A landmark decision in a Texas case has strengthened lenders' ability to negotiate during Chapter 11 reorganizations.

It has been a long time since lenders - laboring under increasing regulatory pressure - could view any judicial development as favorably.

The federal court decision in the Greystone III Joint Venture case could significantly reduce real estate loan losses. And by capping these losses and freeing up additional capital, it could also open new loan opportunities for real estate investors.

The Greystone decision could benefit lenders across the board, on interest rates as well as loss ratios.

Debtors Lose Some Control

The case was decided by the U.S. Court of Appeals for the Fifth Circuit and recently upheld on a motion for rehearing.

It appellate decision reversed rulings that permitted the debtor to manipulate and control the classification of creditors - and thereby the voting process.

The decision will make it more difficult for a debtor to "cram down" a plan of reorganization over objections of creditors.

Greystone, the debtor, had borrowed $8.8 million from Phoenix Mutual Life Insurance Co. to purchase an office building in Austin. The property was the only significant asset of the debtor.

In 1989, after Greystone defaulted on the note, Phoenix began foreclosure proceedings. Greystone sought Chapter 11 protection.

At the time of the filing, Greystone owed trade creditors $10,000, taxing authorities over $100,000, and Phoenix approximately $9.35 million.

The court valued the office building, which secured the Phoenix loan, at the appraised value of $5.83 million, leaving Phoenix with an unsecured deficiency claim of approximately $3.5 million.

Divide-and-Conquer Strategy

Greystone's plan of reorganization split the unsecured creditors into two groups: trade creditors and Phoenix. The plan called for the debtor to invest $500,000 as equity in the reorganized entity and to pay in full the $10,000 in trade debts.

The debtor also classified tenants under leases assumed by the debtor as an "impaired class of creditors," in an attempt to garner further support for the plan.

Under the proposal, Phoenix would have suffered significant losses. The trade creditors and tenants approved the plan, over the vigorous objections of Phoenix.

The Bankruptcy Code provides that any class of impaired creditors can force approval of a plan of reorganization. By splitting its creditors, Greystone was able to "cram down" the reorganization over Phoenix's objections.

Key Points of Appeal

Phoenix appealed to the U.S. District Court for the Western District of Texas, which affirmed the Bankruptcy Court's decision.

Phoenix then turned to the U.S. Court of Appeals for the Fifth Circuit, arguing that:

* There was no validity to splitting the unsecured Phoenix claim from other unsecured creditors.

* The "new value exception" to the absolute priority rule was not permissible under the Bankruptcy Code.

* Tenants under leases assumed by the debtor were not an impaired class of creditors for determining acceptance of the "cram down" plan of reorganization.

Powerhouse Punch for Lenders

The Court of Appeals agreed with Phoenix, holding that a debtor "may not classify similar claims differently in order to gerrymander an affirmative vote on a reorganization plan." The court affirmed its position in denying the debtor's request for rehearing.

This ruling, unless overturned on the anticipated appeal to the Supreme Court, packs a power-house punch for lenders' rights.

It is going to restrict the debtors' ability to gerrymander creditors' votes in order to force the adoption of contested plans to the unjust detriment of lenders. It represents a significant shift, in the lenders' favor, in the "balance of leverage" in Chapter 11 cases.

Of course, the best method of solving these issues is to recognize and address financial difficulties early on. By working together, lenders and debtors should be able to safely sidestep the costs and complexities of playing out scenarios like Greystone's.

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