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Third Circuit Affirms Confirmation of Plan with Reasonable Classification Scheme and Secured Creditor’s Right to Vote Subordinated Debt

In re Coastal Broadcasting Sys., Inc., 2014 WL 2808260 (3d Cir. June 23, 2014)

On June 23, 2014, the Third Circuit Court of Appeals issued an Opinion affirming the Delaware District Court’s decision to affirm confirmation of a chapter 11 plan of reorganization.  In doing so, the Court upheld the enforceability of a voting assignment in a subordination agreement that arose from a pre-petition out-of-court restructuring.

Prior to its bankruptcy filing, Coastal Broadcasting Systems, Inc. (“Coastal”) effectuated an out-of-court restructuring whereby the company redeemed the shares of two shareholders (the “Appellants”) in exchange for a $1.7 million promissory note.  In addition, Coastal’s existing secured creditor, Sturdy Savings Bank (“Sturdy”), provided it additional loans.  As part of the restructuring, Coastal, Appellants, and Sturdy signed a Subordination and Intercreditor Agreement (the “Agreement”) pursuant to which Appellants’ promissory notes were subordinated to Sturdy’s debt.  The Agreement permitted Sturdy to, among other things, vote the subordinated debt in connection with any future reorganization of Coastal.  Coastal was unable to service its debt following the out-of-court restructuring, failed to obtain a forbearance or other relief from its lenders, and ultimately faced a lawsuit in which the Appellants sought recovery of the monies owed to them.  In January 2011, Coastal filed for bankruptcy protection under chapter 11 of the Bankruptcy Code.

Coastal’s proposed plan of reorganization included five different classes of claims, including, but not limited to: (i) Class 1, comprised of Sturdy as a secured creditor; (ii) Class 3, comprised of all other general unsecured creditors; and (iii) Class 4, comprised of the Appellants and other former shareholders.  The disclosure statement provided that Class 3 claims would share pro rata in a $100,000 distribution and Class 4 claims would receive nothing per the Agreement.  Class 3 (the only class deemed impaired by Coastal) voted in favor of the proposed plan.  Sturdy stated that it would vote in favor of the proposed plan on behalf of the Class 4 claims.  Appellants objected to confirmation based on classification and feasibility.  More specifically, Appellants argued that their claims were impaired (entitling them to vote), that they were improperly classified in a separate class from other unsecured creditors, and that the plan was not feasible under 11 U.S.C. § 1129(a)(1).  Moreover, Appellants argued that their voting rights were not, in fact, assigned to Sturdy because the Agreement only applied to liquidations.

At the confirmation hearing, the Bankruptcy Court concluded that while the Appellants’ claims were properly classified, the proposed plan improperly designated the claims as unimpaired.  Notwithstanding, the Court confirmed the plan because it determined Sturdy was entitled to and, indeed, voted for confirmation on behalf of the Class 4 claims pursuant to the rights afforded to it by the Agreement.  On appeal, the District Court affirmed the decision of the Bankruptcy Court.

Giving plenary review to the District Court’s decision, the Third Circuit affirmed.  Construing the Agreement under New Jersey law, the Court upheld the enforceability of the voting assignment in the Agreement, noting that it specifically permitted Sturdy to vote the Appellants’ debt if there was a reorganization of Coastal.  Regarding the classification objection, the Court recognized that “‘the grouping of similar claims in different classes’ is permitted so long as the classification is ‘reasonable.’”  Here, because Appellants’ claims were uniquely subject to the Agreement, the Court held that there was nothing unreasonable about placing Appellants in a separate class from other unsecured creditors.  The Court also observed, however, that since Sturdy was allowed to vote Appellants’ debt, any error in the Class 4 classification scheme was harmless as Sturdy would have voted in favor of the plan on behalf of Class 4.  With respect to the feasibility objection, the Third Circuit noted that the Bankruptcy Court determined Coastal’s income to be sufficient.  Despite the Appellants’ argument that Coastal had a low monthly profit margin, the Third Circuit found no indication that the Bankruptcy Court’s feasibility determination was clearly erroneous.