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How bankruptcy restructures debt

steiner-eric-s-col-sig“Restructure debt” describes what bankruptcy can do and is one of the primary benefits of Chapter 13 and Chapter 11 bankruptcy.

The Bankruptcy Code contains several provisions that form the framework to allow for debt restructuring.  11 U.S.C. § 507 prioritizes debt into domestic support obligations, administrative expenses such as attorneys’ and other professionals’ fees, unpaid wages, certain taxes, and various other categories. This prioritization scheme provides for payment of certain debts over others.

In Chapter 13, arrears on secured debt and priority tax claims must be paid within the three- to five-year plan, while general unsecured debt can be paid as little as nothing. In contrast, a Chapter 11 plan can group classes of claims together to receive the same treatment provided that the claims are “substantially similar,” and secured claims can be grouped into their own classes to be paid over longer periods of time with lower interest than contractually provided for.

11 U.S.C. § 506 provides one of the statutory authorities to restructure secured debt in Chapter 11 and Chapter 13. This provision allows the debtor to lower a secured claim to the value of the secured creditor’s collateral.

If the value of a secured creditor’s claim is more than the value of its collateral, as long as the collateral is not the debtor’s principal residence, the claim is split into a secured claim up to the value of the collateral, and an unsecured claim for the rest. Interest can also generally be lowered to prime plus 1 percent on the new principal balance, and the term of the loan can be extended.

If a debtor obtained a hard-money loan for $3 million with 14 percent interest payable six months from the date of the loan to purchase property now worth $2 million, the principal can be lowered to $2 million, the interest reduced to prime plus 1 percent, and the loan term may be extended.

11 U.S.C. § 506 also allows a debtor to “strip” a wholly unsecured lien, thus converting a secured claim into an unsecured claim.  In the previous example, if there was a second lien on the property for $1 million and third and fourth liens, because the third and fourth liens are wholly unsecured, they can be restructured as unsecured debt.

 ‘Cram down’ a plan

While Chapter 13 allows limited restructuring of secured debt and easier restructuring of unsecured debt, Chapter 11 also allows a debtor to “cram down” a plan over the objection of certain classes of creditors as long as one impaired class votes in favor of the plan pursuant to 11 U.S.C. § 1129.

A cram-down Chapter 11 plan can be confirmed if the plan does “not discriminate unfairly” and is “fair and equitable” with respect to a dissenting class of creditors.

To be fair and equitable for secured creditors, a plan must provide (1) that the secured creditor retain its lien and that the secured creditor receive deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property; or (2) that the property is sold free and clear of all liens but that the lien attaches to the proceeds of the sale, or (3) that the secured creditor receive the indubitable equivalent of its claim.

Deferred cash payments effectively allow debtors to rewrite loans with an extended maturity date and lower interest rate. The indubitable equivalent standard has been defined by the 4th Circuit that “the treatment afforded the secured creditor must be adequate to both compensate the secured creditor for the value of its secured claim, and also insure the integrity of the creditor’s collateral position.” In re Bate Land & Timber LLC, 877 F.3d 188 (4th Cir. 2017).

A Chapter 11 plan is considered fair and equitable if (1) the unsecured creditor receives the full amount of its claim on the effective date of the plan – usually 30 days after confirmation; or (2) all junior classes, including equity holders of the debtor, do not retain or receive anything under the plan.  This requirement is generally referred to as the “absolute priority rule.”

If the equity holders wish to retain their interest in the reorganized debtor, they can inject new value into the reorganized debtor. The specific contours cramming down a plan are complex, and the bankruptcy code strives to balance the interests of debtors and creditors.

The ability to alter secured debt by lowering principal, interest and adjusting loan terms make Chapter 11 and Chapter 13 powerful tools for restructuring debt. Chapter 11 also can force dissenting classes of creditors to accept a plan allowing debtors to emerge from bankruptcy leaner and profitable.

Eric S. Steiner is the managing member of Steiner Law Group, LLC in Baltimore and primarily practices in the areas of commercial and consumer bankruptcy, and commercial litigation.