Ninth Circuit Finally Rules on Separate Classification of Deficiency Claims

In the winter 1996 issue of this report, Terry J. Allen discussed the Barakat case pending with the Ninth Circuit Court of Appeals. On November 12, 1996, the Ninth Circuit issued its decision: At first blush, a resounding victory for undersecured creditors in single-asset Chapter 11 cases. In Barakat, the Ninth Circuit affirmed the decisions of both the bankruptcy court and the district court and held that absent a legitimate business or economic justification, a Chapter 11 debtor may not classify an undersecured creditor's deficiency claim separately from general unsecured claims if the purpose was solely to create an impaired consenting class for confirmation purposes. (The Ninth Circuit also held that the debtor may not classify trade creditors' unsecured claims separately from general unsecured claims.) As a result of these classification rulings, the debtor's Plan in Barakat could not be confirmed since it lacked an impaired accepting class as required under Section 1129(a)(10) of the Bankruptcy Code. The Court provided no explanation of what facts might satisfy the "economic justification" test, or how an economic justification might differ from a "business justification" — if at all.

The Ninth Circuit's ruling in Barakat will make it more difficult for Chapter 11 debtors, in general, to confirm a Plan over the objections of an undersecured creditor whose deficiency claim constitutes at least one-third of all unsecured claims, and therefore either controls or blocks the vote of its class. However, creative debtor's counsel will undoubtedly resort to other means to satisfy the requirement for at least one impaired consenting class.

Remember: So long as the debtor is not employing separate classification to gerrymander an impaired consenting class, the Barakat decision will not apply. So, a debtor may still create one or more separate classes of impaired secured claims (if there are multiple secured creditors) and give one impaired secured creditor favorable treatment on its secured claim to obtain that creditor's favorable vote. Thus, secured leases on the debtor's office fax or copying machine are viable candidates for separate classification. Also possible, as the battleground expands, is the attempted separate classification of claims secured by liens on a second asset acquired by the debtor on the eve of filing bankruptcy.