Cram Down in Bankruptcy Proceedings
Bankruptcy proceedings are often long drawn processes. The reason behind this is simple. If a company has to come out of bankruptcy, it has to get all its creditors to agree to a reorganization plan. The creditors are divided into classes based on the seniority of their debt. Each class is then expected to vote in favor of or against the reorganization plan.
Creditors often vote in favor of the reorganization plan if they are likely to receive more money under the plan than they would receive under liquidation. However, it has been seen that often creditors reject a perfectly feasible plan in order to gain leverage on the other parties.
They use delaying tactics so that others give them a bigger share of the pie just to get their vote.
In order to prevent such situations from arising, the bankruptcy law in the United States includes a provision. This provision is called cram-down. In this article, we will have a closer look at what cram down is and what are the requirements which need to be fulfilled before a cram down is executed.
What is a Cram Down?
A cram down is a unique power given by the bankruptcy law in the United States to the bankruptcy courts. According to the provisions of the law, the bankruptcy court has the right to enforce the reorganization plan into execution even though one or more classes of creditors may not agree with its provisions in simple words.
If 7 out of 10 impaired classes of creditors vote in favor of the reorganization plan, the court can simply overlook the objections of the other three classes of creditors and force them to accept the reorganization plan. It is very rare that the court has to actually use the cram down provisions. In most cases, it is only used as a counterweight to tip the scales back in favor of the debtor organization.
In the absence of cram down provisions, many creditors would simply become unreasonable since they know that the debtor would have no other option but to bow down to their demands. Because of the existence of cram down provisions, they now know that the debtor could simply overlook their demands if they get too unreasonable.
Requirements for Executing a Cram Down
The court does allow the bankruptcy judge to allow a cram-down. However, this provision is only there to deal with unreasonable creditors. It is still the responsibility of the bankruptcy court to ensure that the dissenting class of creditors get their fair share regardless of their unreasonable stand.
This is the reason why the law mandates that certain conditions be fulfilled before the execution of a cram down is legally allowed.
- The debtor organization has to prove to the court that there has been no unfair discrimination towards the dissenting creditors.
Unfair discrimination is defined as when certain creditors belonging to the same class are paid more than other creditors in the class. It is the duty of the debtor organization to explain that the dissenting creditors have been given an offer that is equal in value as compared to other creditors in their class.
- The debtor organization also has to prove that the priority of claims has been maintained.
The bankruptcy law states a certain priority in which claims have to be paid off. This means that secured senior creditors have more rights on the assets of the firm as compared to junior creditors. It is the duty of the debtor organization to prove that this priority will be maintained. They have to convince the judge that no junior class of creditors will be paid more money at the expense of senior creditors if a cram-down is executed.
- The debtor organization also has to prove to the court that the interests of the dissenting creditors will be protected. This means that if a creditor holds a mortgage on a piece of real estate owned by the firm, it will continue to have that claim.
The company cannot divest the real estate or liquidate it without paying the dissenting creditors first. The mortgage is considered to be collateral, and that must remain in place for the position of the creditor to be maintained. Also, if the creditor decides to auction the collateral, it has to first give the right to the creditor to place a credit bid.
- Also, debtor organizations have to prove that the deferred value of the cash flow that they offer is equal to or greater than the present value of cash, which the dissenting creditors may receive in case the plan is not executed. In order to do this, the present liquidation value may be calculated, and the ongoing interest rate for securities of similar risk may be used to arrive at a value.
- Lastly, the courts decide that the cash flows are being deferred by a reasonable amount of time. Most cram-down deferrals last for about five years. Bankruptcy courts are unlikely to allow a cram down if the debtor proposes that a five-year loan will be repaid over a twenty-year period!
From the above conditions, it is fair to assume that the cram down provisions are only present to bargain with unreasonable creditors.
The requirements for the execution of a cram down ensure that the debtor cannot use the cram down provisions as long as the creditors are being reasonable and are willing to negotiate.
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