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Working Group Proposal #2: Classification of Claims

The chapter 11 Working Group makes its recommendations in the context of larger chapter 11 cases, not in the context of single asset, partnership, or small cases.

Section 1122, which prescribes the rules for classifying claims, unequivocally states that substantially dissimilar claims may not be placed in the same class. The Code is silent, however, on the converse question: must all legally similar claims (such as all non-priority unsecured claims) be placed in a single class? Currently, the answer is not clear. As a consequence, a court often dedicates valuable time and resources to addressing the permissibility of separate classification of similar claims before it reaches the merits of the case. [ FN: As of 1994, one bankruptcy court counted over one hundred and fifty published opinions that discussed the question of whether section 1122(a) permitted separate classification of similar claims. In re Bloomingdale Partners , 170 B.R. 984, 988 (Bankr. N.D. Ill. 1994).]

Litigation of classification issues has yielded a wide array of responses. A few courts have concluded that section 1122 freely permits separate classification of similar claims. Some courts have held that separate classification of legally similar claims is prohibited per se. Most courts have taken a middle ground and have hypothesized that only "reasonable" separate classification of similar claims is permissible. Courts have adopted disparate approaches to determine what is reasonable: some have focused on the proponent’s purpose for separate classification, while others have based their determinations on the "nature" of the claims and the extent to which these claims warrant a separate voting voice. Due to the varying interpretations, the same plan could be presented to several courts and receive three different responses: separate classification is prohibited, separate classification is optional, or separate classification is mandatory.

The variety of possible outcomes is multiplied at the appellate level. Courts have not even been able to agree on whether classification decisions constitute findings of fact, conclusions of law, or both, and therefore the decisions are reviewed under different standards of deference. The same set of circumstances may be reviewed by one court de novo and by another court for clear error only.

As a result, plan proponents receive little guidance as to how they can structure their repayments, and parties have less confidence in their negotiating positions when they bargain withthe debtor.

The Working Group specifically seeks to address the circumstance where the plan proponent needs to treat differently, and thus must classify separately, groups of creditors that have the same repayment priority under the Bankruptcy Code and therefore under the majority view would be considered "substantially similar." The proponent’s need at issue is not confirmation-based, i.e., how to engineer an assenting impaired class to cram down a plan, but rather a true business-reorganization need, i.e., what plan provisions are necessary to reestablish productivity and economic viability. In light of these parameters, two issues inhere in the question of whether separate classification is permissible: how much flexibility should be available to a plan proponent to provide different treatment to some creditors in a plan of reorganization, and what obstacles should the Code impose to prevent a plan proponent from using classification to engineer an assenting class and to muster the class votes necessary to confirm a plan.

The Recommendation

The chapter 11 Working Group recommends that the Commission consider a proposal to accomplish the following:

Section 1122 should be amended to provide that a plan proponent may classify legally similar claims separately if, upon objection, the proponent can demonstrate that classification is supported by a "rational business justification."

The Code expressly would permit a plan proponent to classify legally similar claims (e.g., unsecured bank debt and past-due-pension contributions) separately and treat them differently if, upon objection, [ FN: "For the purposes of the plan and its acceptance, the court may, on motion after hearing on notice as the court may direct, determine classes of creditors and equity security holders pursuant to §§1122, 1222(b)(1) and 1322(b)(1) of the Code. " Fed. R. Bankr. P. 3013. A creditor also could object to classification on the basis of 11 U.S.C. §1129(a)(1), which requires a plan to comply with the applicable provisions of Title 11. See also Fed. R. Bankr. P. 3020(b); see also H.R. Rep. No. 595, 95th Cong., 1st Sess. 412 (1977); see also 5 Collier on Bankruptcy ¶ 1129.02[1] (15th ed. 1996).] the proponent could establish it had a legitimate business reason. The proponent’s justification for separate classification would have to be supported by credible proof. This proposal is consistent with views expressed by several circuit courts of appeal. [ FN: See , e.g. , Boston Post Road Ltd. Partnership v. FDIC (In re Boston Post Road Ltd. Partnership) , 21 F.3d 477, 483 (2d Cir. 1994) ( "debtor must adduce credible proof of legitimate reason for segregating the FDIC ’s unsecured claim from the unsecured claims of [debtor] ’s trade creditors "), cert. denied , 115 S. Ct. 897 (1995) ; Phoenix Mutual Life Ins. Co. v. Greystone III Joint Venture (In re Greystone III Joint Venture) , 995 F.2d 1274, 1279 (5th Cir. 1991)( "if section 1122(a) permits classification of ‘substantially similar ’ claims in different classes, such classification may only be undertaken for reasons independent of the debtor ’s motivation to secure the vote of an impaired, assenting class of claims "), cert. denied , 113 S. Ct. 72 (1992). For a further exploration of the courts ’ consideration of this type of analysis, see p. 6 of this proposal.]

Other significant constraints on the treatment of claims, in addition to the rational business justification requirement, would protect creditors. Consistent with current chapter 11 practice and principle, this proposal would allow some discrimination among parties. Yet, as always, in a cramdown situation section 1129(b) would prohibit unfair discrimination and would require that the plan be "fair and equitable." [ FN: 11 U.S.C. §1129(b)(1) does not prohibit all discrimination, only unfair discrimination: "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 notwithstanding the requirements of such paragraph if 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. "]

Thus, the Working Group's approach seeks to provide flexibility for a business to meet its reorganization needs without sacrificing the interests of creditors overall. If a plan proponent could justify the separation of two creditor groups, it would be able to separate them into two classes. Any justification for separate classification would be premised on disparate treatment, such as immediate payment for employees and payment over time for commercial creditors. [ FN: For this reason, this proposal would minimize the gerrymandering problem often associated with classification disputes. See p. 21 of this proposal. If the proponent did not have a business reason to treat two substantially similar claims differently, this proposal would prohibit their separate classification.] The types of distinctions made between classes might include the timing of payment, the form of payment (cash or debt instruments), or the value of the ultimate repayment.

Background

A chapter 11 plan proponent must designate classes of claims and classes of interests in its plan. [ FN: 11 U.S.C. §1123(a).] While section 1123 limits the proponent’s discretion in its treatment of claims within the same class, [ FN: Id. §1123(a)(4) (plan shall "provide the same treatment for each claim or interest of a particular class, unless the holder of a particular claim or interest agrees to a less favorable treatment ").] section 1122 governs a plan proponent’s flexibility in determining what claims should be placed in a class in the first place. The latter provision explicitly states that classes must be internally homogenous, i.e., claims may not be classified together unless they are "substantially similar" to one another. [ FN: 11 U.S.C. §1122 Classification of claims or interests (a) Except as provided in subsection (b) of 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 interest of such class. (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.] The provision does not state that substantially similar claims must be classified together.

Courts and commentators have looked to prior law and to the legislative history to determine the meaning of this statutory silence. Under the Bankruptcy Act, as amended by the Chandler Act, the court classified claims and interests. In cases under chapter X and chapter XII, the court did so according to the "nature of their respective claims." [ FN: 11 U.S.C. §597 (Repealed 1978).] According to the interpretive case law, substantial differences in the nature of claims dictated separate classification, although the courts were afforded some discretion. [ FN: In re Los Angeles Land & Investments, Ltd. , 282 F. Supp. 448 (D. Haw. 1968), aff ’d , 447 F.2d 1366 (9th Cir. 1971); see also Scherk v. Newton , 152 F.2d 747, 751 (10th Cir. 1945) ( "classification should be based on substantial differences in the nature of claims. All creditors of equal rank with claims against the same property should be placed in the same class "); Brinkley v. Chase Manhattan Mortgage and Realty Trust (In re LeBlanc) , 622 F.2d 872, 878 (5th Cir. 1980) ( "as a general rule, the classification in a plan should not do substantial violence to any claimant ’s interest. The plan should not arbitrarily classify or discriminate against creditors "); accord , In re Palisades-on-the-Desplaines , 89 F.2d 214 (7th Cir. 1937).] chapter XI did not impose the same limitations. Chapter XI expressly validated "provisions for treatment of unsecured debts on a parity with the other, or for the division of such debts into classes and the treatment thereof in different ways or upon different terms." [ FN: 11 U.S.C. §757(1) (Repealed 1978). Chapter XI may be an inapt analogy as it did not provide for cram down plans.]

chapter 11 of the 1978 Bankruptcy Code draws on elements of both Chapters X and XI, but it does not indicate which, if either, of the two prior approaches to classification of similar claims was incorporated into the Code. The legislative history is notably silent on the issue of separate classification of similar claims. [ FN: The House Judiciary Committee reported the following: §1122 Classification of claims and equity securities : This section codifies current case law surrounding the classification of claims and equity securities. It requires classification based on the nature of the claims or interests classified, and permits inclusion of claims or interests in a particular class only if the claim or interest being included is substantially similar to the other claims or interests of the class. Subsection (b) is also a codification of existing practice, contains an exception. The play 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. Report of the Committee on the Judiciary, House of Representatives, to Accompany H.R. 8200, H.R. Rep. No. 95-595, 95th Cong., 1st Sess. (1977). The Report of the Commission on the Bankruptcy Laws recommended that "[i]f necessary for the purpose of the plan or its acceptance, on the request of any party in interest, the administrator shall designate classes of creditors and equity security holders which are of substantially similar character and the members of which enjoy substantially similar rights . . . except that the administrator may create a separate class of creditors having unsecured claims of less than $100 for reasons of administrative convenience. " Report of the Commission on the Bankruptcy Laws of the United States, July, 1973, H.R. Doc. No. 93-137, 93d Cong., 1st Sess., pt. II, at 241 (1973). By way of comparison, the analogous chapter 13 classification provision permits the placement of unsecured claims into more than one class as long as the plan does not discriminate unfairly against any of the classes. 11 U.S.C. §1322(b)(1). Commentators have noted that the same general rules apply for classification in chapter 11 cases as in chapter 13 cases. See Stefan A. Riesenfeld, "Classification of Claims and Interests in chapter 11 and 13 Cases, " 75 Cal. L. Rev. 391, 404 (1987) (reviewing case law interpreting sections 1122(a) and 1322(b)(1)); see also In re Colfer , 159 B.R. 602, 605 (Bankr. D. Maine 1993) (language of section 1322(b)(1) "recognizes that a debtor may discriminate among classes of equal priority debt, so long as the discrimination is not unfair "). Of course, chapter 13 cases do not implicate gerrymandering concerns since creditors do not vote on the plans.] Courts have adopted varying interpretations of the pre-Code case law and Congressional intent in light of the lack of explicit guidance. [ FN: Courts have commented that the legislative history sheds little light on this particular issue. See , e.g. , In re Boston Post Road Ltd. Partnership , 21 F.3d 477, 483 (2d Cir. 1994), cert. denied , 115 S. Ct. 897 (1995) (analysis of legislative history "sheds little light "); Appeal of Finch Fuel Oil (In re Jersey City Medical Center) , 817 F.2d 1055, 1060 (3d Cir. 1987) (legislative history "inconclusive "); Teamsters Nat ’l Freight Ind. Negotiating Committee v. U.S. Truck Co., (In re U.S. Truck Co.) , 800 F.2d 581, 586 (6th Cir. 1986) ( "Congress has sent mixed signals ").] Academics have reached conflicting conclusions as well. [ FN: See , e.g. , Scott F. Norberg, "Classification of Claims Under chapter 11 of the Bankruptcy Code: The Fallacy of Interest Based Classification, " 69 Am. Bankr. L. J. 119 (1995) (section 1122 permits separate classification of similar claims only insofar as is consistent with enforcing absolute priority rule and encouraging settlement); Bruce A. Markell, "Clueless on Classification: Toward Removing Artificial Limits on chapter 11 Claim Classification, " 11 Bankr. Dev. J. 1 (1995) (separate classification permissible unless dissenter establishes that class includes claims with different non- bankruptcy liquidation priorities); Louis S. Robin, "Classification of Claims: An Examination of Disregarded Legislative History, " 98 Com. L. J. 225 (1993) (Bankruptcy Act and Code drafters intended to permit separate classification); Peter E. Meltzer, "Disenfranchising the Dissenting Creditor Through Artificial Classification or Artificial Impairment, " 66 Am. Bankr. J. 281 (1992) (gerrymandered classification disenfranchises parties who should be able to block plan and defeats Code goal of requiring proponent to provide indicia of success in negotiations with creditors); Linda J. Rusch, "Gerrymandering the Classification Issue in chapter 11 Reorganizations, " 63 U. Colo. L. Rev. 163 (1992) (separate classification appropriately prevents dissenting creditors from exercising veto power over reorganization, leaving impartial judge to determine whether reorganization satisfies Code requirements); Thomas C. Given & Linda J. Phillips, "Equality in the Eye of the Beholder - - Classification of Claims and Interests in chapter 11 Reorganizations, " 43 Ohio St. L. J. 735 (1982) (courts should consider equitable principles when analyzing classification, especially when plans propose discriminatory treatment).]

The Case Law: To What Extent Have Courts Permitted Separate Classification of Similar Claims?

The case law, especially circuit case law, has developed largely in the context of single asset real estate cases. [ FN: In a typical single asset chapter 11 case, the mortgage holder is quite undersecured and has elected to vote the unsecured portion of its claim with the general unsecured claims. See 11 U.S.C. §1111(b). Because the size of the deficiency claim dwarfs the other unsecured claims, the mortgage holder would control this class ’ voting. The debtor will need an impaired class to accept the plan to proceed to cram down. See 11 U.S.C. §1129(a)(10). Thus, the debtor might classify the deficiency claim separately from the general unsecured creditors and offer to pay the general unsecured claims enough to make their holders accept the plan while still leaving them impaired.] While this type of case is not under primary consideration in this chapter 11 Working Group Proposal, the holdings are nonetheless relevant to all chapter 11 cases and section 1122 inquiries.

While the language of section 1122 does not prohibit separate classification of similarclaims per se, most courts have held that the Bankruptcy Code imposes some limits on a proponents’ ability to classify similar claims separately so that classification is reasonable and comports with a basic sense of fairness. [ FN: In re U.S. Truck Co. Inc. , 800 F.2d 581 (6th Cir. 1986). See also In re Greystone III Joint Venture , 995 F.2d 1274, 1279 (5th Cir. 1991), cert. denied , 113 S. Ct. 72 (1992); Olympia & York Florida Equity Corp. v. Bank of New York (In re Holywell Corp.) , 913 F.2d 873 (11th Cir. 1990); Hanson v. First Bank of South Dakota, N.A. , 827 F.2d 1310, 1313 (8th Cir. 1987); State Street Bank and Trust Co. v. Elmwood Inc. (In re Elmwood Inc.) , 182 B.R. 845 (D. Nev. 1995); In re D&W Realty Corp. , 165 B.R. 127 ( S.D.N.Y. 1994), rev ’g 156 B.R. 140 (Bankr. S.D.N.Y. 1993); In re Aztec Co. , 107 B.R. 585 (Bankr. M.D. Tenn. 1989); In re 500 Fifth Avenue Assoc. , 148 B.R. 1010 (Bankr. S.D.N.Y. 1993), aff ’d , No. 93-844, 1993 WL 316183 (S.D.N.Y. May 21, 1993).] Considering the interplay of section 1122(a) with other related sections (e.g., sections 1122(b), 1111(b), 1129(a)(10), and 1129(b)), some courts have surmised that a completely permissive classification policy would circumvent the intent of these provisions. [ FN: Some courts have concluded that section 1122(b) would be meaningless if 1122(a) freely permitted separate classification: a "fair reading of both subsections suggests that ordinarily ‘substantially similar claims, ’ those which share common priority and rights against the debtor ’s estate, should be placed in the same class. " In re Greystone III Joint Venture , 995 F.2d 1274, 1278 (5th Cir. 1991) , cert. denied , 113 S. Ct. 72 (1992) ; John Hancock Mutual Life Ins. Co. v. Route 37 Business Park Assoc. , 987 F.2d 154,158 (3d Cir 1993); In re Pine Lake Village Apt. Co. , 19 B.R. 819, 829 (Bankr. S.D.N.Y. 1982) (section 1122(b) "is the only exception expressed in the Code for separately designating unsecured claims. Any other designation would have to comply with 11 U.S.C. §1129(b)(1) that prescribes as a prerequisite for confirmation that ‘the plan does not discriminate unfairly "). See also Scott F. Norberg, "Classification of Claims Under chapter 11 of the Bankruptcy Code: The Fallacy of Interest Based Classification, " 69 Am. Bankr. L. J. 119, 125 (1995) (classification exists only to maintain the rights of creditors under the absolute priority rule).] In devising a more restrictive rule to determine what might constitute a legitimate reason for separate classification, courts essentially have chosen between two theoretically different approaches: some courts have asserted that separate classification would be appropriate only if the proponent had a legitimate reason for treating the claims differently, while others have held that separate classification would be acceptable if the "nature" of the claim warranted the segregated classification.

Legitimate Business Reasons

To withstand a challenge to classification of claims that are substantially similar, according to this view, a proponent must prove the existence of "legitimate reasons." [ FN: See , e.g. , Aetna Casualty and Surety Co. v. Clerk, U.S. Bankruptcy Court, New York, NY (In re Chateaugay Corp., Reomar Inc., LTV Corp.) , 89 F.3d 942 (2d Cir. 1996); In re Boston Post Road Ltd. Partnership , 21 F.3d 477, 483 (2d Cir. 1994), cert. denied , 115 S. Ct. 897 (1995); In re Greystone III Joint Venture , 995 F.2d 1274, 1279 (5th Cir. 1991), cert. denied , 113 S. Ct. 72 (1992); In re Kleigl Bros. Universal Electric Stage Lighting Co. Inc. , 149 B.R. 306 (Bankr. E.D.N.Y. 1992) (valid business justification warranted separate classification of union claim, which did not constitute unfair discrimination). One bankruptcy court noted in 1995 that "separate classification for valid business reasons is uniformly accepted. " In re SM 104 Ltd. , 160 B.R. 202, 217 (Bankr. S.D. Fla. 1993), citing In re Johnston , 140 B.R. 526, 529 (Bankr. 9th Cir. 1992), aff ’d , 21 F.3d 323 (9th Cir. 1984), and Piedmont Assoc. v. Cigna Property & Casualty Insurance , 132 B.R. 75, 78 (N.D. Ga. 1991) (distinctions in size and nature of debt are not valid business reasons for separate classification, and proposed treatment constituted unfair discrimination); but see Principal Mutual Life Insurance Co. v. Baldwin Park Towne Center, Ltd. (In re Baldwin Park Towne Center, Ltd. ), 171 B.R. 374, 376 (Bankr. C.D. Cal. 1994) (business justification standard imposes "unfair burden on debtor to prove a negative, " which creates non-Code based bias against debtor).] A plan proponentmight accomplish this by presenting evidence that the debtor’s business would be affected adversely if it were precluded from treating two groups of creditors differently. [ FN: Courts have used various tests to determine whether separate classification and disparate treatment of legally similar claims is permissible, and, as a corollary, does not constitute unfair discrimination. See , e.g. , In re 11,111 Inc. , 117 B.R. 471, 478 (Bankr. D. Minn. 1990) (considering 1) whether there is reasonable and fair basis for different treatment; 2) whether debtor could consummate plan without discrimination; 3) whether discrimination is proposed in good faith; and 4) whether degree of discrimination is proportional to its rationale); see also In re Bloomingdale Partners , 170 B.R. 984, 997 (Bankr. N.D. Ill. 1994) (rejecting reasonableness test or flexible standard in favor of "restrictive classification, " but stating in dictum that claims might be found to be substantially dissimilar if it were vital to the reorganization to the business to treat differently two groups of unsecured creditors, such as warranty claims and trade creditor claims).]

The recent LTV decision provides a good example of this business-oriented approach. [ FN: In re Chateaugay Corp., Reomar Inc., LTV Corp. , 89 F.3d 942 (2d Cir. 1996).] LTV’s plan proposed to segregate its unpaid workers’ compensation claims and to guarantee they would be paid in full, while Aetna would receive common stock after confirmation for its surety-reimbursement claims, which probably would yield between thirty-seven and forty-four cents on the dollar of Aetna’s debt. [ FN: Id. , at 946.] The Court of Appeals for the 2^nd Circuit endorsed the view that "to warrant having separate classification of similar claims, the debtor must advance a legitimate reason supported by credible proof." [ FN: Id. , at 949, citing In re Boston Post Road Ltd. Partnership , 21 F.3d 477, 483 (2d Cir. 1994), cert. denied , 115 S. Ct. 897 (1995).] LTV presented evidence that its employees perceived these benefits to be state law "entitlements," and that these benefits may be the only wage replacement they would receive, which led to the following conclusion:

Were the debtor unable to satisfy workers’ compensation obligations . . . the unions representing LTV’s employees would react so negatively as to jeopardize peaceful labor relations and thereby cast into doubt LTV’s ability to secure sales contracts from customers . . . Congress gave reorganizing debtors considerable flexibility in their treatment of general unsecured creditors to position themselves for future economic viability [citations omitted]. The debtors want to use that Code-given flexibility to facilitate a reorganization that will leave LTV strong and successful, a goal consonant with the purpose of § 1122. [ FN: Id. , at 949, citing affidavit of Vice President of Industrial Relations of LTV Steel Co. Inc.]

Because the treatment of Aetna’s claims would not have the same impact on LTV’sreorganization, the Court found that the bankruptcy court was not clearly erroneous in determining that LTV had a valid business reason for providing superior treatment to its unpaid workers. [ FN: In addition, the bankruptcy court found, and the reviewing courts agreed, that this classification was not designed to create an assenting impaired class. Id. , at 950.] "It is no injustice to limit the surety’s recovery to that of an unsecured general creditor. . . Had LTV not esteemed labor harmony so highly and decided against giving priority status to the workers in the non-bonded states, Aetna would have no argument on its perceived inequitable treatment." [ FN: Id. , at 948.]

A few other cases are illustrative of the "rational business justification" approach and how it has been utilized. In Richard Buick, the car dealership’s plan proposed to pay its dealer-trade claims in full while its other general unsecured claims would receive only 5% of their claims. [ FN: In re Richard Buick Inc. , 126 B.R. 840 (Bankr. E.D. Pa. 1991) (denying confirmation for other reasons).] The court found that there was sufficient justification to segregate the dealer claims and offer them superior treatment:

[Witness] testified without rebuttal that full payment of dealer-trade claims was absolutely necessary to the future success of the Debtor’s business. Not only was it needed to re-establish a good relationship with other dealers whose trades would supply a large percentage of the vehicles sold, but also this treatment was needed because both of the franchisees willing to resume a relationship with the Debtor, i.e., Buick and Volvo, had made full payment of dealer-trade claims a prerequisite of their continuing respective future relationships with the Debtor. Therefore, the Debtor had good reason for allowing the degree of favorable treatment allotted to these parties. [ FN: Id. , at 852.]

Likewise, when a lighting company debtor segregated its union’s unsecured claim from other unsecured claims, the bankruptcy court found that the debtor had demonstrated adequate business justification. [ FN: In re Kleigl Bros. Universal Electric Stage Lighting Co. Inc. , 149 B.R. 306 (Bankr. E.D.N.Y. 1992). The court applied the four part test used in In re 11,111 Inc. , 117 B.R. 471, 478 (Bankr. D. Min. 1990) (test outlined p. 7, n. 19 of this proposal).] The court found that "the Debtor’s ability to continue to operate a union shop is absolutely critical to its ability to function successfully in its industry." [ FN: Id. , at 308.] In another case, a debtorpaper company classified its unsecured creditors based on the size of their respective claims. [ FN: In re Nat ’l Paper & Type Co. of Puerto Rico , 120 B.R. 624 (D.P.R. 1990).] Under the plan, smaller claims would receive more than 10% of their debts monthly, while larger claims would receive less than 2% per month. Over the objection of a larger creditor, the bankruptcy court confirmed the plan and the district court found that "the classifications in this case are justified because they foster the continued success of this business." [ FN: Id. , at 626 (applying clear error standard), citing In re Planes Inc. , 48 B.R. 698 (Bankr. N.D. Ga. 1985); In re Atlanta West V.I. , 91 B.R. 620 (Bankr N.D. Ga. 1988). See also In re LeBlanc , 622 F.2d 872, 879 (5th Cir. 1982) . "The trade creditors advanced goods and services to the debtor in the ordinary course of business, frequently without any knowledge of the debtor ’s financially perilous condition and without any real opportunity to protect themselves. Furthermore, the proponents of the plan who were to operate the hotel under the plan may well have needed to maintain good relations with trade creditors upon whom they would have to rely to furnish additional goods and services to the hotel. In contrast, the insiders made loans to the debtor when they were in a position to know of the debtor ’s financial condition and the risks involved with those loans. Also, the insiders were not going to have any ongoing relationship with the hotel after confirmation of the plan. " Id.] This is the extent to which this court explained its holding.

Courts that have indicated that the "business reason" approach might be viable generally have agreed that classification for the purpose of engineering an assenting impaired class does not qualify for separate classification. Most circuit courts have disallowed debtors’ attempts to separate out a deficiency claim from the remainder of the general unsecured creditors when this is done only to ensure satisfaction of 11 U.S.C. § 1129(a)(10), i.e., for "gerrymandering" purposes. [ FN: See , e.g. , In re Boston Post Road Limited Partnership , 21 F.3d 477 (2d Cir. 1994) (proponent unable to offer credible proof of business justification for separate classification of FDIC from trade creditors), cert. denied , 115 S. Ct. 897 (1995) ; John Hancock Mutual Life Ins. Co. v. Rt. 37 Business Park Assoc. , 987 F.2d 154 (3d Cir. 1993) (mortgagee entitled to relief from stay due to impossibility of confirmation due to lack of legitimate accepting impaired class); Lumber Exchange Building Ltd. Partnership v. Mutual Life Ins. Co. of New York (In re Lumber Exchange Building Ltd. Partnership) , 968 F.2d 647 (8th Cir. 1992) (debtor unable to proffer legitimate reason for separately classifying deficiency claim, and therefore could not propose confirmable plan); Travelers Ins. Co. v. Bryson Properties, XVIII (In re Bryson Properties, XVIII) , 961 F.2d 496, 502 (4th Cir.) ( "where all unsecured claims receive the same treatment in terms of the Plan distribution, separate classification on the basis of natural and unnatural recourse claims is, at a minimum, highly suspect, " and requires further justification), cert. denied , 113 S. Ct. 191 (1992) ; In re Greystone III Joint Venture , 995 F.2d 1274 (5th Cir. 1991) (debtor unable to provide legitimate reason or sufficient legal distinction to justify separate classification of deficiency claim), cert. denied , 113 S. Ct. 72 (1992) ; but see In re Woodbrook Assoc. , 19 F.3d 312 (7th Cir. 1994) (deficiency claim not substantially similar to other unsecured claims, therefore gerrymandering irrelevant), citing In re SM 104 Ltd. , 160 B.R. 202, 217 (Bankr. S.D. Fla. 1993) (most case analyses of this issue "have turned more on notions of basic fairness and good faith. Indeed, most courts seem to base their rulings less on the language of §1122 than on their view that separate classification is usually done to manipulate the voting "); see also Heartland Federal Savings & Loan Assoc. v. Briscoe Enterprises, Ltd., II (In re Briscoe Enterprises, Ltd.,II) , 994 F.2d 1160 (5th Cir.) (deficiency claim held by city of Forth Worth could be classified separately because city had distinct interests in debtor apartment complex), cert. denied , 114 S. Ct. 550 (1993).] Some single-asset debtors who have tried to use the legitimate business reason argument have thwarted their own attempts. In Greystone, the debtor argued, and the bankruptcy court agreed, that Greystone had separately classified the mortgagee’s deficiency claim forbusiness reasons that related to its need to maintain good will among its trade creditors, who otherwise would stop engaging in business with the debtor and would provide the debtor with a negative reputation. [ FN: In re Greystone III Joint Venture , 995 F.2d 1274, 1280 (5th Cir. 1991), cert. denied , 113 S. Ct. 72 (1992). Cf. In re Elmwood Inc. , 182 B.R. 845, 849 (D. Nev. 1995) (upholding separate classification of deficiency claim because plan provided for bank to be repaid from net operating income from rental units, rendering claim "a different kind, species, and character ").] In its rejection of this contention, the Court of Appeals for the 5^th Circuit stated:

Greystone’s justification for separate classification of the trade claims might be valid if the trade creditors were to receive different treatment from Phoenix. Indeed, Greystone initially treated a separate class of unsecured creditors that could be wooed to vote for the plan by the promise to pay their remaining claims in full outside the plan. Greystone then changed course and eliminated its promise. Because there is no separate treatment of the trade creditors in this case, we reject Greystone’s "realities of business" argument. [ FN: Id. , at 1280-1281.]

Likewise, in Lumber Exchange, the debtor argued that separate classification of the mortgagee’s deficiency claim was warranted because "secured creditors look to different assets for repayment than do unsecured creditors and because the maintenance of good business relationships is important to a debtor’s ongoing business." [ FN: In re Lumber Exchange Building Ltd Partnership , 968 F.2d 647, 649 (8th Cir. 1992).] To this, the 8^th Circuit responded that "[t]here is some authority for the proposition that a plan may classify trade creditors separately from, and treat them more generously than, other creditors if doing so is necessary to a debtor’s ongoing business. [citations omitted] The integrity of Lumber Exchange’s argument, however, is belied here by the plan’s own terms. The proposed plan treats trade creditors less generously, not more. Accordingly, we conclude that this proffered justification for separate classification is not legitimate." [ FN: Id. ; see also In re Bryson Properties, XVIII , 961 F.2d 496, 502 (4th Cir. 1992) (debtor unable to justify separate classification when proposing identical treatment for natural and unnatural recourse claims); but see In re Briscoe Enterprises, Ltd.,II , 994 F.2d 1160 (5th Cir.) (deficiency claim held by city of Forth Worth could be classified separately because city had distinct interests in debtor apartment complex), cert. denied , 114 S. Ct. 550 (1993).]

"Nature of Claim"

To identify legitimate reasons for segregating a claim, other cases have not focused on the intent of the proponent, but rather, have analyzed the nature of the claims or interests at issue. As at least one court has explained it, this view is premised, in part, on a belief that each class mustrepresent a voting interest that is "sufficiently distinct and weighty to merit a separate voice." [ FN: John Hancock Mutual Life Ins. Co. v. Rt. 37 Business Park Assoc. , 987 F.2d 154 (3d Cir. 1993) (deficiency claim does not warrant "separate voice "); see also Hanson v. First Bank of South Dakota, N.A. , 827 F.2d 1310, 1313 (8th Cir. 1987) (trade creditor interests not sufficiently unique to warrant separate classification).]

Some courts have held that certain unsecured claims are substantially dissimilar from others; in such cases, not only is separate classification permissible, but mandatory. [ FN: See In re Woodbrook Assocs. , 19 F.3d 312, 318 (7th Cir. 1994) (deficiency claim not substantially similar to general unsecured claims); In re Overland Park Merchandise Mart Partnership, L.P. , 167 B.R. 647 (Bankr. D. Kan. 1994) (same); Principal Mutual Life Insurance Co. v. Baldwin Park Towne Center, Ltd. (In re Baldwin Park Towne Center, Ltd. ), 171 B.R. 374, 377 (Bankr. C.D. Cal. 1994) (deficiency claim not same "species " as trade claims); In re SM 104 Ltd. , 160 B.R. 202, 218 (Bankr. S.D. Fla. 1993); see also In re D&W Realty Corp , 156 B.R. 140, 141 (Bankr. S.D.N.Y. 1993), rev ’d 164 B.R. 127 (S.D.N.Y. 1994) (reversing on basis that deficiency claims are substantially similar to general unsecured claims); In re the Mason & Dixon Lines Inc. , 63 B.R. 176 (Bankr. M.D.N. Car. 1986) (pension fund withdrawal liability claims not substantially similar to general unsecured claims).] Other courts have taken a slightly different approach: claims that may be substantially similar still might have sufficiently "distinct" or "unique" legal interests to warrant separate classification. [ FN: See In re U.S. Truck Co. , 800 F.2d 581 (6th Cir. 1986); see also In re Briscoe Enterprises, Ltd., II , 994 F.2d 1160 (5th Cir.), cert. denied , 114 S. Ct. 550 (1993) ; In re Jersey City Medical Center , 817 F.2d 1055 (3d Cir. 1987); In re Bjolmes Realty Trust , 134 B.R. 1000, 1003 (Bankr. D. Mass. 1991) (fact that undersecured claim could have different legal rank indicates distinction from trade debt); In re Gato Realty Trust Corp , 183 B.R. 15 (Bankr. D. Mass. 1995) (same).]

According to courts that take this "nature of claim" approach, the focus of classification historically has been on the nature or legal character of the claim as it relates to the assets of the debtor. [ FN: J.P. Morgan & Co. v. Missouri Pacific Railroad , 85 F.2d 351 (8th Cir.), cert. denied , 57 S. Ct. 230 (1936); accord , Appeal of Hawley Fuel Coalmart Inc. (In re AOV Industries Inc.) , 792 F.2d 1140, 1150 (D.C. Cir. 1985); In re Fantastic Homes Enterprises Inc. , 44 B.R. 999, 1000 (Bankr. M.D. Fla. 1984) (denying plan with four classes of unsecured claims for failure to show their distinct natures).] To determine the proper definition of "nature," many courts have turned to the explanation offered by a district court in Los Angeles Land and Investments:

The test to be applied appears to be one directed toward a determination of the "nature" of the claim. This would encompass an analysis of the legal character or the quality of the claim as it relates to the assets of the debtor. Basically, it is simply a method of recognizing the rights of creditors which call for difference in treatment. Generally, however, "all creditors of equal rank with claims against the same property should be placed in the same class."

The courts recognize that the word "nature" is used in no technical sense in law but is used in its ordinary common vernacular, wherein it means kind, sort, species or character. Where the differences are in the rates of interest, in the amounts, in the dates of maturity, in names of payees, the manner in which theclaim arose, and such other minor details, they cannot affect the "nature," i.e. the kind of claim . . . Unsecured creditors may, under special circumstances, be divided into separate classes where the legal character of their claims is such as to accord them with a status different from the other unsecured creditors. [ FN: In re Los Angeles Lumber and Investments, Ltd. , 282 F. Supp. 448 (D. Haw., 1968), aff ’d , 447 F.2d 1366 (9th Cir. 1971), citing Scherk v. Newton , 152 F.2d 747 (10th Cir. 1945); see also In re Fantastic Homes Enterprises Inc. , 44 B.R. 999 (M.D. Fla. 1984); In re Northeast Dairy Cooperative Federation Inc. , 73 B.R. 239 (Bankr. N.D.N.Y. 1987) (debt incurred by detrimental reliance did not have sufficient salient legal differences from other unsecured creditors to warrant separate classification); In re Creekside Landing, Ltd. , 140 B.R. 713 (Bankr. M.D. Tenn. 1989) (plan properly separately classified four groups of deficiency claims on account of "unique " interests, but plan unfairly discriminated); In re Aztec Co. , 107 B.R. 585 (Bankr. M.D. Tenn. 1989) (same).]

While most courts have considered a claim’s legal nature to be a question of law, a few appellate courts have held that this is a factual determination, and have applied a more deferential standard. [ FN: See Steelcase Inc. v. Johnston (In re Johnston) , 21 F.3d 323, 327 (9th Cir. 1993) (reaffirming 9^th Circuit rule that "substantially similarity " is finding of fact, reviewable for clear error only); In re U.S. Truck Co. , 800 F.2d 581 (6th Cir. 1986) (distinction between claims was finding of fact); Hanson v. First Bank of South Dakota, N.A. , 828 F.2d 1310, 1313 (8th Cir. 1987) (denial of classification motion not clearly erroneous) .] This has exacerbated the inconsistent results.

The 9^th Circuit upheld the disparate treatment of unsecured creditors on the basis that they were not substantially similar: in Steelcase v. Johnston, Johnston’s plan provided monthly installments equaling payment in full for most general unsecured creditors while creditor Steelcase would receive lump sum full repayment in the event that Steelcase was victorious in its pending litigation with Johnston. [ FN: 21 F.3d 323 (9th Cir. 1993). Steelcase also claimed that its separate classification was unfair discrimination treatment under section 1129(b) . The court held that there were reasonable and non-discriminatory reasons for the separate treatment. Id. , at 328.] Over Steelcase's continuing objections, the 9^th Circuit upheld the bankruptcy court's finding that Steelcase’s claim could be classified and treated differently. Steelcase’s claim was found to be "situated differently" than the general unsecured creditors for several reasons: 1) The litigation still was ongoing and would determine Steelcase’s treatment under the plan; 2) Steelcase was partially secured in the assets of another chapter 11 debtor in which Johnson was the chief executive officer and the majority stockholder; 3) it was highly likely that Steelcase would get paid before the other general unsecured claims, and therefore the court believed that Steelcase had little grounds to complain. [ FN: Id. , at 328.] These aforementioned factors afforded Steelcase a "different status" than the claimants in other classes. [ FN: Id. ; but see In re AOV Ind. Inc. , 792 F.2d 1140 (D. C. Cir. 1985) (existence of co-debtor does not change "nature " of creditor ’s claim). "It is the ‘nature ’ of their claims being classified that is significant, not the nature of other claims or interests a creditor might have. " Id. , at 1151.] The 9^th Circuit reviewed the bankruptcy court’s conclusion regarding the substantial similarity of claims for clear error only.

Adopting the reasoning of a previous bankruptcy court opinion, the 7^th Circuit held in Woodbrook that a deficiency claim, which had acquired recourse status solely through the mechanism of the section 1111(b) election, had to be classified separately from other general unsecured creditors. [ FN: In re Woodbrook Assocs. , 19 F.3d 312, 318 (7th Cir. 1994), citing In re SM 104 Ltd. , 160 B.R. 202, 218 (Bankr. S.D. Fla. 1993). But see Norwest Bank Worthington v. Ahlers , 108 S. Ct. 963, 968 (1988) ( "Code provides that undersecured creditors can vote in the class of unsecured creditors " ); see also In re D&W Realty Corp 164 B.R. 127 (S.D.N.Y. 1994) (deficiency claims are substantially similar to general unsecured claims) , rev ’g 156 B.R. 140, 141 (Bankr. S.D.N.Y. 1993) .] "Significant disparities do exist between the legal rights of the holder of a section 1111(b) claim and the holder of a general unsecured claim which render the two claims not substantially similar and which preclude the two from being classified together under section 1122(a)." [ FN: In re Woodbrook Assocs. , 19 F.3d 312, 318 (7th Cir. 1994); but cf. In re Lumber Exchange Building Ltd. Partnership) , 968 F.2d 647, 649 (8th Cir. 1992) ( how claim attains its status does not alter its legal character).] The holding in Woodbrook runs counter to the majority of other circuit courts which have folded unsecured debt from 1111(b) elections into classes of general unsecured debt. The case did not "permit" a plan proponent to classify such debt separately; it required separate classification. In one sense, the Woodbrook court used a conservative standard and yet reached what some commentators might find to be the most permissive outcome by mandating separate classification in the single asset cases that have engendered the greatest criticism. Woodbrook is a reminder that any classification standard might generate litigation.

The 7^th Circuit took a principled approach by determining simply that the claims were not substantially similar. Other cases, however, imply that claims may be "substantially similar" and still be sufficiently distinct in nature to warrant, but not mandate, separate classification at the proponent’s discretion. For example, in U.S. Truck, the debtor sought to segregate the Teamsters’ claim, which was the product of the debtor’s rejection of the collective bargaining agreement. [ FN: In re U.S. Truck Co. , 800 F.2d 581 (6th Cir. 1986).] The plan provided the same treatment for the unions and the other unsecured creditors. [ FN: In re U.S.Truck Co. , 47 B.R. 932, 938 (E.D. Mich. 1985), aff ’d , 800 F.2d 581 (6th Cir. 1986).] Citing the broad discretion afforded to courts in classification matters, [ FN: "[W]e do find one common theme in the prior case law that Congress incorporated into section 1122. In those pre-Code cases, the lower courts were given broad discretion to determine proper classification according to the factual circumstances of each individual case. " Id. , at 813, citing Anderson, "Classification of Claims and Interests in Reorganization Cases Under the New Bankruptcy Code, " 58 Am. Bankr. L. J. 99, 107 (1984).] the Court of Appeals for the 6^th Circuit upheld the classification:

The Teamsters Committee has a different stake in the future viability of the reorganized company and has alternative means at its disposal for protecting its claim. The Teamsters Committee’s claim is connected with the collective bargaining process. In the words of the Committee’s counsel, the union employeeshave a "virtually unique interest." [citation omitted] These differences put the Teamsters Committee in a different posture than the Class XI claims. The Teamsters Committee may choose to reject the plan not because the plan is less than optimal to it as a creditor, but because the Teamsters Committee has a noncreditor interest -- e.g., rejection will benefit its members in the ongoing employment relationship . . . to allow the Committee to vote with the other impaired creditors would be to allow it to prevent a court from considering confirmation of a plan that a significant group of creditors with similar interests have accepted. [ FN: Id. , at 587. See In re Bjolmes Realty Trust , 134 B.R. 1000, 1003 (Bankr. D. Mass. 1991) ( "The potential held by the FDIC ’s claim for a difference in legal rank with the trade debt is therefore an indication of very real difference in these debts "); In re Gato Realty Trust Corp , 183 B.R. 15 (Bankr. D. Mass. 1995) (same).]

By relying on indirect factors, the court did not have to assess the debtor’s own admission that it separately classified the Teamster’s claim from the other unsecured claims to ensure that it had an impaired assenting class. [ FN: The court claimed, however, that it was concerned about "the potential for abuse " in discretionary classification. In re U.S. Truck Co. , 800 F.2d 581, 587 (6th Cir. 1986).]

Some courts have offered even less explicit justification for their findings of reasonableness. The 3^rd Circuit upheld separate classification on the basis of reasonableness when it affirmed the confirmation of a public municipal hospital’s plan. [ FN: In re Jersey City Medical Center , 817 F.2d 1055 (3d Cir. 1987). Chapter 9 plans are subject to section 1122 by virtue of 11 U.S.C. §901(a).] The plan separately classified physicians holding indemnity claims (who would receive 100% of their claims), pre-petition medical malpractice claimants, non-priority employee benefit claims, and general creditors. The latter three classes each would receive 30% of their claims, although all creditors retained their rights to recover from municipal third parties. After stating that similar claims may be placed in different classes if the classification is "reasonable," [ FN: Id. , at 1060, 1061.] the court concluded:

We immediately note the reasonableness of distinguishing the claims of physicians, medical malpractice victims, employee benefit plan participants, and trade creditors. We additionally recall that JCMC’s unsecured creditors overwhelmingly favored the plan. This fact commends the plan’s classification scheme, at least insofar as it affects Finch.[citations omitted] Further, we find nothing to show arbitrariness toward Finch as a member of ‘Class Five’; indeed, the general unsecured creditors’ committee points out in his brief that both ‘Class Five’ and ‘Class Four’ ultimately will receive 30% of their claims on the effective date of theplan. [ FN: Id. , at 1061.]

Later building on Jersey City Medical Center, the 3^rd Circuit reasoned that a classification determination "must be informed by the two purposes that classification serves under the Code: voting to determine whether a plan can be confirmed [citations omitted] and treatment of claims under the plan . . . In a ‘cramdown’ case, to this means that each class must represent a voting interest that is sufficiently distinct and weighty to merit a separate voice." [ FN: John Hancock Mutual Life Ins. Co. v. Rt. 37 Business Park Assoc. , 987 F.2d 154 (3d Cir. 1993) (deficiency claim does not warrant "separate voice ").]

In a case coming out of the 5^th Circuit, Heartland Federal Savings and Loan v. Briscoe Enterprises, a low-income-housing complex, classified the deficiency claims of each of its undersecured mortgagees, Heartland and the city of Fort Worth, separately from the general unsecured creditors. [ FN: In re Briscoe Enterprises, Ltd.,II , 994 F.2d 1160 (5th Cir.), cert. denied , 114 S. Ct. 550 (1993).] The plan provided the same treatment to these three classes of unsecured claims. While it emphasized the "narrowness of this holding," the Court of Appeals reversed the district court and affirmed the bankruptcy court’s confirmation of the plan on a clear error standard. [ FN: Id.] The court found that Fort Worth had a unique, distinct "non-creditor" interest in the low income housing debtor and provided $20,000 in monthly rental assistance for the tenants. [ FN: Id. , at 1167. While this seems to be a legal dissimilarity argument, the court characterized it as a business justification distinction.] Moreover, Heartland could nominate one of three trustees for the property and thus had means to protect its interest. Fort Worth’s different interest in the outcome of the case and the fact that Heartland was protected adequately were sufficient to support the bankruptcy judge’s holding that separate classification was permissible.

Permitting Any Separate Classification of Similar Claims

Some courts have interpreted the lack of explicit prohibition in section 1122(a) to mean that the provision does not preclude separate classification of similar claims and that alternative chapter 11 provisions address the fairness concerns raised by other courts. The Court of Appeals for the D.C. Circuit has held that the plain language of section 1122 "does not require that similar claims must be grouped together, but merely that any group created must be homogenous." [ FN: Barnes v. Whelan , 689 F.2d 193, 201 (D.C. Cir. 1982) (sections 1122(a) and 1322(b)(1) did not preclude debtor from separately classifying co-signed debts, but treatment under plan unfairly discriminated), citing 5 Collier on Bankruptcy ¶ 1122.03(1)(b) at 1122-6 (15th ed. 1982), In re Gay , 3 B.R. 336 (Bankr. D. Colo. 1980), and In re Kovich , 4 B.R. 403 (Bankr. W.D. Mich. 1980). While the D.C. Circuit made this pronouncement in the context of a chapter 13 case, its statement is relevant because section 1322(b)(1) specifically incorporates section 1122 by reference. See 11 U.S.C. §1322(b)(1), and additional discussion in this proposal, p. 4, n. 11.] TheD.C. Circuit retracted slightly from this position, albeit in dictum, in a later case when it "note[d] in passing that, while there is no restriction on the total number of classifications, logistics and fairness dictate consolidation rather than proliferation of classes, so long as they are internally homogenous." [ FN: In re AOV Ind. Inc. , 792 F.2d 1140, 1150 (D.C. Cir. 1986) (upholding single classification of all unsecured creditors against challenge by creditor with third-party guarantor that sought separate classification for its claim), citing Scherk v. Newton , 152 F.2d 747, 751 (10th Cir. 1945).]

After it analyzed the appropriate means of statutory interpretation, a bankruptcy court in Oklahoma also determined that section 1122 does not preclude separate classification of similar claims under a plain meaning analysis of the provision and that such an interpretation was consistent with other provisions of the Bankruptcy Code. [ FN: In re ZRM-Oklahoma Partnership , 156 B.R. 67, 70 (Bankr. W.D. Okl. 1993). "Congress chose to grant the debtor this capability and it is not for the courts to eliminate it . . . Whether Congress has wisely balanced the conflicting interests at play here is not a question the judiciary is competent to decide. " Id , at 71. Accord , In re Huckabee Auto Co. , 33 B.R. 132, 137 (Bankr. M.D. Ga. 1981) (overruling claimant ’s objection on basis that Bankruptcy Code does not require plan to classify similar claims together, but denying confirmation on other grounds); In re Rochem, Ltd. , 58 B.R. 641, 642 (Bankr. D.N.J. 1985) (upholding separate classification of tort creditor from trade creditors and law firm because Code does not require substantially similar claims to be classified together).] The court also was confident that other mechanisms in the Bankruptcy Code adequately curtail gerrymandering, i.e. the section 1129(b) unfair discrimination prohibition, the good faith requirement of section 1129(a)(3), the section 1129(a)(7) best interest test, and the section 1111(b) recourse election. [ FN: In re ZRM-Oklahoma Partnership , 156 B.R. 67, 70 (Bankr. W.D. Okl. 1993); In re Rochem, Ltd. , 58 B.R. 641 642 (considering unfair discrimination), citing In re Ratledge , 31 B.R. 897 (E.D. Tenn. 1983). Accord , B.M. Brite v. Sun Country Development Inc. (In re Sun Country Development Inc.) , 764 F.2d 406, 408 (5th Cir. 1985) (plan that changed unsecured creditors ’ status due to insufficient cash flow was proposed in good faith).]

In a chapter 9 case, another court was persuaded by this analysis. [ FN: City of Colorado Springs , 187 B.R. 683 (Bankr. D. Col. 1995).] In overruling the objection of a class of bond claims to their separate classification and disparate treatment as compared to other bond claims, the court ruled that section 1122 does not require that similar claims be classified together and that "issues of gerrymandering can and should be addressed as part of the "unfair discrimination analysis" of § 1129(b)." [ FN: Id. , at 689; see In re Holywell Corp. , 913 F.2d 873, 880 (11th Cir. 1990) (separately classifying and subordinating unsecured claim of insider was unfair discrimination).] The court was not convinced by the primary arguments advanced in the line of cases on separate classification issues:

Unfortunately, the narrow concern that classification of similar claims not be used to gerrymander voting has blossomed into a line of authority in which plan proponents routinely are required to justify separate classification of similar claims or such classification is forbidden regardless of whether gerrymandering is an issue. In short, judicial interpretation of § 1122(a) to avoid gerrymandering has resulted in a rewriting of the section. [ FN: Id. , at 688.]

Thus, in accordance with a "plain meaning" interpretation of the statute, several courts have refused to infer a restriction on separate classification that does not appear in the Bankruptcy Code and instead have relied on the unfair discrimination provision in section 1129(b) to protect dissenting classes of creditors.

Prohibiting Separate Classification of Similar Claims

Some courts have taken the position that substantially similar claims must be classified together. [ FN: See Granada Wines Inc. v. New England Teamsters and Trucking Ind. Pension Fund , 748 F.2d 42 (1st Cir. 1984); see also In re Mastercraft Record Plating Inc. , 32 B.R. 106, 108 (Bankr. S.D.N.Y. 1983) ( "There is no authority for classifying similar claims differently other than §1122(b) just discussed. General unsecured claims are all alike, whether they are disputed or not, whether over or under $20,000"), rev ’d on other grounds , 39 B.R. 654 (S.D.N.Y. 1984); In re S&W Enterprises , 37 B.R. 153, 158 (Bankr. N.D. Ill. 1984) (disallowing debtor ’s attempt to separate three general unsecured claims into two classes and treat classes differently if debtor unable to prove applicability of section 1122(b)), citing 3 Norton Bankr. L. & Prac., §63.06 (1981).] Even among the courts that have embraced this position, similar outcomes are not guaranteed because these courts do not agree on the definition of "substantially similar." [ FN: Cf. Granada Wines , 748 F.2d 42, 47 (1st Cir. 1984) (claims of same "nature " with respect to the estate, determined by repayment priority, are substantially similar) with In re Bloomingdale Partners , 170 B.R. 984, 997 (Bankr. N.D. Ill. 1994) (suggesting that unsecured claims are not necessarily substantially similar to each other), citing In re Woodbrook Assocs. , 19 F.3d 312, 318 (7th Cir. 1994) ( "Similarity is not a precise relationship, and the elements by which we judge similarity or resemblance shift from time to time in bankruptcy . . . [it] is necessarily a case-by-case determination "). Not all courts agree with the assumption in Granada Wines that pension fund withdrawal liability claims are substantially similar to general unsecured claims. See In re the Mason & Dixon Lines Inc. , 63 B.R. 176 (Bankr. M.D.N. Car. 1986)(pension fund withdrawal liability claims are not substantially similar to general unsecured claims and cannot be classified together). The court in Mason & Dixon Lines stated that Granada Wines was not controlling because it "neither discussed nor recognized the repeal of former 11 U.S.C. §597 or the enactment of 11 U.S.C. §§1122 and 1123. " Id. , at 181.] At confirmation, the debtor in Granada Wines requested separate classification of a pension fund claim. Relying on pre-Code case law, legislative history, and chapter X of the Bankruptcy Act, the Court of Appeals for the 1^st Circuit held that "[t]he general rule regarding classification is that ‘all creditors of equal rank with claims against the same property should be placed in the same class.’ [citation omitted] Separate classifications for unsecured creditors are only justified‘where the legal character of their claims is such as to accord them a status different from the other unsecured creditors,’" [ FN: Granada Wines , 748 F.2d at 47, quoting In re Los Angeles Land and Investments, Ltd. , 282 F. Supp. 448, 453 (D. Haw. 1968), aff ’d , 447 F.2d 1366 (9th Cir. 1971), and citing Scherk v. Newton , 152 F.2d 747 (10th Cir. 1945). But see In re LeBlanc , 622 F.2d 872, 878 (5th Cir. 1980) ( "The fact that bankruptcy courts are courts of equity, however, allows exceptions to any strict rules of classification of claims. A bankruptcy court can permit discrimination when the facts of the case justify it "). The plan proponent in Granada requested separate classification at the confirmation hearing and not in the plan itself, so some might consider the Granada court ’s brief analysis to be dictum.] While the debtor attempted to prove that the withdrawal liability claim was legally distinct from the other general unsecured claims, the court concluded that the debtor’s reliance on certain provisions of the Multiemployer Pension Plan Amendment Act was misplaced.

Although the bankruptcy court decision in Bloomingdale Partners cited Granada Wines with approval, [ FN: See , e.g. , In re Bloomingdale Partners , 170 B.R. 984 (Bankr. N.D. Ill. 1994). "Section 1122(a) provides that claims that are not "substantially similar " must be classified separately. It is logical to apply this Code-based test in a correlative manner to fill the void left by the amorphous "reasonableness " and "gerrymandering " standards. " Id. , at 996- 997.] it diverged markedly in that the court contemplated that a plan proponent could show the lack of substantial similarity by articulating differences among the claims. [ FN: Id. , at 997.] This conceivably is a more lenient standard than that proffered in Granada Wines, which deemed claims to be substantially similar if they were of equal rank. [ FN: Granada Wines , 748 F.2d at 46, citing In re Los Angeles Land and Investments, Ltd. , 282 F. Supp. 448, 453 (D. Haw. 1968), aff ’d , 447 F.2d 1366 (9th Cir. 1971).]

Summary of the Case Law

As the preceding discussion illustrates, the ambiguity of section 1122(a) has yielded a wide range of results. Courts have employed theoretically disparate approaches, and in attempts to establish some guiding principles, courts have imputed a variety of requirements into section 1122(a) analysis, many of which already exist in other sections of chapter 11.

Reasons Underlying the Proposal

Certainty

The first salutary consequence of the Working Group's recommendation is that it would provide certainty to what is presently an uncertain area of the law. The conflicts in the case law between circuits, and even within the circuits, on the appropriate classification standards yield unpredictability in the plan negotiation process, which results in much needless litigation. A clear and uniform rule would improve the plan negotiation and confirmation process.

Business Flexibility

The Working Group favored a proposal that would afford plan proponents flexibility to structure a plan of reorganization to meet the business needs of the parties in interest and to facilitate the reorganization of the debtor, while creditors’ interests receive appropriate protection. The Working Group concluded that a requirement that all unsecured claims be classified together needlessly constrains the rehabilitative process and unnecessarily restricts the bargaining latitude of a plan proponent in light of the variety of valid reasons that might justify separate classification. [ FN: Because business flexibility is the guiding force in this proposal, this proposal does not address the extent to which a creditor has an entitlement to separate classification beyond what section 1122 already provides, i.e., when a substantially similar claim must be classified separately.] Moreover, to permit unsecured claims to be classified separately only upon a determination that a claim has a "distinct nature," when the proponent has no business reason for separate classification, perpetuates a vague and questionable standard that wastes the courts’ time and resources.

Under this proposal, a proponent differentially could treat claims with the same liquidation priority if the proponent could establish a rational business justification. This proposal, in essence, contemplates use of the LTV test rather than the U.S. Truck test. Using this standard, and consistent with most circuit case law, a court could not uphold a classification scheme where the only benefit to the proponent would be the creation of an assenting class for voting purposes.

There are a number of instances in which a plan proponent might request separate classification and disparate treatment of creditors for business purposes. Among the examples:

A company failed to make required retirement plan contributions in the months before bankruptcy. Concerned about the negative impact on the work force, the company proposes to pay the retirement arrearage in excess of the wage priority claims in cash at plan confirmation. Other commercial debt holders would be paid in full over four years with market interest.

A creditor group plans to take over a business that is in bankruptcy and wants to keep thesuppliers that currently are doing business with the company. In its plan, the group proposes to pay 50% of the trade debt over 90 days, and to pay a similar percentage of the bank debt, with interest, over two years.

A creditor advocates a plan in which a substantial proportion of the creditors would receive stock as part of their payout to prevent the business from being strapped for cash. Some of its creditors prefer to receive stock or are willing to accept either cash or stock. Legal restrictions may prevent certain creditors, such as government agencies, from taking stock. Other creditors, such as individuals, may not be in an economic position to receive repayment in stock. The creditor’s plan might propose two groups: a cash payment group and a stock-and-cash payment group.

A business depends upon a unique supplier. The plan calls for 50% payment to unsecured creditors, but this supplier won't ship its goods unless it is paid 100%. For the survival of the business, the plan separately classifies the critical creditor and proposes different payment for the other unsecured creditors.

A business intends to pay all unsecured creditors 50%. The small trade creditors cannot afford to wait for repayment and the debtor wants to maintain business relations with these creditors, so the plan proposes to pay them 50% in cash at confirmation. The large bank creditors would receive 50% over three years at prevailing market interest rates.

As the preceding examples demonstrate, separate classification based on a rational business justification gives the plan proponent--the debtor or the creditor--the flexibility to propose a plan that responds to the business needs of the entity.

Plan Confirmation

A proponent’s ability or inability to classify claims separately can have a significant influence on a plan proponent's likelihood of success in confirmation. A class is deemed to have accepted a plan if two-thirds in dollar amount and one-half in number of creditors that have voted have cast affirmative votes. [ FN: 11 U.S.C. §1126(c).] To the extent that all unsecured debt must be classified together, a single disgruntled creditor with a large claim can dominate the plan process and may force liquidation of a company even if many of the unsecured creditors support reorganization. On the other hand, if the debtor had an unfettered right to classify similar claims separately, it could construct classes to increase the likelihood of plan confirmation over the strong objections of a number of creditors.

Yet, because creditors can challenge classification prior to the plan confirmation stage, [ FN: See , e.g. , Fed. R. Bankr. P. 3013.] explicitly requiring a "rational business justification" would invalidate classification that does nothing except create an assenting impaired class for purposes of voting. It mandates a focus onthe business reasons for the plan, which many believe is the appropriate focus for discussion and evaluation of chapter 11 plans. It also would limit the amorphous and tangential consideration of the "nature" of claims.

Giving the plan proponent some flexibility in plan classification rather than requiring automatic single classification and similar treatment of all unsecured non-priority debt may facilitate the confirmation of some chapter 11 plans that might not be feasible without the flexibility to structure a workable business plan that involves differential treatment. It also might limit the veto power of a single creditor whose claim otherwise would dominate an unsecured class -- if the plan proponent had a legitimate reason for the separate classification. [ FN: This would be consistent with much of the circuit case law. See , e.g ., In re Boston Post Road Ltd. Partnership , 21 F.3d 477, 481 (2d Cir. 1994), cert. denied , 115 S. Ct. 897 (1995); John Hancock Mutual Life Ins. Co. v. Route 37 Business Park Assoc. , 987 F.2d 154 (3d Cir. 1993); In re Lumber Exchange Building Ltd. Partnership. , 968 F.2d 647 (8th Cir. 1992).]

Reduced Potential for Litigation

When the preliminary version of this proposal was presented to the Commission in June, the proposal carried an additional feature: a broader application of the "unfair discrimination" standard that would be available to any objecting creditor and not limited only to creditors in a dissenting class. After the Commission questioned whether this would increase litigation in chapter 11 cases and give hold-outs increased power by threatening to litigate in consensual plans, the Working Group amended the proposal to minimize these possibilities. By leaving the section 1129(b) "unfair discrimination" standard undisturbed, a creditor in a dissenting class in a cramdown plan, but not a dissenting creditor in a consensual plan, would be able to object to its treatment on this basis. No single creditor would have the opportunity to object to classification and treatment that were acceptable to a majority of its class, so hold-out litigation over these points would terminate. In essence, class voting would govern and trigger the objections available to the hold-out creditor: only if a class dissented and the plan proponent persisted with a cramdown plan would the section 1129(b) "unfair discrimination" standard be applicable. This additional creditor protection would be available only in cramdown plans, where it is most needed.

Thus, the proposal in its current form preserves the flexibility a plan proponent sometimes needs to establish a workable reorganization plan while it limits needless litigation. To reiterate, if a plan proponent wanted to classify two creditor groups with similar legal rights (e.g., two groups of non-priority unsecured creditors), the "rational business justification" test would govern the validity of the classification and could be challenged during the course of the case as the rules permit. If the classification scheme met this test, and if the plan proponent offered a plan that was accepted by the majority of creditors in each class and that met all the other requirements of section 1129(a), the plan would be confirmed. If, however, a class voted against the plan and the proponent sought cramdown, a creditor also could raise a section 1129(b)(1) "unfairdiscrimination" claim based on the differential treatment of the classes. [ FN: Relatively few large chapter 11 cases are confirmed through cramdown due to the complexity and expense entailed in valuation proceedings. However, the rules that apply to cramdown have a profound impact on the allocation of bargaining power and leverage of parties in out-of-court negotiations for consensual plans.]

Of course, there will be some litigation of what constitutes an adequate "business justification." However, the rule would not be implemented on a clean slate. As the case law discussion in earlier pages of this proposal illustrated, many courts already are familiar with interpreting "business justification" in the context of claims classification disputes, and the existing case law could provide some guidance for this determination. While this test makes the proponent’s judgment a factor which might become a subject of court review, the prescribed business-oriented approach to section 1122 capitalizes on the very nature of the expertise of the bankruptcy courts and properly focuses the inquiry. Moreover, most courts have agreed that this would be a factual inquiry, reviewable for clear error only, and therefore would not unduly burden the appellate process. The Commission might recommend this as the appropriate standard in its report.

In any event, while the application of this rule would prompt some litigation, the same could be said for the alternative clarifications that could be made to section 1122. If the Commission proposed that section 1122 should preclude separate classification of legally similar claims, parties would litigate even more frequently the question of what claims are "legally similar." Cases such as those cited in the "Nature of Claim" section of this proposal illustrate that this type of litigation already has yielded conflicting results. Is legal similarity defined by bankruptcy law? by state law? [ FN: Some courts have argued that bankruptcy law determinations of the nature and priority of claims against the estate supersede many state law differences; while the state law characterization of claims is of primary relevance in other parts of the Code, see Butner v. United States , 99 S. Ct. 914 (1979), the Code has eradicated some of such legal distinctions in the chapter 11 context. See , e.g. 11 U.S.C. §1111(b); In re Greystone III Joint Venture , 995 F.2d 1274, 1279 (5th Cir. 1991) (section 1111(b) would be rendered meaningless if state law characterizations of claims were upheld), cert. denied , 113 S. Ct. 72 (1992); see also Hanson v. First Bank of South Dakota, N.A. , 828 F.2d 1310 (8th Cir. 1987).] by any and all non-bankruptcy law? Already, the circuits disagree about whether trade debt is "legally similar" to debt that becomes recourse unsecured debt by operation of section 1111(b). [ FN: Cf. In re Woodbrook Assocs. , 19 F.3d 312, 317 (7th Cir. 1994) with In re Greystone III Joint Venture , 995 F.2d 1274 (5th Cir. 1991), cert. denied , 113 S. Ct. 72 (1992).]

Under a "legally similar" standard, courts also may reach conflicting conclusions on whether nominally secured creditors, who realistically have no effective security, are "legally similar" to completely unsecured creditors. Parties also might litigate whether special state law collection rights given only to certain types of claimants, such as consumer protection laws, make their claims "legally dissimilar" to bank debt. These types of questions already have been the subject of conflicting interpretation; most likely, the disparities would be exacerbated if the natureof the claim became the paramount inquiry.

The test used to control separate classification also may have an impact on the delay and cost of the appellate process. The business justification test is fact-based, which means that cases decided under this standard should be subject to the clearly erroneous standard of review. [ FN: See In re Chateaugay Corp., Reomar Inc., LTV Corp. , 89 F.3d 942, 950 (2d Cir. 1996) ( "no reason to suppose that proffered business reasons were legitimate was clearly erroneous "); In re Greystone III Joint Venture , 995 F.2d 1274, 1281, n. 7 (5th Cir. 1991), cert. denied , 113 S. Ct. 72 (1992) ( "Whether there were any good business reasons to support the debtor ’s separate classification of claims is a question of fact "); Bustop Shelters of Louisville Inc. v. Classic Homes Inc. , 914 F.2d 810, 812 (6th Cir. 1990) (lower courts have broad discretion to determine proper classification according to factual circumstances , reviewable for clear error only).] The legal similarity test, by contrast, has been treated by most courts as a question of law to be reviewed de novo. [ FN: See In re Greystone III Joint Venture , 995 F.2d 1274, 1281, n.7 (5th Cir. 1991) ( "Issues such as the similarity in priority and legal attributes and the ultimate question whether treatment in the same or separate classes is necessary, are legal issues reviewable by our court de novo "), cert. denied , 113 S. Ct. 72 (1992); In re Woodbrook Assoc. , 19 F.3d 312, 317 (7th Cir. 1994); In re Lumber Exchange Building Ltd Partnership , 968 F.2d 647, 649 (8th Cir. 1992); In re Bryson Properties, XVIII , 961 F.2d 496, 502 (4th Cir.), cert. denied , 113 S. Ct. 191 (1992); but see In re Johnston , 21 F.3d 323, 327 (9th Cir. 1993) (reaffirming 9th Circuit rule that bankruptcy court ’s finding of substantial similarity is finding of fact, reviewable for clear error only); see In re U.S. Truck, Co. , 800 F.2d 581 (6th Cir. 1986) (distinctions between claims was finding of fact reviewable for clear error only); Hanson v. First Bank of South Dakota, N.A. , 828 F.2d 1310, 1313 (8th Cir. 1987) (denial of motion for classification not clearly erroneous); In re Bloomingdale Partners , 170 B.R. 984, 997 (Bankr. N.D. Ill. 1994) (whether claims are substantially similar is "single finding of fact ").] The opportunity to appeal the legal similarity standard would be greater as litigants could ask the district courts and courts of appeals to review the full records of classification decisions from the bankruptcy courts.

The Working Group favored the "business justification" test not only because it will minimize the amorphous legal similarity test litigation, but because it more properly focuses the inquiry on the business needs of the reorganizing company rather than concentrating on the legal attributes of a few creditors. The Working Group also believed that the mechanisms already available in confirmation proceedings in sections 1129(a) and (b) afford ample protection to creditors. Ideally, the proposal would minimize litigation to an irreducible core, but when parties did litigate the issue of classification, the court’s time and energies would be utilized more productively because they would be focused on the business plan of the entity.

Competing Considerations

In light of the current state of confusion in the case law, plan proponents currently lack adequate guidance for permissible classification, which yields litigation and delay. However, the fact that clarification would be helpful does not support the approach of the Working Group per se. The confusion also could be diminished to a certain extent by flat prohibition of separateclassification of substantially similar claims or by express validation of discretionary classification of similar claims.

The rational business justification standard would enable plan proponents to determine what would be necessary to attain a workable plan of reorganization, and thus could be perceived as favoring reorganization. While the Working Group concluded that facilitating the reorganization process is an appropriate goal of the chapter 11 process, not everyone might agree.

This proposal would minimize the significance of a substantial body of case law regarding the "uniqueness" or "nature" of certain claims. Some might prefer that similar claims be classified separately based on the need to have a distinct voice in the reorganization process. However, under the proposal, courts still would be able to determine whether claims are "substantially similar" in the first instance. The proposal merely prevents the utilization of intermediate and amorphous standards of similarity, e.g., "substantially similar but sufficiently distinct." Moreover, the "nature"/"uniqueness" test in its various formulations has permitted more gerrymandering because it has not required that the proponent treat the classes differently; as the case law indicates, often the most obvious reason that a proponent would separate certain claims based on their "unique natures" is to maximize the likelihood of a favorable outcome in the voting process. [ FN: See In re U.S. Truck Co. , 800 F.2d 581 (6th Cir. 1986); In re Briscoe Enterprises, Ltd.,II , 994 F.2d 1160 (5th Cir.), cert. denied , 114 S. Ct. 550 (1993).]

Yet, some might be concerned that this proposal, which makes separate treatment a prerequisite to separate classification, would encourage plan proponents to discriminate among creditors. The Working Group was comfortable knowing that an unhappy creditor could object on the basis of "rational business justification," and, in cramdown, the "no unfair discrimination" test would further protect its interests. The additional tests imposed by some courts already are available to creditors via other chapter 11 provisions and do not need to be imported into section 1122. Yet, some observers might find these mechanisms to be insufficient. Some may believe that the prescribed level of discretion should not be left in the hands of the courts, although many courts would have less latitude under this proposal than they do under the present ambiguous law.

Finally, the scope of this recommendation merits additional attention, and it is important to note what this proposal does not resolve. This proposal is aimed primarily at chapter 11 cases of large businesses. Disparate treatment might be warranted in larger business cases due to factorsincluding standard business practices and course of dealing with trade creditors, labor relations issues, and increased availability of different types of payment (i.e. classes of stock). Small businesses may or may not have as much business need for separate classification. This proposal would have implications in single asset real estate and limited partnership cases as well. If other devices were in place to control abuses in single asset and small business cases, the proposed recommendation may be helpful and may shift litigation to other issues that better reflect what is at stake in those cases.

Because this proposal focuses on the classification of claims that concededly are "legally similar," it does not re-define the boundaries of that term. The proposal was not designed to resolve the inter- and intra-circuit disputes on legal/substantial similarity that have significant implications for debtors’ abilities to structure their plans. Thus, although it should be minimized, there might be some lingering litigation over whether claims are legally similar and thus eligible for classification in a single group.