Second Circuit Rules that Bankruptcy Courts May Award Appellate Legal Fees as Sanction for Contempt

Reorganization proceedings, in contrast to liquidation sales, constitute a rather recent development in insolvency law. Embodied by Chapter 11 in the US, this trend has been further brought to light by the European Directive 2019/1023 of 20 June, 2019 on restructuring and insolvency, that requires EU Member States to set up a preventive reorganization framework. Reorganization plans typically involve complex interplays between competing stakeholders’ interests, and the classification of claims for the purpose of voting on the reorganization plan is both an illustration of these tensions and a mechanism designed to address them. Choices of European policymakers, especially in France where the classification of claims represents a major change, can offer new perspectives on best practices for modern reorganization plans. The classification of claims is an important feature of reorganization proceedings. First, it appears as a countermeasure to the debtor-in-possession and other debtor-friendly rules. Second, it promotes the adoption of a plan against hold-out problems from hostile minority or out-of-the-money creditors. Third, it provides guarantees of fairness and viability of the plan, through the consent of a representative majority of creditors.

Given the importance of claims’ classification, the design of classes has drawn a lot of attention during the implementation of the EU Directive in France. Debtor-in-possession proceedings leave the debtor with significant power over classification, with the potential for abuse through “gerrymandering”, i.e., the strategic classification of claims to create an artificially accepting impaired class, ensuring the adoption of a potentially unfair plan. Bankruptcy statutes fail to provide clear and binding criteria to restrict such strategies. Similarly, Chapter 11 case law – although precedents, notably Matter of Greystone III Joint Venture out of the 5th Circuit, have suggested a ban on gerrymandering – has been reluctant to challenge debtors’ classifications. Instead, policymakers have set protective rules for creditors, mainly the best-interest-of-creditors test and the absolute priority rule. However, these protections may be circumvented and difficult to enforce.

In this context, procedural design is suggested as a means of reconciling debtor-friendly rules with effective protections for creditors, thus ensuring a balance of interests in reorganization proceedings. First, effective judicial review over the classification of claims appears desirable and is addressed under French law with (i) the appointment of a trustee, with limited powers, assisting the debtor in possession, and (ii) an early, dedicated and fast-tracked appeal against the classification of claims, allowing the judicial resolution of disputes over classification before the adoption of the plan. A similar result may be achieved through a reinforcement of classification hearings. Second, hostile classification strategies could be avoided through prepackaged plans, in which the debtor negotiates with its creditors prior to filing for Chapter 11. French law provides for a dedicated two-stage framework through conciliation proceedings – confidential negotiations under the supervision of a court-appointed professional – followed by fast-tracked reorganization proceedings, where the plan can be adopted through a vote in classes that have been designed within the conciliation negotiations. Such proceedings are consistent with the modern negotiated, deal-approach to reorganizations while making use of insolvency mechanisms against hold-out problems, thus favoring a preventive and pragmatic solution to distressed situations.