In re Body Transit, Inc., 2020 WL 4574907 (E.D. Penn. August 7, 2020) was one of the first published bankruptcy decisions involving the intersection between the so-called “1111(b) election” and subchapter V of chapter 11 of the Bankruptcy Code.
This opinion is quite striking.
The Court’s analysis in Body Transit may signal a willingness by bankruptcy courts to interpret words and phrases in generally-applicable chapter 11 code sections differently in “subchapter V” cases under the Small Business Reorganization Act of 2019 (“SBRA”) than in traditional, non-subchapter V cases.
There is a lot to analyze in this opinion, but this blog post will focus on only one aspect of the Body Transit opinion—the Court’s stated use of the “purposes and policies” underlying SBRA to influence its determination of what constitutes “inconsequential value” for purposes of the “inconsequential value exception” to the section 1111(b) election. The Court’s analysis may be a bellwether as to how other courts approach subchapter V cases versus traditional chapter 11 (i.e., non-subchapter V) cases. This case is important, as section 1111(b) elections may, at least anecdotally, become much more useful and prolific in subchapter V cases, given the altered voting structure and the potential for temporarily depressed collateral values (i.e., due to the Covid-19 pandemic and the emergency use authorization of a Covid-19 vaccine in the United States).
But First, A Nutshell Explanation of The 1111(b) Election
The nuances of the so-called “1111(b) election” are complicated enough to give even very experienced bankruptcy practitioners nightmares, and are beyond the scope of this blog post. Generally speaking, under Bankruptcy Code section 1111(b), an undersecured creditor (i.e., a creditor whose claim is only partially “in the money” based on the present fair market value of its collateral) may make the 1111(b) election in a pending chapter 11 case to protect itself against a perceived “temporary undervaluation” of its collateral. When made, the election forces the plan proponent’s plan to treat the undersecured creditor’s entire “nominal” claim as secured at the time of the collateral’s liquidation, despite the fact that the claim is actually undersecured at the time the chapter 11 plan is being considered. The election can be quite useful in the current context as a hedge, if the creditor views its collateral’s value as being temporarily depressed or undervalued (e.g., due to the Covid-19 pandemic).
Absent making the 1111(b) election, an undersecured creditor is entitled to receive (a) the net present value of its collateral on the “in the money” secured portion of its claim, and (b) a pro rata share of distributions under the plan on its “out of the money” unsecured deficiency claim. As noted above, the net present value of the secured portion of the claim is determined by applying the applicable discount rate to the secured portion of the claim. That rate is usually the source of litigation, and courts have adopted various methods for ascribing an appropriate discount rate (e.g., blended rate versus a formula rate of prime plus basis points to account for the time value of money and risk, etc.). When an undersecured creditor makes the 1111(b) election, the creditor’s entitlement to have the “out of the money” portion of its claim treated the same as other unsecured creditors under the plan is waived, and the creditor’s nominal unsecured claim is treated as a non-interest bearing secured lien claim on its collateral if/when the collateral is ever actually liquidated. The election, therefore, reverses one of the principal effects of Bankruptcy Code section 506(a) (a Code section which bifurcates an undersecured creditor’s claim into two claims—a secured claim and an unsecured claim—based on the collateral value).
But again, there are trade-offs to making the election.
Section 1111(b) Election’s Impact on Voting
Bifurcated claims, as impaired claims, are each entitled to vote separately on a proposed plan. Voting is critical in traditional chapter 11 cases because the plan proponent must obtain the favorable vote of an impaired “consenting” class (i.e., a class that votes “yes” to the plan), or else the plan fails—i.e., may not be “crammed-down” over the objection of an impaired objecting class.
When an undersecured creditor’s claim is bifurcated under section 506(a) (and assuming no election has been made), it may vote both of those claims. And, depending on how the deficiency was classified in the proposed plan (and the relative size of the deficiency claim and the number of other creditors in that class), the vote of the unsecured deficiency claim could allow the creditor to effectively block plan confirmation in a traditional chapter 11 case (by swaying the entire class’s vote). But, upon making the election, the secured creditor loses its ability to vote its unsecured deficiency claim. Giving up that “extra” vote of the deficiency claim could be a major concession for a creditor looking to block confirmation of a traditional chapter 11 plan.
However, in subchapter V cases, the favorable vote of an impaired consenting class is not required for cramdown. Indeed, voting in subchapter V cases appears to be more geared toward determining whether the plan being confirmed is “consensual” or “nonconsensual.” See 11 U.S.C. §§ 1181(a), 1191(b). While that determination is critical to subchapter V mechanics, it is not a basis to “block” plan confirmation because a nonconsensual plan may still be confirmed. By contrast, in a traditional chapter 11 case, the failure to obtain an impaired consenting class is an effective “game over” for the plan being proposed. So, making the election (and thus giving up the right to vote) may be less of a concession in a subchapter V context than in a traditional chapter 11 context.
(As an aside, the difference between a consensual and nonconsensual plan may be more dramatic than meets the eye—particularly if the subchapter V debtor is an individual. In particular, because section 1115 does not apply in subchapter V cases, in individual subchapter V cases, property of the estate arguably does not include the debtor’s postpetition assets and earnings. That is, unless the plan is ultimately confirmed as a nonconsensual plan, in which case property of the estate includes such postpetition property. See 11 U.S.C. § 1186(a). It is difficult to know how courts will address this rather bizarre provision in the SBRA, which differs significantly from traditional individual chapter 11 cases. But, case law on this point of law is still developing and no known reported cases exist. And, again, a detailed discussion of this aspect of subchapter V is beyond the scope of this blog post.)
The 1111(b) Election Essentially Waives “Best Interests” Arguments
There’s another drawback—the “best interests of creditors test,” which provides that claims in impaired classes must receive not less than what those claims would have received in a chapter 7 case, does not apply to the claims of creditors who make the election. See, e.g., In re Sunnyslope Housing Ltd. Partnership, 859 F.3d 637 (9th Cir. 2017). So, when an undersecured creditor makes the election, it may lose rights to argue that it would be better off in a chapter 7 case based on a liquidation analysis. Yet another concession….
So, the decision to make the election should not be made lightly.
But, importantly, the value of commercial real estate may be experiencing a temporary downturn, given the recent rolling-out of apparently efficacious Covid-19 vaccines in the United States (and around the World).
And Now, A Brief Synopsis of The “Inconsequential Value Exception” to the 1111(b) Election
Under the so-called “inconsequential value exception” to the 1111(b) election, “A class of claims may not elect the application of paragraph (2) of this subsection if—(i) the interest on account of such claims of the holders of such claims in such property is of inconsequential value. . . .” 11 U.S.C. § 1111(b)(1)(B)(i). Courts have used different approaches in analyzing the “inconsequential value exception” in traditional Chapter 11 cases. Some courts compare the value of the asserted secured interest with the overall value of the collateralized asset to determine whether the lien is of “inconsequential” value. Other courts compare the value of the security interest to the total dollar amount of the underlying secured claim (this was the approach taken by the Body Transit court).
Under this latter approach, if the secured portion of a creditors claim is “inconsequential” in relation to the size of the overall claim, then the creditor may not make the election because the claim would, under non-bankruptcy law—for all intents and purposes—be ostensibly an unsecured claim—the proverbial tail wagging the dog. So, the policy and reasoning goes, the exception to the election should operate to avoid giving creditors greater rights than they would otherwise have under non-bankruptcy law.
But, does the term “inconsequential value” have a different meaning in a traditional chapter 11 as opposed to a subchapter V case? According to Body Transit, the answer is yes.
Body Transit Facts
The debtor in Body Transit (“Debtor”) was a company that owned three fitness clubs, two of which the Debtor closed and allowed to be either sold or foreclosed upon. But, the Debtor sought to reorganize under the SBRA as to the third fitness club, which was subject to First Bank’s (“Bank”) lien. The Debtor filed a plan of reorganization, which it amended after the Bank made an 1111(b) election. The Debtor also filed a motion to value the Bank’s collateral and an objection to the Bank’s election.
The Court valued the property and determined that the secured portion of the creditor’s claim was 8.2% of its total claim. It then found that 8.2% was “inconsequential” and, therefore, came within the inconsequential value exception to the 1111(b) election. As a result, the Court granted the Debtor’s objection to the Bank’s election.
The relevant portion of the Court’s reasoning was as follows:
The key point here is that the “inconsequential value” determination is not a bean counting exercise; the determination cannot be based solely on a mechanical, numerical calculation. Some consideration must be given to the policies underlying both the right to make the § 1111(b) election and the exception to that statutory right. In other words, while “the numbers” provide an important starting point in deciding how much value is “inconsequential,” the court also must consider other relevant circumstances presented in the case and make a holistic determination that takes into account the purpose and policy of the statutory provisions that govern the reorganization case. . . .
To some degree also, the Debtor’s election to reorganize under subchapter V and the purposes and policies underlying the SBRA influence my determination of the level of value that is “inconsequential.”
In re Body Transit, 2020 WL 4574907, *17-18 (E.D. Pa. Aug. 7, 2020).
In other words, the meaning of “inconsequential value” may be different in traditional chapter 11 cases as opposed to subchapter V cases because of, among other things, the purposes and policies underlying the SBRA (which policies and purposes do not apply in non-subchapter V cases). This is a noted departure from the “plain meaning” approach to statutory construction, which has historically pervaded Bankruptcy Code interpretation. See, e.g., In re VP Williams Trans, LLC, Case No. 20-10521 (MEW), 5-9 (Bankr. S.D.N.Y. Sep. 29, 2020) (rejecting Body Transit’s “policies and procedures” analysis and, instead, opting to use a Webster’s Dictionary to define the term “inconsequential” in a subchapter V case).
Section 1111(b) elections may become much more prolific in subchapter V cases. For one thing, subchapter V case do not require an impaired consenting class as a prerequisite to plan confirmation. And, during the Covid-19 pandemic, collateral values (think commercial real estate values) may be temporarily depressed (at least until, hopefully, vaccines may be widely distributed and administered).
The Court in Body Transit imported one aspect of the SBRA’s legislative purpose—i.e., “streamlining” of reorganizations—to influence its interpretation of the meaning of “inconsequential value” for the purposes of determining whether a secured creditor may make an 1111(b) election. That resort to SBRA legislative history basically tipped the scales, resulting in the Court denying the creditor’s section 1111(b) election rights. In short, Body Transit is a “bad case” for secured creditors looking to make an 1111(b) election—especially where they find themselves on the cusp of being out-of-the-money or in a collateral valuation dispute.
But, there are arguments against Body Transit’s approach. In particular, Body Transit’s analysis does not appear to comport with the “plain meaning” approach to Bankruptcy Code interpretation. And, under Body Transit, the phrase “inconsequential value” could mean different things in different chapter 11 cases depending on whether the case is a traditional chapter 11 case, a small business case, or a subchapter V case.
The bottom line is that secured creditors should be aware of the issues posed by Body Transit, and should be prepared to address these issues if their 1111(b) elections are contested based on the “inconsequential value” exception to the 1111(b) election.
By Gerrick Warrington
Associate at Frandzel Robins Bloom & Csato, L.C.