and 17) in the event Class 15 voted for the plan. Id. However, Class 15 voted against the plan. Id. The Court held that the inclusion of the provision resulted in the plan not being confirmable because it was unfair, not equitable, and resulted in unfair discrimination, especially because “Classes 16 and 17 not only lost any possible distributions, but also the right to vote effectively, since they could not know until after [class 15] had cast its vote (due on the same date as that of all other claimants) . . . what their own status was.” Id.
More recently, the issue arose during the disclosure statement hearing in the Molycorp bankruptcy. Molycorp, the United States’ only rare earth miner, filed for bankruptcy protection in 2015 and sought approval of its disclosure statement. The disclosure statement and the proposed plan contained broad releases of current and former directors and officers of Molycorp and also a “death trap” provision that provided as follows:
If the Entire Company Sale Trigger does not occur, the [Accepting GUC Distribution, will] be shared Pro Rata among the Holders of General Unsecured Claims in Class 5A who do not opt out of the Third Party Releases, if (a) Class 5A votes to accept the Plan and (b) none of (1) the Creditors’ Committee or any of its members, (ii) the Ad Hoc Group of 10% Noteholders or any of its members or (iii) the 10% Notes Indenture Trustee objects to the Plan.
Calling the inclusion of the provision “unprecedented and impermissible,” the Creditors’ Committee argued that this issue is “not only a confirmation issue, [but also] a voting issue [that] must be addressed at the disclosure statement hearing.” The Creditors’ Committee asserted that the provision deviates from the standard set forth by Zenith and other courts because the provisions that have passed muster in those cases “have been conditioned solely on a class voting to reject, not on whether a fiduciary or a creditor in a different class filed an objection to a plan.” In addition, the Creditors’ Committee asserted that the provision “attempts to shield the D&O Releases from any objections.” The United States Trustee argued that “this plan is patently non-confirmable because the collective effect of the deathtrap and the third-party release provisions is to muzzle the creditors and the fiduciaries from exercising their rights, and it should not be approved.” The United States Trustee noted that “[t]here is no democratic process involved” and that “[n]othing could be more fundamentally unfair or inequitable than provisions like this, that tell the creditors, you better vote for the plan or you get nothing.” At the disclosure statement hearing in January 2016, Judge Sontchi agreed ruling that the “deathtrap based on the objection is unacceptable.” Calling the proposal “ridiculous,” Judge Sontchi said to Oaktree’s attorney “I’d rather you not give them anything than you squash the rights of fiduciaries . . . [y]ou are trying to shut the committee — you’re trying to put the committee in an impossible situation, where they have — if they object to — on a legitimate basis, [where] everybody has voted yes, they are robbing their constituency of a recovery.” With respect to the releases, the Court noted that they are a “confirmation issue” and that “they’re fine for disclosure statement purposes.”
While a “death trap” provision can be, and often is, an important and useful tool in preventing time consuming and expensive cramdown fights, practitioners should be cautious in proposing provisions that deviate from the standards articulated by Zenith and other courts. In particular, courts have shown hostility to death trap provisions that (1) condition the recovery of multiple classes upon the vote of one class and (2) that limit the proper exercise of fiduciary duties.
As the law continues to evolve on these matters, please note that this article is current as of date and time of publication and may not reflect subsequent developments. The content and interpretation of the issues addressed herein is subject to change. Cole Schotz P.C. disclaims any and all liability with respect to actions taken or not taken based on any or all of the contents of this publication to the fullest extent permitted by law. This is for general informational purposes and does not constitute legal advice or create an attorney-client relationship. Do not act or refrain from acting upon the information contained in this publication without obtaining legal, financial and tax advice. For further information, please do not hesitate to reach out to your firm contact or to any of the attorneys listed in this publication.