Opinion
Case No. 95-11924-AM (Jointly Administered), Case No. 95-11893-AM
April 12, 1996
Kevin M. O'Donnell, Esquire, McKinley, Schmidtlein, O'Donnell Bornmann, P.L.C., Alexandria, VA, counsel for the debtor
Karen S. Elliott, Esquire, McSweeney, Burtch Crump, P.C., Richmond, VA, counsel for Fannie Mae
Kermit A. Rosenberg, Esquire, Holmes Rosenberg Doherty, P.C., Arlington, VA, counsel for Myron Erkiletian
Linda L. Najjoum, Esquire, Hunton Williams, Fairfax, VA, counsel for Crestar Bank
MEMORANDUM OPINION
This matter is before the court on confirmation of the "Fourth Amended Joint Plan of Reorganization" dated March 11, 1996, proposed by Colonial Associates Limited Partnership. Objections to confirmation have been filed by The Federal National Mortgage Association ("Fannie Mae") and by the chapter 11 trustee. An evidentiary hearing was held on March 11, 19, 20, and 22, 1996, after which the court took the matter under advisement. For the reasons stated in this memorandum opinion, which constitutes the court's findings of fact and conclusions of law under F.R.Bankr.P. 7052, confirmation of the plan must be denied.
Although entitled a "joint" plan of reorganization, the adjective is a misnomer. The debtor in this case, Colonial Associates Limited Partnership, is one of thirteen real estate partnerships or limited liability companies ("the DeLuca entities") owned or controlled by real estate developers Robert and Marilyn DeLuca, who themselves filed a voluntary petition under chapter 11 of the Bankruptcy Code in this court on May 5, 1995. At or around the time of their personal filing, the DeLucas caused the various DeLuca entities also to file chapter 11 petitions in this court. An order for joint administration of the DeLucas' own case with the cases of the DeLuca entities was entered early in the proceeding before it became apparent that each of the DeLuca entities was separate and distinct in terms of its assets and debt structure. In any event, the DeLucas and ten of the DeLuca entities chose to file what are in effect eleven different plans contained in a single document identified as a "joint" plan. The plan has previously been confirmed as to two of the DeLuca entities and has been withdrawn as to five others. As will be become apparent in the discussion of the plan provisions, the treatment of claims in this case is unrelated to the treatment of claims in any other case, and the plan stands or falls on its own merits without regard to what happens in the other cases.
Fannie Mae filed a competing plan of reorganization, but after the court ruled that the plan improperly classified the claim of Crestar Bank, Fannie Mae withdrew its plan. An objection to confirmation was filed by Myron Erkiletian but was withdrawn at the confirmation hearing after the debtor agreed to amend the plan to address his and Crestar Bank's concerns. The chapter 11 trustee did not participate in the confirmation hearing.
Because confirmation is being denied on feasibility grounds, ordinarily there would be no need to discuss at length the other grounds urged by Fannie Mae in opposition to confirmation. Since there is always a possibility that the debtor may seek to modify its plan, however, the court believes that some discussion is warranted with respect to the other issues.
Facts
Colonial Associates, Limited Partnership ("the debtor" or "the partnership") is a Virginia limited partnership whose sole asset is a 100-unit apartment complex known as the Country Club Apartments, located in York County, Virginia, just outside Williamsburg. The project was originally built in 1971 and consists of 25 buildings, each with four units. It was purchased by the debtor in 1988 with the assistance of a $2,500,000 loan from Green Park Financial, secured by a first deed of trust against the property. The note was assigned to and is now held by Fannie Mae, and the current principal balance is $2,427,853.26.
The general partners of the debtor are Robert and Marilyn DeLuca, who are also limited partners. Their aggregate partnership interest is 35%. Other members of their family are limited partners with aggregate interests of 16%. Myron Erkiletian ("Erkiletian") owns a 10% limited partnership interest. The Erkiletian Family Trust and several individuals related to or sponsored by Erkiletian are the remaining limited partners, with a total interest of 39%. Erkiletian, himself a developer, acquired his interest on July 16, 1992, after he was approached by Robert DeLuca, who was anxious to raise some cash. Erkiletian is not related by blood or marriage to the DeLucas nor was he previously involved in any business venture with the DeLucas or the debtor. As the transaction was ultimately structured, Erkiletian paid $500,000 to various of the existing limited partners to acquire a total 49% limited partnership interest and in addition agreed to loan $250,000 to the partnership. The $250,000 was immediately used, with Erkiletian's consent, to pay off various loans to the partnership by the DeLucas or their related entities. The $250,000 loan was evidenced by a written promissory note dated July 16, 1992, repayable in monthly installments of interest only at 8.5% and due in full December 31, 1995. To fund the entire transaction, Erkiletian used $150,000 of his own money and borrowed $600,000 from Crestar Bank at an interest rate of prime plus one percent, repayable in monthly installments of interest only and due in full December 31, 1995.
As noted above, only 10% is directly owned by Erkiletian individually, and the other 39% by persons or entities he brought to the table. For convenience, the entire 49% will be referred to as the Erkiletian interest.
As collateral for the Crestar $600,000 loan, Erkiletian endorsed and assigned to Crestar the $250,000 note from the debtor and also assigned to Crestar his limited partnership interest. Under an amendment to the limited partnership agreement made contemporaneously with Erkiletian's purchase of his limited partnership interest, the interest payments on the $250,000 note were made directly to Crestar by the partnership. Additionally, the amended limited partnership agreement provided that the debtor would "fond" the full monthly interest payment to Crestar on the $600,000 loan and that Erkiletian would be entitled to "priority" partnership distributions of $500,000, to be paid ahead of distributions to any other partner, for the purpose of paying the principal of the Crestar note. Neither the $600,000 Crestar note nor the $250,000 note assigned by Erkiletian to Crestar was paid when it matured, but the debtor continued to pay Crestar the interest on the $600,000 note through June 1995. Erkiletian testified that his involvement in the partnership's affairs has been solely as a passive investor and that he has not participated in any way in the management of its business.
In 1994 and early 1995, the DeLucas moved large sums of money in and out of the debtor, essentially shuffling cash back and forth among their various enterprises in an effort to keep them afloat. During that time, the debtor was late in paying the Fannie Mae note on a number of occasions and failed to make the payments for March, April, and May, 1995. Fannie Mae moved in state court for the appointment of a receiver, and the debtor responded by filing a chapter 11 petition in this court on May 8, 1995.
During the one year period prior to the filing, a total of $338,700 was paid out of the partnership to the DeLucas or to DeLucas-related entities, and $379,125 was paid from the DeLucas or their entities to the debtor. Focusing on the period from February 1, 1995 until the date of filing, $89,900 was paid out to related parties, and $112,600 was paid in.
Initially, the debtor remained in possession of its estate. Management of the Country Club Apartments was performed, as it had been pre-petition, by American Property Services, Inc. ("APS"), a company wholly-owned by the DeLucas. In response to vocal creditor complaints related to the DeLucas' management of the various DeLuca entities, the debtor itself, in an effort to defuse the controversy, moved for the appointment of a chapter 11 trustee. The court granted During the one year period prior to the filing, a total of $338,700 was paid out of the partnership to the DeLucas or to DeLucas-related entities, and $379,125 was paid from the DeLucas or their entities to the debtor. Focusing on the period from February 1, 1995 until the date of filing, $89,900 was paid out to related parties, and $112,600 was paid in. the motion with respect to ten of the DeLuca entities, including Colonial Associates Limited Partnership. Stanley M. Salus was appointed as chapter 11 trustee on June 27, 1995, and is currently serving in that capacity.
For approximately a month, the chapter 11 trustee continued to use APS as the property manager, but on September 1, 1995, he replaced APS with Habitat America, Inc. ("Habitat"), which currently manages the property. During the period the chapter 11 trustee has been operating the property, the income has not been sufficient to allow the payment of the full amount of the Fannie Mae debt service, even though the cash collateral budgets reflected that sufficient cash would be available for such purpose.
There is a separate motion before the court for allowance of the missed payments as a priority administrative expense under § 507(b), Bankruptcy Code. The court expresses no view at this time as to the merits of that motion.
For the purposes of the confirmation hearing, it was stipulated that the value of the Country Club Apartments was $2,600,000.00, the value placed on it as of February 22, 1996, by an appraiser, Jay B. Call, III, engaged by Fannie Mae. Fannie Mac's pre-petition claim, which the debtor does not dispute, is $2,550,108.17. Fannie Mae also claims post-petition interest and legal fees of $413,212.51. The debtor, without conceding that all of the claimed charges are allowable, agrees that Fannie Mac's secured claim is $2,600,000.00
At the confirmation hearing, extensive evidence was presented concerning the current market rate of interest for a loan secured by an apartment project of the type represented by Country Club Apartments and what rate of return a typical equity investor would require before investing in such a project. The court found that a market exists for an 80% loan-to-value ratio loan on such a project at an interest rate of 7.8% and a 25-year amortization. The court also found that a typical investor would require a 14% rate of return on an investment in the amount of the remaining 20% of the value of the project. Based on that evidence, the court found that a hypothetical "blended" market rate of interest on a 100% loan-to-value ratio loan for property of this type was 9%.
Extensive evidence was also presented concerning the amount of deferred maintenance at the Country Club Apartments, the cost and timing of needed repairs and replacements, and the expected level of operating expenses. The debtor, for the purpose of its cash flow projections, assumed the need for $100,000 in capital improvements over a two year period. It estimated that operating expenses (including a reserve for replacements) would be $306,780 in the first year, increasing by 3% annually. The Call appraisal estimated a need for $50,000 in immediate capital improvements and operating expenses on a stabilized basis of $344,324, which included an increased allowance for maintenance expenses to account for the age of appliances and the expected need for replacements. A budget prepared by Habitat for the chapter 11 trustee estimated annual operating expenses in the first year of $347,878 plus $136,780 in necessary capital improvements during that same period. Douglas A. Gardner, a professional engineer hired by Fannie Mae, after surveying the physical condition of the buildings and appliances, estimated that $196,875 of repairs and replacements would be needed in the first year, with an additional $256,108 over the next four years. Finally, James Brent Clarke, III, an experienced property manager who served as a trouble-shooter to Erkiletian, estimated that, assuming the deferred maintenance had been corrected, the reasonable operating expenses for the project would be $313,960 in the first year. Estimates of first-year net operating income ranged from a low of $274,242 (Call) to a high of $327,074 (Clarke). This compares with an average net operating income, in the three years prior to the chapter 11 filing, of $260,593. Since reconciliation of these widely disparate and conflicting estimates is central to the issue of the plan's feasibility, they will be discussed in more detail below in connection with that issue.
Conclusions of Law and Discussion
Confirmation of a plan of reorganization in a chapter 11 case is governed by § 1129, Bankruptcy Code. If every impaired class of claims votes to accept the plan by the requisite majority and all the other requirements of § 1129(a) are met, the court is required to confirm the plan. If one or more impaired classes of claims does not accept the plan, but all the remaining requirements of § 1129(a) are met, the court may nevertheless confirm the plan under the "cramdown" provisions of § 1129(b) if the court finds that the plan does not discriminate against, and affords fair and equitable treatment to, the rejecting classes. In this case, two impaired classes have rejected the plan: the class consisting of Fannie Mac's secured claim and the class consisting of the general unsecured claims (all of which have been purchased and voted by Fannie Mae). Accordingly, the plan can be confirmed, if at all, only under the cramdown provisions of § 1129(b). Fannie Mae and the trustee assert that the plan fails to meet the requirements for confirmation in a number of respects, the most important of which are as follows:
1. The claim of Crestar Bank has been improperly classified to gerrymander a non-insider impaired accepting class.
2. The $250,000 claim voted by Crestar Bank is an "insider" claim and therefore cannot satisfy the requirement that at least one non-insider impaired class has accepted the plan.
3. The plan fails to provide Fannie Mae with deferred payments having a present value equal to the amount of its secured claim.
4. The plan's negative amortization of Fannie Mac's claim is not fair and equitable.
5. The plan is not feasible.
Rulings on the first three issues were made orally on the record at the confirmation hearing but will be briefly discussed in this opinion in order to provide a context for the remaining issues.
A. The Proposed Plan
The debtor's plan divides claims and equity interests into seven classes and provides the following treatment:
Class 1 — Administrative Claims. These are estimated at $50,000, although the pending motion by Fannie Mae for allowance of an administrative claim in the amount of the missed debt service payments would, if granted, essentially triple this amount. These claims are to be paid from "funds first available" at or after confirmation.
Class 2 — Priority Claims. There are no known claims in this class.
Class 3 — Secured Claim of Fannie Mae. Fannie Mae would retain its lien. The principal and all accrued interest and allowed charges as of the effective date of confirmation would be capitalized and paid in monthly installments, at an interest rate "to be determined by the court," over seven years. The first payment would be made 90 days after the effective date of confirmation. This class is impaired and has voted to reject the plan.
As noted above, the court ruled at the confirmation hearing that the debtor would have to pay at least 9% interest, and the amortization period could not exceed 25 years. Taking into account the accrual of two months interest resulting from the delay in the date of the first payment, the required monthly payment would be $22,147.62. At the end of the seven years, the principal balance will have been paid down to $1,992,106.93.
Class 4 — Tenant Security Deposits. These claims are to be paid in the ordinary course of business and are unimpaired. The plan does not contain an estimate of the number of such claims that have matured during the period the debtor has been in chapter 11 and which presumably would have to be paid in full at confirmation.
Class 5 — General Unsecured Claims. There are approximately $17,000 in claims in this class, all or essentially all of which have been purchased by Fannie Mae. These claims will be paid in full from available cash flow after payment of the administrative claims, tenant security deposits, and the debt service on the Fannie Mae claim. Although the plan provides no time limit for the payment of these claims, the debtor's "reorganization operating budget" admitted into evidence at the hearing shows these claims being paid in the first two months. This class is impaired and has voted to reject the plan.
Class 6 — "Related Party" Unsecured Claims. This class consists of a single claim represented by the $250,000 note payable to Erkiletian and assigned to Crestar. This claim is to be paid in full from available cash flow after payment of the administrative claims, tenant security deposits, debt service on the Fannie Mae claim, and the general unsecured claims, but is to be subordinated to the creation of a $50,000 reserve for capital improvements. The plan provides no schedule for the payment of this claim, but at the confirmation hearing the debtor estimated that payments would begin in approximately the 18th month. This class is impaired and has voted to accept the plan.
Both Crestar and Erkiletian voted this claim and initially voted to reject the plan. As a result of the debtor's agreement to modify the treatment of this class, both Crestar and Erkiletian amended their ballots to accept the plan. At the confirmation hearing, the court determined that Crestar was entitled to vote the claim and that cause existed to allow Crestar to amend its ballot to accept the plan with the modifications agreed to by the debtor.
Class 7 — Equity Interests. This consists of the partnership interests of the general and limited partners. The DeLucas will contribute an additional $50,000 in capital to the partnership on the effective date of the plan and another $50,000 on the first anniversary of the plan. All the partners will retain their partnership interests without modification, and Erkiletian would retain his right to priority partnership distributions as provided for under the amended limited partnership agreement, but such distributions would be "subordinated" to the creation of the $50,000 reserve for capital improvements. This class has accepted the plan.
Although the debtor has characterized this class as "impaired" because partnership distributions are "subordinated" to the creation of the $50,000 capital reserve account, the use of cash flow to pay for needed immediate capital improvements to the project does not in any realistic sense constitute "subordination," even if for accounting purposes such expenditures are shown "below the line" after net operating income ("NOI"). There is nothing in the amended limited partnership agreement to suggest that the general partner did not always have authority to set aside funds to pay for needed repairs, whether those are characterized as ordinary maintenance or "capital improvements." Even though the amended limited partnership agreement committed the partnership to the "funding" of the monthly interest due on the $600,000 Crestar note, such payments were in the nature of partnership distributions and, as a practical and legal matter, could only be made to the extent of available cash flow. Accordingly, the court does not consider Class 7 to be "impaired" within the meaning of § 1124(1), Bankruptcy Code, since the plan "leaves unaltered the legal, equitable, and contractual rights" of the general and limited partners, including Erkiletian.
B. Whether Crestar's claim should be classified as "equity"
As noted above, the only class to accept the plan — other than the debtor's equity interest holders — is Class 6, consisting of the claim of Crestar Bank as the assignee of the $250,000 note from the partnership to Erkiletian. The claim is listed on the debtor's schedules as being held by Erkiletian and is not listed as disputed, unliquidated, or contingent. Erkiletian did not file a proof of claim with respect to the note, but Crestar did, and the claim has not been objected to. Under F.R.Bankr.P. 3001(e)(3), where a claim has been transferred for security before proof of the claim has been filed "the transferor or transferee or both may file a proof of claim for the full amount." If both the transferor and the transferee file proofs of the same claim, the claims will be consolidated, and, in the absence of an agreement by the parties "respecting voting of the claim, payment of dividends thereon, or participation in the administration of the estate," the court, after notice and a hearing, "shall enter such orders respecting these matters as may be appropriate." Id. At the confirmation hearing, Erkiletian agreed that Crestar had the right to vote the claim and to receive plan payments on account of the claim. Accordingly, the court ruled that Crestar was entitled to vote the claim.
A separate order has been entered reflecting the court's ruling.
Fannie Mae vigorously asserts, however, that regardless of who is entitled to vote the claim, it is not really a "debt" at all but rather an equity interest and is improperly classified as a debt. Alternatively, Fannie Mae argues, if it is a debt, it has been improperly placed in a separate class from general unsecured debts for the purpose of gerrymandering an impaired accepting class. Since under § 1129(a)(10), Bankruptcy Code, at least one non-insider class of impaired claims must accept the plan before the debtor can attempt a cramdown under § 1129(b) with respect to the impaired rejecting classes, it follows that if Crestar's claim has been improperly placed in its own class, then the debtor's plan fails to satisfy an essential requirement for confirmation.
"(a) The court shall confirm a plan only if all of the following requirements are met: * * * (10) If a class of claims is impaired under the plan, at least one class of claims that is impaired under the plan has accepted the plan, determined without including any acceptance of the plan by any insider."
As to Fannie Mac's first argument, the court concludes that the $250,000 promissory note is an actual debt and not merely, as Fannie Mae would have it, an equity interest. It is true, of course, that bankruptcy courts are courts of equity, and, as such, "possess the power to delve behind the form of transactions and relationships to determine the substance." In re United Energy Corp., 944 F.2d 589, 596 (9th Cir. 1991). And it is also true that Erkiletian in his testimony loosely referred to the entire $750,000 as the purchase price for his 49% interest. The fact is, however, that the parties, for their own reasons, chose to structure the transaction in part as a direct purchase of limited partnership interests and in part as a loan to the partnership. The loan is evidenced by a promissory note and on its face represents an unconditional promise to repay a sum certain with interest. There is no suggestion that structuring of the transaction was done for any improper or fraudulent purpose or for the purpose of gaining any unfair advantage in the event the partnership were to become a debtor in bankruptcy. Additionally, there is nothing in the note or the amended limited partnership agreement to suggest that Erkiletian, or Crestar Bank as assignee, could not enforce the note against the partnership according to its terms. In short, no compelling reason has been presented for the court to exercise its equity powers to disregard the form of the transaction, and the court declines to do so. Accordingly, the court concludes that the note is properly treated by the debtor's plan as a debt distinct from Erkiletian's limited partnership interest.
Fannie Mae argues that one indicia that the $250,000 loan represents equity rather than debt is that its repayment was "subordinated" to the payment of ordinary operating expenses. Under ¶ 6 of the "Assignment and Second Modification to First Amendment and Restatement of Limited Partnership Agreement of Colonial Associates Limited Partnership" dated July 16, 1992,
The loan made by the Substituted Partners shall be repaid to the Substituted Partners . . . from Available Cash Flow (including the proceeds of any sale or refinancing of the partnership property) in preference to any other loans by the Partners to the Partnership or any other distributions to the Partners, and the unpaid portion of such loan shall be finally due and payable by the Partnership on December 31, 1995.
(emphasis added). While it can be argued that in providing for payment from "Available Cash Flow," the parties implicitly recognized that normal operating expenses took priority, there is no express language to that effect, and the thrust of ¶ 6 is not to limit the repayment obligation (as might, for example, be deduced if the language were "only [or solely] from Available Cash Flow") but rather to ensure that the $250,000 loan was paid ahead of "any other loans" by partners and that no excess cash flow would be paid to other partners in the form of distributions before required payments were made on the note. In short, read as a whole, the purpose of ¶ 6 is not to subordinate the note obligation but rather to protect it and in some respects grant it priority.
C. Whether the debtor has classified claims to gerrymander an accepting class
Fannie Mae argues further, however, that in placing the $250,000 note in a class by itself, the debtor has improperly attempted to manipulate the voting on the plan. As discussed above, debtor cannot obtain confirmation without satisfying the requirement of § 1129(a)(10) — sometimes referred to as the "gatekeeper" test — that at least one non-insider impaired class has accepted the plan. If Crestar's $250,000 claim were placed in the same class as the debtor's unsecured trade creditors (Class 5), the debtor would be unable to satisfy the requirements for acceptance by that class, since Fannie Mae has purchased and holds more than one-half in number of the claims in that class and has voted those claims against the plan. Without acceptance by at least one impaired class, the debtor would be unable to satisfy the "gatekeeper" test of § 1129(a)(10), and its plan could not be confirmed.
In re 266 Washington Assocs., 141 B.R. 275, 287 (Bankr.E.D.N.Y. 1992) ("Section 1129(a)(10) (operates as a statutory gatekeeper barring access to cram down where there is absent even one impaired class accepting the plan."); In re W.C. Peeler Co., Inc., 182 B.R. 435 (Bankr.D.S.C. 1995). Peeler explains the rationale of § 1129(a)(10) as follows:
Cramdown is a powerful remedy available to plan proponents under which dissenting classes are compelled to rely on difficult judicial valuations, judgments and determinations. The policy underlying § 1129(a)(10) is that before embarking upon the tortuous path of cramdown in compelling the target of cramdown to shoulder the risk of error necessarily associated with a forced confirmation, there must be some other properly classified group that is also hurt and nevertheless favors the plan.
182 B.R. at 436, quoting In re 500 Fifth Avenue Assocs., 148 B.R. 1010 (Bankr.S.D.N.Y. 1993).
"A class of claims has accepted a plan if such plan has been accepted by creditors . . . that hold at least two-thirds in amount and more than one-half in number of the allowed claims of such class held by creditors . . . that have accepted or rejected such plan." § 1126(c), Bankruptcy Code. Although Crestar's $250,000 claim would constitute more than two-thirds in dollar amount of the voting claims, it would constitute less than one-half of the number of claims in the class.
At the outset, the court notes the irony of Fannie Mae's objection to the separate classification of the $250,000 note, when Fannie Mae's original plan (since withdrawn) did the same. Additionally, the court observes that the issue of classifying the $250,000 note separately from other unsecured claims assumes significance only because Fannie Mae purchased all the other unsecured claims with the apparent purpose of blocking confirmation of the debtor's plan. See, In re Applegate Property, Ltd., 133 B.R. 827 (Bankr.W.D.Tex. 1991) (disqualifying claims purchased by insider of debtor from voting against creditor's plan). But see, In re Federal Support Co., 859 F.2d 17 (4th Cir. 1988) (creditor's vote against plan could not be disqualified as having been cast in bad faith unless voted for an "ulterior purpose").
In opening statement, counsel for Fannie Mae represented that Fannie Mae had purchased the claims only because it learned that insiders of the debtor were attempting to do the same. In two of the other DeLuca entity cases, both the debtor (acting through insiders) and the major secured creditor have engaged in large-scale purchase of claims. In view of Fannie Mae's withdrawal of its own plan and the court's ruling that the debtor's plan did not improperly classify Crestar's $250,000 claim, neither the debtor nor Fannie Mae presented evidence with respect to the circumstances surrounding or the reasons for the purchase of the claim, and the court expressly makes no ruling on the issue.
Be that as it may, the question before the court is whether, as colorfully expressed by one court, the plan violates the commandment that "thou shalt not classify similar claims differently in order to gerrymander an affirmative vote on a reorganization plan." In re Grey stone III Joint Venture, 948 F.2d 134, 139 (5th Cir. 1992). The leading case in this Circuit on the issue is Travelers Ins. Co. v. Bryson Properties, XVIII (In re Bryson Properties, XVIII), 961 F.2d 496 (4th Cir. 1992). In Bryson, the court began its analysis by noting that § 1122, Bankruptcy Code, governing classification of claims, "requires substantial similarity between claims that are placed in the same class" but "does not . . . require that all substantially similar claims be placed within the same class, and . . . grants some flexibility in classification of unsecured claims." 961 F.2d at 502. The court observed, however, "there is a limit on the debtor's power to classify claims," and agreed with other courts that had held that "[i]f the plan unfairly creates too many or too few classes, if the classifications are designed to manipulate class voting, or if the classification scheme violates basic priority rights, the plan cannot be confirmed." Id.
"(a) Except as provided in subsection (b) of this section, a plan may place a claim or an interest in a particular class only if such claim or interest is substantially similar to the other claims or interests of such class.
(b) A plan may designate a separate class of claims consisting only of every unsecured claim that is less than or reduced to an amount that the court approves as reasonable and necessary for administrative convenience."
In Bryson, the debtor attempted to place the major secured creditor's deficiency claim in a different class than general unsecured claims, even though both classes were treated the same in terms of distribution. In light of the identity of treatment, the court held the separate classification was "clearly for the purpose of manipulating voting," and on that basis held that the plan could not be confirmed. But see, LW-SP2, L.P. v. Krisch Realty Assocs., L.P. (In re Krisch Realty Assocs., L.P.), 174 B.R. 914 (Bankr.W.D.Va. 1994) (undersecured creditor's deficiency claim was not substantially similar to claims of other unsecured creditors and could be separately classified).
In the present case, there are logical reasons for classifying the $250,000 unsecured claim separately from the other unsecured claims. First, although (as discussed below) Erkiletian is not an "insider" of the debtor, as a limited partner his motivation in lending to the debtor is presumably very different from the ordinary trade creditor extending credit, and it is reasonable to assume that the holder of the $250,000 note would have interests not shared by the trade creditors. As observed in Krisch, supra, where the court approved separation of the trade debt and a deficiency claim into separate classes, trade debt "is the type of debt which must be incurred to keep the business going from day-to-day," while the deficiency claim was one which, when incurred, the parties "expect will be paid back over a long period of time." 174 B.R. at 921.
Although in this case both Class 5 and Class 6 are to be paid in full, the total of the Class 5 claims is only approximately one-tenth of the single Class 6 claim. By deferring payment of the Class 6 claim until the Class 5 claims are paid, the claims of trade creditors (all of which are held by Fannie Mae) will be paid relatively quickly, while payment of the $250,000 claim will be spread out over many years. While this disparate treatment might — an issue the court need not decide — present a problem if Crestar were to object, here Crestar has accepted the plan. Put another way, while it might be difficult to require Crestar to accept a forced subordination of its claim to the general unsecured claims, it is certainly not uncommon in the chapter 11 context for creditors who are owners of the business to agree to payment on less favorable terms than trade creditors. Although Crestar, as assignee of the claim, has interests distinct from that of Erkiletian, nevertheless Crestar could reasonably see the survival of the debtor as its best chance to be repaid by Erkiletian on account of the $600,000 note. Crestar could therefore have sound business reasons for agreeing to less favorable treatment than the trade creditors are receiving in order to enhance the likelihood that it will ultimately be paid in full. Accordingly, the court cannot find that separate classification of the Crestar claim is without a reasonable basis or was done solely to gerrymander an impaired accepting class.
D. Is the $250.000 note an "insider" claim?
One final issue must be addressed before leaving the question of whether the debtor has satisfied the "gatekeeper" test is whether the $250,000 claim is an "insider" claim, since under § 523(a)(10), the requirement that at least one impaired class has accepted the plan must be "determined without including any acceptance of the plan by any insider." With respect to a debtor that is a partnership, § 101(31)(C), Bankruptcy Code, defines "insider" to include
(i) general partner in the debtor;
(ii) relative of a general partner in, general partner of, or person in control of the debtor;
(iii) partnership in which the debtor is a general partner;
(iv) general partner of the debtor; or
(v) person in control of the debtor[.]
Additionally, under § 101(31)(E), Bankruptcy Code, an insider also includes an "affiliate" of the debtor. An "affiliate," in turn, is defined as "an entity that . . . owns, controls, or holds with power to vote, 20 percent or more of the outstanding voting securities of the debtor." § 101(2)(A), Bankruptcy Code. Moreover, as noted recently by the Fourth Circuit, "It is well settled that the statutory definition is not exhaustive; `[r]ather, an insider may be any person or entity whose relationship with the debtor is sufficiently close so as to subject the relationship to careful scrutiny.'" Butler v. David Shaw, Inc., 72 F.3d 437, 443 (4th Cir. 1996). In order for someone who does not fall squarely within the statutory definition to qualify as an insider, however, the alleged insider "must exercise sufficient authority over the debtor so as to unqualifiably dictate corporate policy and the disposition of corporate assets." Id.
In Shaw, the alleged insider, David Shaw, had been the president and sole shareholder of David Shaw, Inc. The assets of David Shaw, Inc. were purchased by Edward Tatum, who then transferred them to a newly-created entity, Edward Tatum Motors, Inc. As part of the purchase, Tatum agreed to employ Shaw, his wife, and his son at the dealership. After the sale, Shaw retained the title of manager "but did not exercise any managerial authority over the debtor's operation or personnel . . ., did not make personnel decisions, did not handle the payroll or accounts receivable, and was otherwise uninvolved in the management of the business." Id. Accordingly, the court held that Shaw's corporation (David Shaw, Inc.) was not an insider of Edward Tatum Motors, Inc.
In the present case, Erkiletian is not a general partner of the debtor and is not related to the general partners. Although with his family interests Erkiletian owns more than a 20% interest in the partnership, a limited partnership interest does not constitute a "voting security." In re Maruki USA Company, Inc., 97 B.R. 166, 169 (Bankr.S.D.N.Y.) ("a limited partnership has no voting securities"); In re Piece Goods Shops Co., L.P., 188 B.R. 778, 795-798 (Bankr.M.D.N.C. 1995) (Class B Common Stock and preferred stock with rights to vote only on extraordinary corporate action not "voting securities."). As in Shaw, there is no suggestion that Erkiletian makes management decisions, handles the payroll or accounts receivable, or is otherwise involved in the management of the business. Fannie Mae argues, however, that Erkiletian is an insider because (1) the deal between him and Robert DeLuca was not arm's length; (2) the DeLucas caused the debtor to make preferential payments to Erkiletian; and (3) Erkiletian had sufficient "power over the debtor" to compel it to modify the plan as originally proposed to provide more favorable treatment of Erkiletian's claim.
While there is no evidence in this case that would support the characterization of Erkiletian's limited partnership interest as a "voting security," the quoted language in Maruki may not be correct in all situations. Clearly, a limited partnership interest is a "security," as that term is used in the Bankruptcy Code. § 101(49)(A). Under the Virginia Uniform Limited Partnership Act, "the partnership agreement may grant to all or a specified group of the limited partners the right to vote upon any matter. . . ." § 50-73.23, Code of Va. (emphasis added). Voting on a certain limited class of matters does not constitute "[participation] in the control of the business," which would otherwise make the limited partner liable for the partnership's obligations. § 50-73.24, Code of Va. These matters include "[t]he sale, exchange, lease, mortgage . . . or other transfer of all or substantially all of the assets . . ." and "[a] change in the nature of the business." § 50-73.24(B)(6)(b) and (d). It is certainly possible that a grant of voting rights to limited partners could, in a given case, be sufficiently broad as to involve a limited partner in the conduct of the business. Since no party has offered in evidence the complete limited partnership agreement — all that was offered was simply the amendment admitting Erkiletian as a limited partner — the court is unable independently to determine what voting rights, if any, Erkiletian has as a limited partner of Colonial Associates, L.P. However, it was represented by counsel for Erkiletian, and not denied by counsel for Fannie Mae, that Erkiletian had no voting rights under the partnership agreement. On the present state of the record, therefore, the court cannot find that Erkiletian had any right to vote on matters affecting the conduct of the partnership's business.
An "arm's length" transaction is one entered into in good faith in the ordinary course of business by unrelated parties with independent interests. Huffman v. New Jersey Steel Corp. (In re Calley Steel Corp.), 182 B.R. 728, 735 (W.D.Va. 1995). Conversely, a transaction that is not arm's length is one that is not entered into in good faith or that is "incurred as an insider arrangement with a closely-held entity." Id. Regardless of what the DeLucas did with the money tendered by Erkiletian — and there is nothing inherently improper in using the proceeds of one loan to pay off another loan — nothing in the transaction suggests that Erkiletian lacked good faith. This transaction was a negotiated business deal between two seasoned real estate developers. Erkiletian was not related to the DeLucas and was not involved in any other business ventures with them. While Erkiletian may well have, as Fannie Mae argues, struck a very favorable bargain, it was not as a result of any special influence or relationship he had with the debtor. Simply put, a hard bargain is not the same as overreaching.
Fannie Mae points to the fact that the limited partnership agreement was amended to make the partnership, in effect, liable for the $600,000 that Erkiletian borrowed from Crestar. But nothing in the amended partnership agreement creates any direct liability from the partnership to Crestar. Rather, what the agreement does is to defer any partnership distributions to partners other than Erkiletian until the Crestar loan is repaid. By committing funds that would otherwise be distributed to the partners to pay Erkiletian's liability to Crestar Bank, the partnership, as such, has given up nothing. It is the other partners (namely the DeLucas and their family members) who have given up their right to partnership distributions until Erkiletian is repaid the amount he borrowed to purchase the partnership interests. Presumably this was in the financial interest of the other partners at the time the agreement was reached, because all of them signed the amended limited partnership agreement consenting to the arrangement.
Finally, Fannie Mae points out that the prior plan (the "Third Amended Joint Plan of Reorganization") contained terms very much less favorable to Erkiletian than the Fourth amended plan. Under the prior proposed plan, no payment was to be made on "related party" unsecured claims. Rather, such claims were to be treated as a contribution to capital, and the claimant's capital account adjusted accordingly. Unquestionably, neither Erkiletian nor Crestar Bank liked that proposed treatment, and in fact each of them voted against the plan and filed objections to it. The debtor, in order to obtain confirmation, had to convince at least one class of creditors to vote for the plan. With every impaired class having voted against the plan, the only way the debtor could obtain confirmation was to modify the treatment of one of the impaired classes to the point where it was acceptable to that class. This is precisely what the debtor did. "The mere exercise by a lender of financial control over a debtor incident to the debtor-creditor relationship does not make the lender an insider." In re Krisch, supra, 174 B.R. 920 (Bankr.W.D.Va. 1994) (emphasis added). Any influence that Erkiletian or Crestar Bank had over the debtor to modify the treatment of the $250,000 claim derived solely from the debtor-creditor relationship and the debtor's compelling need to make peace with at least one class of creditors, not from some underlying special relationship.
The language in the Fourth amended plan was further modified by terms read into the record at the confirmation hearing.
Of course, what has been said with respect to Erkiletian applies with even stronger force to Crestar Bank, even though Erkiletian has pledged his limited partnership interests and distribution rights to the Bank as collateral for the $600,000 loan, and in some respects the Bank simply stands in Erkiletian's shoes. The court, as noted above, has ruled that as between Erkiletian and Crestar Bank, Crestar Bank has the right to vote the claim. There is no evidence of any special relationship between Crestar Bank and the debtor and no evidence that Crestar Bank ever exerted any control over the management of the debtor. Accordingly, the court concludes that Crestar Bank is not an "insider" and that no basis exists to disregard its vote in determining whether the debtor has obtained the acceptance of at least one impaired class.
E. Does the plan pay Fannie Mae the present value of its secured claim?
Since Fannie Mae is an impaired class and has rejected the plan, the plan can be confirmed, if at all, only under the cramdown provisions of § 1129(b), Bankruptcy Code. In order for the court to confirm a plan over the objection of an impaired rejecting class, the court must find that the plan "does not discriminate unfairly, and is fair and equitable to," the rejecting class. § 1129(b)(1). In order to be "fair and equitable" to a rejecting class of secured claims, the plan must, at a minimum, provide one of the following three treatments of the claims:
1. The holders of the claims retain the liens securing the claims and receive on account of their claims "deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan," at least equal to the value of the creditor's secured interest; or
2. The collateral is sold free and clear of liens, with the liens attaching to the proceeds of sale, and with the secured creditor having the right to bid at the sale and to credit the amount of its claim against the purchase price; or
3. The creditor realizes "the indubitable equivalent" of its secured claim.
§ 1129(b)(2)(A) (emphasis added). With respect specifically to the first described treatment, the statute requires that where the creditor is receiving "deferred cash payments," the stream of payments must have a present value equal to the creditor's secured interest. As explained by Judge Tice of this court in In re Birdneck Apt. Assocs. II, L.P., 156 B.R. 499, 507 (Bankr. E.D. Va. 1993),
Simply stated, "present value" is a term of art for an almost self evident proposition: a dollar in hand today is worth more than a dollar to be received a day, a month or a year hence. This concept may also be expressed by a corollary proposition: a dollar in hand today is worth exactly the same as (1) a dollar to be received a day, a month or a year hence plus (2) the rate of interest which the dollar would earn if invested at an appropriate interest rate.
(internal citations omitted). As further noted in Birdneck,
The deferred payment of an obligation under a chapter 11 plan of reorganization is essentially a coerced loan and the rate of return with respect to such loan must correspond to the rate which would be charged or obtained by the creditor making a loan to a third party with similar terms, duration, collateral, and risk. Therefore, the appropriate discount rate used to calculate present value must be determined by reference to the "market" interest rate for a loan of like terms, with due consideration for the quality of the collateral and the risk of subsequent default.
Id. at 508 (citations omitted). The practical difficulty with applying this test in the case where — as here — the secured claim is equal to the value of the collateral, is that ordinarily there is no actual market for a 100% loan-to-value ratio commercial real estate loan. Id. The expert testimony in the present case, for example, did not support any loan-to-value ratio above 80%. In Birdneck, the court held,
To deny confirmation because there is no actual market for a similar loan would in effect be giving the market permission to repeal § 1129(b)(2). . . . Therefore, the court's inquiry must focus on a hypothetical market rate of interest for a loan of similar terms.
Id. The interest rate experts who testified in this case focused, as did the expert in Birdneck, on constructing a hypothetical market rate using a "Mortgage-Equity/Band of Investment Analysis," in which the amount to be repaid is broken into two "bands" or components: (1) a first-priority "debt" component in an amount equivalent to the loan-to-value ratio for which there is an actual market for loans, and (2) a second priority "equity" component for the remaining amount of the claim. The market interest rate for the debt component is then "blended" with the prevailing rate of return required by investors for the equity component to arrive at a hypothetical market rate of interest on a 100% loan-to-value ratio loan.
The actual computation is a weighted average. In Birdneck, the expert testified, and the court found, that the market would support a loan-to-value ratio of 70% for the debt component at an interest rate of 8.66%. For the remaining 30% equity component, the required rate of return would be 14%. The "blended" rate was found to be 10.74%.
As discussed above, the debtor's Fourth amended plan proposes that Fannie Mac's $2,600,000 secured claim be reamortized over 30 years and paid in monthly installments, with interest "at an annual percentage rate determined by the Court," and with a balloon payment in seven years. At the confirmation hearing, conflicting evidence was presented by interest rate experts testifying for the debtor and for Fannie Mae. Both of the debtor's experts, Christopher Kallivokas and Raymond A. Yancey, testified that Fannie Mae lenders with delegated underwriting authority would make so-called "second tier" 80% loan-to-value ratio loans on apartment projects like Country Club Apartments and that, although 25 years was normally the amortization period for such loans, a waiver could be readily obtained for a 30 year amortization. Both witnesses agreed the current rates were volafile: one said the currently-quoted rate was around 7.260 percent, the other between 7.60 and 7.70 percent. One of the witnesses opined that the rate of return an investor would require to invest in the project would be 14%, the other 12%. One of the witnesses (Kallivokas) testified that the resulting blended rate for a hypothetical market rate loan was 8.61%; the other expert (Yancey) did not testify to a blended rate, although his testimony would support a blended rate of between 8.48% and 8.56%. Fannie Mac's expert, Lawrence J. Grady, testified that, primarily because of the age of the project, the more likely lender for this type of project would be Freddie Mac; that the maximum loan-to-value ratio would be 75%; that the interest rate would be 8.49%; and that the amortization period would be 25 years, with either a 7 or 10 year call. He also opined that an equity investor would require a 16% rate of return, for a blended rate of 10.37%. Fannie Mac's representative, William G. Yakabuchi, testified that under Fannie Mac's current lending guidelines, Fannie Mae would not waive the 25-year maximum amortization period for a second-tier loan on an apartment project of this age.
The original plan provided for an interest rate of 8%.
After weighing the conflicting testimony, the court found that the market rate of interest for a 80% loan-to-value ratio secured by an older apartment project similar to Country Club Apartments was 7.8%, and that an investor would require a 14% rate of return on the remaining 20% equity component. Based on those findings, the court found that a hypothetical market rate of interest on a 100% loan-to-value ratio loan would be 9%, a figure the court arrived at by calculating the weighted average of the two components:
.80x 7.8 = 6.24% .20 x 14.0 = 2.80% blended rate = 9.04%, rounded to 9%
Accordingly, the court concludes that an interest or discount rate of 9% — which the debtor at the hearing agreed to pay — will provide Fannie Mae with deferred payments having a present value equal to the allowed value of its secured claim as required by § 1129(b)(2)(a)(i).
F. Is the two-month negative amortization of Fannie Mae's claim fair and equitable?
Although the Fourth amended plan does provide for Fannie Mae to retain its lien and to receive deferred payments having a present value equal to the amount of its secured claim, it does so with a twist, namely that, although the amount of the recapitalized claim is determined "as of a date thirty days after the effective date of the plan," payments on the claim will not commence until 90 days after the date of the plan. Fannie Mae complains that this 90 day deferral of debt service on the reamortized debt constitutes impermissible "negative amortization."
Read literally, this language would tend to suggest that the debtor did not intend to pay the interest accruing on Fannie Mae's claim during the first 30 days after the effective date of confirmation, contrary to § 1129(b)(2)(A)(i)(II), which mandates the payment of interest measured from the effective date of the plan. The confusion is compounded by the debtor's revised reorganization operating budget (Debtor Exhibit 3) filed in open court at the confirmation hearing. That budget adds to Fannie Mae's claim the interest accruing during the first 30 days after confirmation but then inexplicably shows a first payment being made 60 rather than 90 days after confirmation. In any event, it appears that the debtor's intent is that Fannie Mae's claim of $2,600,000 would accrue interest commencing with the effective date of the plan; that the first 60 days of interest would be added to the principal balance; and that payments would begin on the augmented amount 90 days after the effective date of the plan.
There is no question that in the cramdown context "[a] plan must be fair and equitable in a broad sense, as well as in the particular manner specified in 11 U.S.C. § 1129(b)(2)." Travelers Ins. Co., v. Bryson Properties, XVIII (In re Bryson Properties, XVIII), 961 F.2d 496, 505 (4th Cir. 1992). In this connection, nothing in § 1129(b)(2)(A) specifically requires that the "deferred cash payments" be regular or in an amount sufficient to pay all accrued interest through that point. In re Carlton, 186 B.R. 644, 648 (Bankr. E.D. Va. 1994) (Tice, J). "Negative amortization," or deferral of interest, "refers to `a provision wherein part or all of the interest on a secured claim is not paid currently but instead is deferred and allowed to accrue[,]' with the accrued interest added to the principal and paid when income is higher." Id. Although, as explained in Carlton, most courts have declined to adopt a per se rule against negative amortization, nevertheless "courts are hesitant to confirm such plans because the plans tend to place undue risks on creditors," and such plans must be carefully reviewed on a case-by-case basis. Id. at 649. Among the factors to be considered are the following:
1. Does the plan offer a market rate of interest and present value of the deferred payments;
2. Is the amount and length of the proposed deferral reasonable;
3. Is the ratio of debt to value satisfactory throughout the plan;
4. Are the debtor's financial projections reasonable and sufficiently proven, or is the plan feasible;
5. What is the nature of the collateral, and is the value of the collateral appreciating, depreciating, or stable;
6. Are the risks unduly shifted to the creditor;
7. Are the risks borne by one secured creditor or a class of secured creditors.
8. Does the plan preclude the secured creditor's foreclosure;
9. Did the original loan terms provide for negative amortization; and
10. Are there adequate safeguards to protect the secured creditor against plan failure.
Id., quoting Great Western Bank v. Sierra Woods Group, 953 F.2d 1174, 1178 (9th Cir. 1992).
Since in this case the court finds that the plan is not feasible, the debtor's proposal clearly does not satisfy the fourth Sierra Woods factor. Were it not for the feasibility issue, however, the court would not find that the very limited deferral of interest proposed in this case places an undue risk on Fannie Mae so as to render the plan no longer fair and equitable in a broad sense. The court has found that the plan offers Fannie Mae a market rate of interest. The deferral period of 60 days is reasonable and is justified by the need to use the cash that would otherwise go to debt service during that period to pay for urgently-needed repairs to the apartment project. Since Fannie Mae begins with a claim equal to the value of its collateral, the result of the interest deferral is that for a brief period at the beginning of the plan, the amount of the outstanding debt exceeds the value of the collateral. Thereafter, principal is steadily paid down, and by the end of the seven years plan period the principal is paid down to $1,992,106.93. The collateral itself, if properly maintained, is stable in value, and the brief interest deferral, while it obviously does increase the risk to the creditor during the first few months of the plan, does not unfairly shift the risk, especially since the funds that would have been used to pay debt service would largely go to make needed repairs to the property, thereby preserving its value. The plan does not preclude Fannie Mae's foreclosure if the debtor fails to make payments. Given the provision for regular monthly payments, the steady reduction of principal after the initial 60 day interest deferral, and the creditor's right to foreclose if the debtor were to default, the court — if it could find the plan was feasible — would also conclude that the plan provided adequate safeguards to protect Fannie Mae against plan failure.
Although the first payment on the reamortized debt would not be made until 90 days after the effective date of confirmation, interest on real estate loans is normally paid in arrears. On a loan with monthly payments, therefore, the first payment includes the interest for the previous month.
The amortization table prepared by Fannie Mae's expert (Fannie Mae Exhibit 4) reflects that on July 1, 1996, the deferred interest would be $39,146.25, which added to the $2,600,000 principal balance would give an outstanding balance due of $2,639,146.25. This exceeds the value of the collateral by approximately 2%.
The plan does not specifically state that the failure to make the reamortized debt service payments constitutes an event of default that would allow Fannie Mae to foreclose. Indeed, the only explicit event of default specified in the plan is the failure to make either of the two $50,000 "new value" contributions. However, it does not appear that the intent of the plan is to deprive Fannie Mae of any right it presently has under its deed of trust to foreclose if there is a default in payments. In any event the court would not confirm a plan that did not, either in the plan itself or in the order confirming the plan, explicitly permit Fannie Mae to accelerate the payments upon default and to exercise its remedies under its deed of trust.
G. Is the plan feasible?
Without question, the most vigorously litigated issue at the confirmation hearing was the feasibility of the debtor's plan. Under § 1129(a) (l 1), Bankruptcy Code, a chapter 11 plan cannot be confirmed unless the court finds that
confirmation of the plan is not likely to be followed by the liquidation, or the need for further financial reorganization, of the debtor . . . unless such liquidation or reorganization is proposed under the plan.
As noted by a leading commentator,
Section 1129(a) (l 1) requires the court to carefully scrutinize the plan to determine whether it offers a reasonable prospect of success and is workable . . . "It is not necessary that success be guaranteed, but only that the plan presents a workable scheme of reorganization and operation from which there may be a reasonable expectation of success." The purpose of Section 1129(a) (l 1) is to prevent confirmation of . . . "visionary or impracticable schemes for resuscitation."
5, Lawrence P. King, Collier on Bankruptcy, ¶ 1129.02 at 1129-61 (15th ed. 1995) (internal citations omitted).
As an initial matter, Fannie Mae argues that the debtor must prove feasibility by clear and convincing evidence. As support for this proposition, Fannie Mae cites Judge Tice's statement in In re Birdneck Apt. Assocs. II, L.P., 156 B.R. 499, 507 (Bankr. E.D. Va. 1993), "Before a plan can be `crammed down' over the objection of a dissenting creditor the debtor must establish by clear and convincing evidence that the plan is fair and equitable." The statement in Birdneck, however, was made in the specific context of determining whether the debtor's proposed payment of 8.25% interest on the secured creditor's claim satisfied the requirement of § 1129(b)(2)(A) that a dissenting class of secured claims must receive deferred payments having a present value equal to the amount of the secured claim. Birdneck did not address the standard of proof with respect to the general confirmation requirements of § 1129(a), Bankruptcy Code, including the feasibility requirement of § 1129(a)(11), and the court's own research has not found any reported case that requires feasibility to be established by clear and convincing evidence, as opposed to a preponderance of the evidence.
But see, Matter of Briscoe Enterprises, Ltd., II, 994 F.2d 1160, 1163 (5th Cir. 1993), cert. denied, — U.S. —, 114 S.Ct. 550, 126 L.Ed.2d 451 (1993) ("A number of bankruptcy courts have used the clear and convincing standard in a cramdown, but in none of the cases have we found a satisfactory explanation why that is the appropriate standard.")
The plain language of the statute requires only that confirmation is not "likely" to be followed by the need for liquidation or further reorganization. As the Supreme Court noted in Grogan v. Garner, 498 U.S. 279, 111 S.Ct. 656, 659, 112 L.Ed.2d 755 (1991), where the Bankruptcy Code is silent on the standard of proof, such silence "is inconsistent with the view that Congress intended to require a special, heightened standard of proof." The Court in that case further observed,
Because the preponderance-of-the-evidence standard results in a roughly equal allocation of the risk of error between litigants, we presume that this standard is applicable in civil actions between private litigants unless "particularly important individual interests or rights are at stake."
Id. (emphasis added). With respect to the cramdown of a secured creditor's claim, there is some indication, arising from Congress's use in § 1129(b)(2)(A) of the phrase "indubitable equivalent," that Congress viewed the rights of a secured creditor whose lien was being modified as "particularly important." Nothing in the language of § 1129 generally, however, suggests that Congress viewed other types of chapter 11 confirmation issues as raising special concerns. Accordingly, the court concludes that, while the burden of proof on the issue of feasibility is unquestionably on the debtor, the standard of proof — at least on issues other than modification of a secured creditor's lien — is the ordinary civil standard of preponderance of the evidence. In re Lock Mill Partners, 178 B.R. 697, 700 (Bankr.M.D.N.C. 1995); U.S. V. Arnold and Baker Farms (In re: Arnold and Baker Farms), 177 B.R. 648 (9th Cir. B.A.P. 1994).
As Judge Shelley sagely observed in In re Adamson Co., Inc., 42 B.R. 169, 176 (Bankr. E.D. Va. 1984), "a court is never presented with a plan that is guaranteed to succeed." Nevertheless, the plan proponent — here the debtor — must demonstrate "a reasonable prospect that the plan of reorganization will succeed." Id. Among the factors relevant to such a determination are "the adequacy of the capital structure, the earning power of the business, economic conditions, the ability of management, and the probability of a continuation of the same management." Id.
The question, in a nutshell, comes to this: will the debtor's net operating income from the Country Club Apartments, coupled with the proposed $100,000 cash infusion, enable the debtor to pay claims as proposed in the plan? To answer this question requires the court to resolve the conflicting evidence presented by the debtor, Fannie Mae, and Erkiletian as to (1) the likely future rent stream, (2) the likely future operating expenses, and (3) the extent and immediacy of needed capital improvements.
The debtor presented no evidence at the confirmation hearing to show that the $100,000 was actually available or where it would come from.
Fortunately for the improvement of the human condition (not to mention the rehabilitation of financially-troubled businesses), the past is not always prologue. On the other hand, both logic and experience teach that the past performance of a business venture, while it may not be an invariable predictor of future performance, is nevertheless — absent some dramatic change in economic conditions, debt structure, or business operations — powerful evidence as to a business's future viability or profitability. Certainly, it is the most objective evidence. In this connection, the court notes that during the one-year period leading up to the chapter 11 filing, the debtor was frequently late in making the debt service payments to Fannie Mae and did not — apparently for the lack of funds — make the three payments due immediately prior to filing, even though the property was 100% leased. Although there were large transfers of cash in and out of the debtor during this period, the debtor's evidence is that the net effect was a modest inflow of cash from the related parties. If that is the case, the debtor's pre-petition performance casts significant doubt upon its ability to perform profitably post-petition absent substantial changes in expected revenues and expenses.
The property has likewise failed to generate sufficient income, during its operation by the chapter 11 trustee, to make full debt service payments to Fannie Mae.
In support of the feasibility of its plan, the debtor presented a detailed operating budget for the first two plan years which reflects an ability, albeit marginal, to pay claims as proposed in the plan. The debtor's budget assumes a beginning level of operating expenses that is less than the historical trend for the three calendar years preceding the chapter 11 filing. The testimony of Bobby Ray Thomas, Jr., the leasing manager for APS who prepared the budget, was less than convincing as to how the expected reduction in operating expenses was to be achieved, and the court was left with the conviction that expenses were simply being arbitrarily reduced or eliminated on paper, without serious regard to whether the debtor could achieve such reductions[28] in fact. For example, the proposed level of advertising expenses was set at $2,400 for the first plan year, although the historical average for the three calendar years leading up to the chapter 11 filing was $5,205. Since the plan's success depends on the project's occupancy rate remaining at its historically high (95 to 100%) level, and since the testimony of Jay B. Call, III, Fannie Mac's appraiser, and Jerry Rhodes, the regional manager for Habitat, established that there are a number of competing apartment projects in the same market that currently have vacancies, the budgeted reduction in advertising expense is simply not supported. As another example, the debtor's budget by the stroke of a pen simply eliminates the existing expense for cable TV service, even though the debtor's contract with the cable supplier still has several years to run. Unlike similar apartment projects in the Williamsburg area — where tenants pay separately for cable TV — the Country Club Apartments provide cable TV service as part of the rent. The rents charged at the project were recently increased to the high end of what the market would support, and testimony was received that if cable TV were no longer included in the rent, the current rents would then be above the market by the monthly cost of the cable TV service (approximately $8.50 per month per unit). The likely result of having an effective rent higher than that of competing projects would be a reduced occupancy rate, which in turn would result in a reduced revenues.
An amended version if the debtor's "reorganization budget" (Debtor's Exhibit 3) was submitted the very morning of the confirmation hearing. It reflected a significantly lower level of operating expenses for 1996 ($306,780) than Debtor's Exhibit 1 ($314,089), prepared March 8, 1996, and also admitted in evidence.
The debtor's budget also incorporates a number of optimistic assumptions about the amount of funds needed to address the deferred maintenance at the project. That there is a considerable amount of deferred maintenance is undisputed. What the parties do dispute is the amount and timing of the needed repairs, which primarily involve the parking lot, cracked sidewalks, playground, rotting woodwork (fascia board, door frames and window trim), curling roof shingles, and failing appliances (furnaces, air conditioners, and stoves). The debtor's reorganization budget presents a two-year $100,000 plan of capital improvements, although no evidence was offered as to how the debtor arrived at those figures. Douglas A. Gardner, a professional engineer hired by Fannie Mae to assess the project's condition, recommended a total of $452,985 ($196,875 in 1996, and the balance over the next four years) in repairs and replacements to bring the project up to good condition.
As noted above, the debtor's budget was not the only one presented. Budgets were also prepared by Jay B. Call as part of his appraisal, by Habitat at the request of the chapter 11 trustee, and by Brent Clarke at the request of Erkiletian. A summary of the resulting projected gross income, operating expenses, and net operating income — together with the historical figures for 1992, 1993, and 1994 for comparison — is shown in the following tables:
The debtor's budget is for the 12-month period April 1996 through March 1997.
After careful consideration of the various budgets, and of the testimony of the witnesses who prepared them, I find Habitat's income projections, with one adjustment, and Call's expense projections, with one adjustment, most convincing. Habitat's income projections are based on actual, current performance, adjusted for seasonal variations of the kind actually experienced in the past. What is more, its income model takes account of the fact that not all leases are for the same term and that leases turnovers do not occur uniformly. Its projection of $637,198 in annual operating revenue needs to be reduced, however, by the $3,600 in expected bad debt write-off in order to be consistent with the other budgets, which include bad debts arising from defaulting tenants as part of the allowance for "vacancy/credit loss" used in arriving at operating revenue. The adjusted figure is therefore $633,598. Habitat's expense projections are meticulous and detailed, but appear skewed by the fact that Habitat is basically functioning in a caretaker capacity, so that, for example, its budget includes leasing costs for equipment that everyone — including Habitat's own regional manager — agreed would be more economical to purchase, as well as travel and telephone costs that would not be incurred if a local property management firm were used. Call's projection of annual operating expenses of $344,324 — based both on the expenses currently being incurred at the Country Club Apartments as well as those incurred by comparable projects — is more solidly grounded in historical performance than the debtor's. It does need to be reduced, however, by the $5,820 in annual lost rent attributable to the management unit, since the income figures that the court is adopting do not include that rent as an income item. The adjusted figure is therefore $338,504.
Habitat's regional offices are located in Northern Virginia, approximately a two to three hour drive distant from the project. So, for that matter, are APS's offices — however, APS has historically absorbed travel and telephone costs in its management fee and has not charged them separately to the project.
One of the 100 units is used as a management office/model apartment and therefore generates no rent. Call included its "potential" rent in his income figures but then subtracted the unrealized rent as an operating expenses. The other budgets did not include the "potential" rent from the management unit as income.
Based on the figures adopted by the court as the most reasonable estimates of operating revenues and operating expenses, the net operating income before debt service would be $295,094 annually, or $24,591 monthly, i.e.
Operating income $633,598 Operating expenses $338.504 Net operating income $295,094 / 12 = $24,591
As noted above, monthly debt service on the reamortized Fannie Mae loan will be $22,148, leaving only $2,443 per month to pay out over time approximately $15,200 in tenant security deposit claims, $17,365 in unsecured claims, and the $250,000 Crestar unsecured claim, as well as to fund the proposed $50,000 reserve for capital improvements. Assuming, as seems likely, that the debtor is budgeting only $100,000 for major repairs — the $50,000 "reserve" in the first year, and the additional $50,000 "new value" contribution due at the end of the first plan year — any required extraordinary repairs in excess of that amount will likely result either in a payment default under the plan (if the repairs are made) or in the gradual deterioration of the property (if the repairs are deferred).
The plan is notably vague as to how the "reserve" would work. The plan calls for a $50,000 "new value" contribution by the DeLucas at confirmation, but it appears that the entirety of the new cash will be needed to pay administrative expenses. The plan makes no payment for three months on the reamortized Fannie Mae secured claim, thus freeing up three month's worth of debt service payments ($66,444). These funds would then be available to pay for the needed extraordinary repairs, such as the pool and the parking lot. Whether this is the $50,000 "reserve" referred to in the plan or whether the debtor expects to be able to create an additional $50,000 in funds to address needed property repairs by deferring payments to Crestar simply cannot be determined from reading the plan. It is also not clear whether the $50,000 is intended to be a true "reserve" in the sense of a constantly-replenished pot of money to be used for major repairs or whether, $50,000 having once been spent for such purposes, the "reserve" ceases to exist.
Even though, in the nature of things, the success of a plan can never be guaranteed, the debtor's plan in this case — while it would be a stretch to go so far as to call it "visionary" or "impractical" — has little chance of success. Even with the proposed cash infusions, the debtor will simply be undercapitalized. (And, as noted above, there is no evidence in the record that the DeLuca actually have, or have access to, the $100,000 needed for the infusion.) The reamortized debt service payment is as high as the debtor was paying previously, and neither the debtor pre-petition, nor the chapter 11 trustee post-petition, has been able consistently to make full and timely debt service payments. There are no dramatic changes in economic conditions or the way the debtor proposes to conducts its business operations that would provide grounds for believing that the project will suddenly turn around. As noted at the beginning of this discussion, the debtor has the burden to establish feasibility of its plan. While the plan put forward by the debtor could succeed, the debtor must show more than a bare possibility of success — the debtor must show at least a reasonable likelihood of success, that is, that success is more likely than failure. The debtor has not met that burden, and accordingly, the court is unable to confirm the debtor's plan.
A separate order will be entered denying confirmation.