The chapter 11 case of In re Hyatt out of the Bankruptcy Court for the District of New Mexico illuminates a debtor’s use of claim classification to allocate creditors different recoveries under a liquidating plan.  While this debtor was ultimately successful in getting its Disclosure Statement approved by the Bankruptcy Court, this strategy ultimately hinges on the specific facts of the case and the jurisdiction in which the debtor finds itself.

In Hyatt, the debtor proposed a liquidating chapter 11 plan in which the plan separately classified and subordinated the punitive damages portion of a claim held by creditor Cornelius Dooley (the “Dooley Claim”) behind the general unsecured claims.  The plan also separately classified the unsecured claim of Farm Credit of New Mexico, ACA (the “Farm Credit Claim”) from the unsecured claims of other creditors.  The Farm Credit Claim was an unsecured claim based on the debtor’s guarantee of third-party debt.

Section 1122 of the Bankruptcy Code sets forth the rules on classifying claims.  It expressly mandates that all claims or interests in a class be “substantially similar” to all other claims or interests in the class.  Importantly, it does not expressly require that all substantially similar claims or interests be placed in the same class.  Rather, it only prevents dissimilar claims from being classified together.

In Hyatt, the Bankruptcy Court surveyed the state of the law on claim classification, noting that some courts have held that section 1122 prohibits separate classification only when the separate classification is motivated by the need to gerrymander a consenting class of impaired claims to satisfy section 1129(a)(9).  Determining a debtor’s motivation is not an easy task.  Other courts permit separate classification of similar claims if there is a business rationale for the separate classification.  The Ninth Circuit has adopted this “legitimate justification” approach.  See In re Barakat, 99 F.3d 1520 (9th Cir. 1996); In re Loop 76, LLC, 465 B.R. 525, 541 (B.A.P. 9th Cir. 2012); In re Johnson, 21 F.3d 323, 328 (9th Cir. 1994).  A third approach is that section 1122(a) only prohibits single classification of dissimilar claims.  The Tenth Circuit has yet to adopt a clear rule on this issue.

The Bankruptcy Court in Hyatt did not pick an approach.  Rather, the Court determined that it could achieve the same result whether it applies the “no gerrymandering” rule or the “legitimate justification” test.  The Court ruled that the Farm Credit Claim could be classified separately from those other unsecured claims because it was not “substantially similar” to the other unsecured claims.  First, the Farm Credit Claim was based on the debtor’s guarantee of a third-party debt to Farm Credit.  Second, the claim was secured by non-estate collateral.  Third, the debt continued to be paid by the third party and was not in default.  Thus, because Farm Credit had a third-party source of payment, plus collateral, the debtor’s plan could propose to treat the claim differently and effectively prefer other unsecured claims held by creditors against the estate.

Regarding the subordination of the Dooley Claim, the debtor’s plan proposed achieving subordination by separately classifying this claim from the other unsecured claims and proposing to pay that class after all other general unsecured claims were paid in full.  The Bankruptcy Court ruled that the debtor could subordinate claims in chapter 11 by separately classifying the subordinated claims.  However, this power was subject to the following limitations: (i) there must be a legitimate reason other than gerrymandering for the separate classification; (ii) the confirmation requirement that a plan not discriminate unfairly is satisfied notwithstanding the disparate treatment of similar claims; and (iii) the absolute priority rule does not bar confirmation.

The Bankruptcy Court ultimately allowed the debtor to move to the plan confirmation stage of the case because the Farm Credit Claim was indeed properly classified and because there was a potential justification for the separate classification and treatment of the Dooley Claim.  Based on these determinations, the Court approved the Disclosure Statement.

An interesting side note to this decision: by addressing claim classification at the disclosure statement hearing, the Bankruptcy Court effectively addressed a confirmation issue prior to the confirmation hearing in an effort to avoid unnecessary expense and delay in the event the debtor was proposing a patently unconfirmable plan.