Raghu writes:
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As the WSJ article I linked to explains, the "first lien priority" of secured
creditors is not as absolute as you seem to suggest. The Obama plan was simply
asking the dissident hedge funds to accept the returns they would get under
bankruptcy law without actually forcing a declaration of bankruptcy. The hedge
funds are forcing a potentially risky bankruptcy out of sheer bloody-mindedness.
I am sure you are much more knowledgeable about this being a bankruptcy lawyer,
but maybe you can comment on the following excerpt from the article:
The absolute priority rule is regularly modified in bankruptcy court, said
Richard Hahn, co-chairman of the bankruptcy practice at Debevoise & Plimpton
LLP, a New York law firm that isnt involved in the Chrysler negotiations. Two-
thirds of the lenders can force the holdouts to go along with them in a
procedure called a cram-down.
Cram-Down
The U.S. bankruptcy code foresees the possibility that it may be necessary to
vary from absolute priority, in particular when a two-thirds majority is
convinced it makes legal or business sense, Hahn said. If the government has
consents from 70 percent, thats more than enough to give equity to junior
creditors.
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The very technical (and greatly simplified) answer is as follows:
The Bankruptcy Code presumptively assumes compliance with the "absolute
priority" rule, which means a junior class cannot receive anything under a plan
unless and until a senior class is paid in full. This is the rule in chapter 7
liquidations. However, the point of chapter 11 reorganization is to negotiate
a consensual plan, and the Code does not require compliance with the absolute
priority rule so long creditors vote in favor of the plan. Because plans are
voted on by classes, and a class is deemed to vote in favor if 2/3 in amount
and 1/2 in number vote in favor, the Code prevents a few holdouts from
preventing a modification that the majority would prefer (this is usually most
relevant to bondholders). Therefore, if a senior class votes in favor of plan
that permits a junior class to receive value under the plan, that is ok under
the Bankruptcy Code.
As a sidenote, the reference to "cramdown" in the article is incorrect.
"Cramdown" does not refer to situations where a minority of the class is
against the plan, but instead refers to situations where one or more classes of
creditors votes against the plan. In that circumstance, the Bankruptcy Code
provides a set of rules that allows confirmation of the plan even though there
is a dissenting class. Very difficult to do and the "absolute priority" rules
comes back into play in a significant way. Chrysler is NOT proposing a
cramdown plan.
However, the absolute priority rule (which can be negated by the majority of a
class voting yes), is entirely distinct from the requirement that a creditor
must receive under a plan at least what the creditor would receive in a chapter
7 liquidation. The latter right is an individual right of each creditor and
can be asserted by the creditor even if the class in which the creditor is a
member votes to accept the plan.
To distinguish the absolute priority rule from the liquidation rule, assume a
situation where the Debtor proposes a plan in which creditors will receive 50
cents on the dollar and the existing shareholders retain 100% of the equity in
the company. Such a plan on its face violates the absolute priority rule
because a junior class (the old equity) is receiving value without the senior
class (the creditors) being paid in full. However, if the class of creditors
votes in favor, the violation of the absolute priority rule is negated by the
class acceptance. However, even if the class votes in favor, the Debtor must
still establish that each creditor will receive at least as much under the plan
as the creditor would receive in a liquidation where the absolute priority rule
applied. If creditors would receive more than 50 cents on the dollar in a
liquidation, the plan cannot be confirmed. On the other hand, if the Debtor
can establish (through appraisal and expert testimony) that in the event of a
liquidation the creditors would receive 50 cents on the dollar or less, the
plan is confirmable.
David Shemano
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