Debtor Has Right to File Bankruptcy to Limit Landlord's Claims

However, a creditor's right to vote on a plan is also limited. If a creditor's claim is capped by application of a statute or reduced by court order, such claim is not “impaired” for plan voting purposes if the debtor is solvent and proposes to pay its creditors in full under a plan.

Therefore, a company can file bankruptcy to limit a creditor's claim and prevent such creditor from voting on its proposed treatment under a plan. Such a strategy has been recently confirmed by the Third Circuit in In re PPI Enterprises (U.S.), Inc., 324 F.3d 197 (3rd Cir. 2003). The court addressed the ability of a debtor to file bankruptcy to limit a landlord's rejection damage claim and prevent the landlord from voting on the debtor's plan when it proposed to pay the capped claim in full. Recognizing that the reduction in the landlord's claim amount is a function of section 502(b)(6) and not the plan, the court upheld the determination that the landlord's claim was not impaired and thus not entitled to vote. The court also upheld the rule that any security deposit (whether or not posted in the form of a letter of credit) must be used to reduce the allowed, capped claim, and not to the uncapped claim. Lastly, the court recognized that filing for bankruptcy to take advantage of the section 502(b)(6) cap is not “bad faith”.

The Facts

PPI Enterprises, Inc. Leased premises from landlord Sheldon Solow for its corporate headquarters. The Lease had a 10-year term with annual rental payments of $620,000 for the first 5 years and $650,000 for the remaining 5 years. PPI obtained a letter of credit for the benefit of Solow as a security deposit under the Lease.

Well before the bankruptcy filing, PPI abandoned the premises and ceased paying rent under the Lease. Solow drew on the letter of credit and applied the proceeds to the rental obligations under the Lease. Solow commenced a state court action, and before the trial on damages was ever held, PPI filed its Chapter 11 petition. Solow moved to dismiss PPI's Chapter 11 petition on the grounds of bad faith. His dismissal motion was denied. PPI's Plan proposed to pay Solow's capped claim in full. Although there were no impaired classes under the Plan, PPI solicited votes to accept or reject the Plan. Only two Class 2 ballots were returned – one “yes” vote and Solow's “no” vote. Solow claimed that because there was no “majority” of accepting votes, Class 2 rejected the Plan. Because the Third Circuit held that Solow's claim was not impaired and, thus, not entitled to vote, the court does not address the ramifications of the debtor having actually solicited votes and failing to obtain a “majority” (ie, more than 50%) in acceptance. Solow renewed his dismissal motion, alleging his claim was improperly classified as “unimpaired” and his vote to reject the Plan should be counted. The Bankruptcy Court held that: 1) Solow's capped claim under section 502(b)(6) should be reduced by the letter of credit proceeds; 2) the bankruptcy was filed in good faith; and 3) as an “unimpaired creditor,” Solow was deemed to have accepted the Plan. Both the District Court and the Third Circuit affirmed on appeal.

Impairment

Under section 1124(1), “a class of claims or interests is impaired under a plan unless, with respect to each claim or interest of such class, the plan leaves unaltered the legal, equitable, and contractual rights to which such claim or interest entitles the holder of such claim or interest.” 11 U.S.C. ' 1124(1). When determining whether a claim is “impaired” so a creditor is entitled to vote on a plan, courts must look to the source of impairment. Importantly, where the alteration of legal rights is a consequence of the bankruptcy filing, and not the terms of the Chapter 11 plan itself, there is no impairment under section 1124(1).

In PPI, Solow asserted the application of section 502(b)(6) rendered his claim impaired and therefore his vote to reject the plan should be counted. The Third Circuit adopted the Bankruptcy Court's reasoning that Solow “confuse[d] two distinct concepts: 1) plan impairment, under which the debtor alters the 'legal, equitable, and contractual rights to which [the] claim entitles the holder of such claim,' and 2) statutory impairment, under which the operation of a provision of the Code alters the amount that the creditor is entitled to under nonbankruptcy law.” PPI Enterprises, 228 B.R. at 353.

The Bankruptcy Court, and the Third Circuit, relied upon the decision in In re American Solar King Corp., 90 B.R. 808, 819-22 (Bankr. W.D.Tex. 1988), where the court found that although the operation of section 510(b) altered creditors' claims, the reduction in the creditors' potential, nonbankruptcy recovery did not result in impairment. In Solar King, the court found that “[i]mpairment results from what the plan does, not what the statute does. A plan which 'leaves unaltered' the legal rights of a claimant is one which, by definition, does not impair the creditor. A plan which leaves a claimant subject to other applicable provisions of the Bankruptcy Code does no more to alter a claimant's legal rights than does a plan which leaves a claimant vulnerable to a given state's usury laws or to federal environmental laws. The Bankruptcy Code itself is a statute that, like other statutes, helps to define the legal rights of persons, just as surely as it limits contractual rights. Any alteration of legal rights is a consequence not of the plan but of the bankruptcy filing itself.” Solar King, 90 B.R. at 819-21. The court aptly noted that, because the Bankruptcy Code limited the landlord's damage claim, PPI could not propose a Plan that departed from the section 502(b)(6) limitation. (Solow also asserted that the repeal of section 1124(3) as a separate exception to the presumption of impairment supports a finding that his claim is not impaired. The repealed section 1124(3) provided that a class of claims is impaired unless the plan provides the holder of such claim cash equal to the allowed amount of such claim. 11 U.S.C. ' 1124(3) (repealed). The court rejected this argument finding that sections 1124(1) and 1124(3) were different exceptions to the presumption of impairment, and the repeal of one does not affect the other.)

The court in PPI ultimately found that because Solow is only entitled to his “legal, equitable, and contractual rights,” as they now exist, to wit, his rights under the Bankruptcy Code and, thus, subject to the section 502(b)(6) cap, the Plan provided him with his full “legal entitlement” and “full and complete satisfaction” of his claim on the Plan effective date. The fact that Solow might have received considerably more if he had recovered on his claim before PPI filed bankruptcy was irrelevant. Because the Bankruptcy Code, and not the Plan, was the only source of limitation on Solow's claim, his claim was not impaired under section 1124(1). Solow also argued that his capped claim should not be reduced by the amount of the security deposit since the security was posted by a letter of credit from a third party (ie, the issuing bank) and not given to him directly by the tenant. The court found that the letter of credit was indeed intended to be treated as a security deposit and, thus, the proceeds should be deducted from the landlord's capped rejection damage claim.

Filing to Take Advantage of Lease Damage Cap Was Not Bad Faith

The final issue decided by the court in PPI was whether PPI's bankruptcy petition was filed in “bad faith”. Under section 1112(b), a court may dismiss a Chapter 11 for “cause” if a petition is filed in “bad faith.” 11 U.S.C. ' 1112(b). The court, in denying the dismissal motion, found that it was not “bad faith” for PPI to file its bankruptcy petition to avail itself of certain Bankruptcy Code provisions. PPI Enters., 228 B.R. at 345. Although the Bankruptcy Court found “the primary purpose of the petition was to cap Solow's claim pursuant to ' 502(b)(6) … [it was] not a use of the Code for a purpose for which it was not intended – indeed, PPI[E][was] using ' 502(b)(6) for exactly its intended purpose … PPI[E]'s filing does not violate the good faith filing doctrine.” Id. The Third Circuit affirmed the Bankruptcy Court's ruling.

Conclusion

The decision in PPI affirms that a solvent debtor may utilize the Bankruptcy Code to limit its creditors' claims and prevent such creditors from voting under a plan. As a result, solvent companies with liabilities resulting from disputed claims limited by the Bankruptcy Code can take advantage of a bankruptcy fling by having an expedited trial on damages (as opposed to waiting over 4 years as in PPI), limit its creditor's claim (either by court order or direct application of the statue), and, as long as the debtor proposes to pay the reduced claim in full under a plan, prevent the creditor from rejecting the plan. It is a powerful tool for otherwise solvent companies to reduce claims.

Adam C. Rogoff is a partner in the financial restructuring department of Cadwalader, Wickersham & Taft, where he concentrates on complex transactional, litigation and advisory work relating to retail restructurings, commercial finance, Chapter 11 bankruptcies, workouts and “prepackaged” Chapter 11 matters. Deborah Piazza, an associate in the department, assisted in the preparation of this article.

One of the fundamental policies of the Bankruptcy Code is to provide an equal distribution to all creditors of a debtor's estate. There are a variety of tools under the Bankruptcy Code to accomplish these goals. One such power is the statutory limitation of a landlord's rejection damage claim under section 502(b)(6). This “cap” is predicated on the desire to prevent excessive rejection damage claims from diluting the distribution to other unsecured creditors, as well as the recognition that landlords – by obtaining repossession of their property – stand in a better position than other creditors to mitigate their damages over time.

Although creditors have various protections throughout the bankruptcy process, they are vulnerable to the application of Bankruptcy Code provisions limiting their claim. As a result, companies with certain types of claims may file bankruptcy solely to take advantage of these claim-limiting provisions. Examples of such provisions include executive compensation claims limited under section 502(b)(7), certain tax liability claims limited under section 502(b)(3) and 502(b)(8), landlord rejection damage claims under section 502(b)(6), and claims resulting from securities litigation limited through subordination under section 510(b).

Another strong bankruptcy policy gives creditors whose claims and rights are “impaired” under a plan the right to vote to accept or reject such plan, thereby allowing creditors to “accept” or “reject” what the debtor proposes to give them. If enough impaired creditors reject a plan, the debtor either needs to proceed with a “cram-down” plan or pursue an alternative one.

However, a creditor's right to vote on a plan is also limited. If a creditor's claim is capped by application of a statute or reduced by court order, such claim is not “impaired” for plan voting purposes if the debtor is solvent and proposes to pay its creditors in full under a plan.

Therefore, a company can file bankruptcy to limit a creditor's claim and prevent such creditor from voting on its proposed treatment under a plan. Such a strategy has been recently confirmed by the Third Circuit in In re PPI Enterprises (U.S.), Inc., 324 F.3d 197 (3rd Cir. 2003). The court addressed the ability of a debtor to file bankruptcy to limit a landlord's rejection damage claim and prevent the landlord from voting on the debtor's plan when it proposed to pay the capped claim in full. Recognizing that the reduction in the landlord's claim amount is a function of section 502(b)(6) and not the plan, the court upheld the determination that the landlord's claim was not impaired and thus not entitled to vote. The court also upheld the rule that any security deposit (whether or not posted in the form of a letter of credit) must be used to reduce the allowed, capped claim, and not to the uncapped claim. Lastly, the court recognized that filing for bankruptcy to take advantage of the section 502(b)(6) cap is not “bad faith”.

The Facts

PPI Enterprises, Inc. Leased premises from landlord Sheldon Solow for its corporate headquarters. The Lease had a 10-year term with annual rental payments of $620,000 for the first 5 years and $650,000 for the remaining 5 years. PPI obtained a letter of credit for the benefit of Solow as a security deposit under the Lease.

Well before the bankruptcy filing, PPI abandoned the premises and ceased paying rent under the Lease. Solow drew on the letter of credit and applied the proceeds to the rental obligations under the Lease. Solow commenced a state court action, and before the trial on damages was ever held, PPI filed its Chapter 11 petition. Solow moved to dismiss PPI's Chapter 11 petition on the grounds of bad faith. His dismissal motion was denied. PPI's Plan proposed to pay Solow's capped claim in full. Although there were no impaired classes under the Plan, PPI solicited votes to accept or reject the Plan. Only two Class 2 ballots were returned – one “yes” vote and Solow's “no” vote. Solow claimed that because there was no “majority” of accepting votes, Class 2 rejected the Plan. Because the Third Circuit held that Solow's claim was not impaired and, thus, not entitled to vote, the court does not address the ramifications of the debtor having actually solicited votes and failing to obtain a “majority” (ie, more than 50%) in acceptance. Solow renewed his dismissal motion, alleging his claim was improperly classified as “unimpaired” and his vote to reject the Plan should be counted. The Bankruptcy Court held that: 1) Solow's capped claim under section 502(b)(6) should be reduced by the letter of credit proceeds; 2) the bankruptcy was filed in good faith; and 3) as an “unimpaired creditor,” Solow was deemed to have accepted the Plan. Both the District Court and the Third Circuit affirmed on appeal.

Impairment

Under section 1124(1), “a class of claims or interests is impaired under a plan unless, with respect to each claim or interest of such class, the plan leaves unaltered the legal, equitable, and contractual rights to which such claim or interest entitles the holder of such claim or interest.” 11 U.S.C. ' 1124(1). When determining whether a claim is “impaired” so a creditor is entitled to vote on a plan, courts must look to the source of impairment. Importantly, where the alteration of legal rights is a consequence of the bankruptcy filing, and not the terms of the Chapter 11 plan itself, there is no impairment under section 1124(1).

In PPI, Solow asserted the application of section 502(b)(6) rendered his claim impaired and therefore his vote to reject the plan should be counted. The Third Circuit adopted the Bankruptcy Court's reasoning that Solow “confuse[d] two distinct concepts: 1) plan impairment, under which the debtor alters the 'legal, equitable, and contractual rights to which [the] claim entitles the holder of such claim,' and 2) statutory impairment, under which the operation of a provision of the Code alters the amount that the creditor is entitled to under nonbankruptcy law.” PPI Enterprises, 228 B.R. at 353.

The Bankruptcy Court, and the Third Circuit, relied upon the decision in In re American Solar King Corp., 90 B.R. 808, 819-22 (Bankr. W.D.Tex. 1988), where the court found that although the operation of section 510(b) altered creditors' claims, the reduction in the creditors' potential, nonbankruptcy recovery did not result in impairment. In Solar King, the court found that “[i]mpairment results from what the plan does, not what the statute does. A plan which 'leaves unaltered' the legal rights of a claimant is one which, by definition, does not impair the creditor. A plan which leaves a claimant subject to other applicable provisions of the Bankruptcy Code does no more to alter a claimant's legal rights than does a plan which leaves a claimant vulnerable to a given state's usury laws or to federal environmental laws. The Bankruptcy Code itself is a statute that, like other statutes, helps to define the legal rights of persons, just as surely as it limits contractual rights. Any alteration of legal rights is a consequence not of the plan but of the bankruptcy filing itself.” Solar King, 90 B.R. at 819-21. The court aptly noted that, because the Bankruptcy Code limited the landlord's damage claim, PPI could not propose a Plan that departed from the section 502(b)(6) limitation. (Solow also asserted that the repeal of section 1124(3) as a separate exception to the presumption of impairment supports a finding that his claim is not impaired. The repealed section 1124(3) provided that a class of claims is impaired unless the plan provides the holder of such claim cash equal to the allowed amount of such claim. 11 U.S.C. ' 1124(3) (repealed). The court rejected this argument finding that sections 1124(1) and 1124(3) were different exceptions to the presumption of impairment, and the repeal of one does not affect the other.)

The court in PPI ultimately found that because Solow is only entitled to his “legal, equitable, and contractual rights,” as they now exist, to wit, his rights under the Bankruptcy Code and, thus, subject to the section 502(b)(6) cap, the Plan provided him with his full “legal entitlement” and “full and complete satisfaction” of his claim on the Plan effective date. The fact that Solow might have received considerably more if he had recovered on his claim before PPI filed bankruptcy was irrelevant. Because the Bankruptcy Code, and not the Plan, was the only source of limitation on Solow's claim, his claim was not impaired under section 1124(1). Solow also argued that his capped claim should not be reduced by the amount of the security deposit since the security was posted by a letter of credit from a third party (ie, the issuing bank) and not given to him directly by the tenant. The court found that the letter of credit was indeed intended to be treated as a security deposit and, thus, the proceeds should be deducted from the landlord's capped rejection damage claim.

Filing to Take Advantage of Lease Damage Cap Was Not Bad Faith

The final issue decided by the court in PPI was whether PPI's bankruptcy petition was filed in “bad faith”. Under section 1112(b), a court may dismiss a Chapter 11 for “cause” if a petition is filed in “bad faith.” 11 U.S.C. ' 1112(b). The court, in denying the dismissal motion, found that it was not “bad faith” for PPI to file its bankruptcy petition to avail itself of certain Bankruptcy Code provisions. PPI Enters., 228 B.R. at 345. Although the Bankruptcy Court found “the primary purpose of the petition was to cap Solow's claim pursuant to ' 502(b)(6) … [it was] not a use of the Code for a purpose for which it was not intended – indeed, PPI[E][was] using ' 502(b)(6) for exactly its intended purpose … PPI[E]'s filing does not violate the good faith filing doctrine.” Id. The Third Circuit affirmed the Bankruptcy Court's ruling.

Conclusion

The decision in PPI affirms that a solvent debtor may utilize the Bankruptcy Code to limit its creditors' claims and prevent such creditors from voting under a plan. As a result, solvent companies with liabilities resulting from disputed claims limited by the Bankruptcy Code can take advantage of a bankruptcy fling by having an expedited trial on damages (as opposed to waiting over 4 years as in PPI), limit its creditor's claim (either by court order or direct application of the statue), and, as long as the debtor proposes to pay the reduced claim in full under a plan, prevent the creditor from rejecting the plan. It is a powerful tool for otherwise solvent companies to reduce claims.

Adam C. Rogoff is a partner in the financial restructuring department of Cadwalader, Wickersham & Taft, where he concentrates on complex transactional, litigation and advisory work relating to retail restructurings, commercial finance, Chapter 11 bankruptcies, workouts and “prepackaged” Chapter 11 matters. Deborah Piazza, an associate in the department, assisted in the preparation of this article.