Court upholds challenge to a restructuring plan for violating the absolute priority rule (Farming Agrícola case)

The Spanish First Instance Court No 1 of Palencia (the Court) has issued a ruling, dated on 14 June 2024, which constitutes one of the first full admission of the challenge against the approval of a restructuring plan by its creditors.

The restructuring plan was submitted by the debtor company (Farming Agrícola) through a request for judicial sanction (homologation) with prior contradiction (contradicción previa). In this sense, under the Spanish Insolvency Law, when filing a request for homologation, the court can be asked for sanction ruling and then opening a period for objections, or, alternatively to open such period prior to the sanction ruling, which will be final. In this particular case, the debtor chose this second option.

The scope of the affected debt included part of the financial and commercial indebtedness of the company and was divided into the following five classes:

• (A) Class consisting of the debt of the ultimate shareholder. Subordinated debt. The debt included in this class would suffer a 100% write-off.
• (B) Class consisting of public debt with the tax authorities. 100% of the debt included in this class would be rescheduled to be paid in full within twelve months.
• (C) Class consisting of financial debt secured with mortgages on the company's headquarters. 100% of the debt included in this class would be paid within ten business days from the approval of the Plan.
• (D) Class consisting of various financial instruments (loans and confirming lines) with and without ICO guarantees. Ordinary debt. The debt included in this class would suffer a reduction of 88% of the principal amount and ordinary interests, and 100% of default interest and expenses. The remaining claim would be paid within 10 business days from the approval of the plan. The challenging creditors (Spanish financial entities) were included in this class.
• (E) Class consisting of commercial debt with essential and critical suppliers. Ordinary debt. 100% of the debt would be paid at an annual rate of 4% and a rescheduling until October 2028.

Current regulation of restructuring plans foresees that cross-class cram-down can be approved if, among other scenarios, the restructuring class is approved by, at least, one class which is in-the-money (even partially). In this particular case, the restructuring plan was voted only by classes A and E above, so its approval and cross-class cram-down to the dissenting classes were feasible on the basis that class E would be an in-the-money class and therefore its support would be sufficient for such purposes.

However, the homologation request was challenged by several of its financial creditors based on the following main grounds:

Incorrect shaping of the restructuring debt perimeter

Challenging creditors considered that there has been an incorrect formation of classes from the perspective of the restructuring perimeter, given that certain financial debt positions (in particular, some working capital lines and a term loan) and commercial debt were not included (allegedly, without justification) under the restructuring.

Following the precedent of the 'Das Photonics' case [see our previous post here], the Court understands that the correct formation of the restructuring perimeter is a prior condition for analysing the correct formation of the classes. However, according to the Court, the debtor proposing the restructuring plan should have a very broad margin to design the perimeter and certain debt positions can be excluded from the perimeter if they are not material to the company's short-term operability. Ultimately, the Court allows the free determination of the restructuring debt perimeter for reasons of strategic or economic opportunity and dismisses this ground for challenge.

Incorrect formation of creditor classes

Secondly, challenging creditors understood that Class C would be a “phony class”, since no debt write-off or stays of payments would be applied to it, but it would be repaid in full immediately after the homologation. It would imply that Class C debts would not be affected by the plan as they are not subject to any restructuring or refinancing.

The Court again dismisses this ground on the basis that the restructuring plan would indeed modify their financial conditions, which, given that their maturity was originally agreed to happen at later dates, implies an effective rescheduling of the position with the subsequent impact on the accrual of interest due to its early repayment.

Absolute priority rule

Finally, challenging creditors considered that there is discrimination between creditors of Class D and Class E due to the imposition of more severe measures, despite those debt instruments having the same seniority ranking under insolvency law (ordinary claims). In this regard, the Court accepts the controversial position that the Insolvency Law allows for an exception to the absolute priority rule for debts of equal rank in different classes, as long as the different treatment is not discriminatory and unjustified (meaning disproportionate).

Ultimately, the Court's position is that it is possible to except this absolute priority rule using the “equity test”. The Court conducted a thorough evidentiary analysis of the restructuring negotiation process, the evolution of the debt over the last few years, the detriment suffered by each stakeholder during this period, risks, etc. Finally, the Court understands that the restructuring measures between both classes do not pass the equity test since the differentiated treatment is disproportionate as there has not been a fair distribution of economic losses within same ranking of affected creditors, even in two separated classes.

In conclusion, the Court upheld the challenge brought by the dissenting creditors and the impossibility of applying the cross-class cram-down requested by the applicant company.