Restructuring

Contributed by Jessica Diab

The absolute priority rule in section 1129(b)(2)(B)(ii) of the Bankruptcy Code provides that creditors in a bankruptcy are entitled to be paid in full before a holder of a junior claim or interest receives any recovery under the plan.  This rule is tempered by the common law “new value” exception, which provides that the holder of a junior claim or interest may retain an interest or receive value under the plan, while holders of a senior claim or interest receive less than payment in full, if the junior holder adds “new value” to the debtor.  The new value exception, however, is not limitless.  In Bank of America Nat’l Trust & Savings Ass’n v. 203 North LaSalle Street Partnership, the Supreme Court set out the first of what appears to be a trend in limits to the “new value” exception.  In 203 North LaSalle, the court held that, where senior debt is impaired and an equity investor is seeking to retain an ownership interest in the debtor based on a contribution of new value, the equity investor must submit the arrangement to a competitive process or market test.  The Supreme Court in 203 North LaSalle held that the market test would enable the existing equity holders to show that they were paying full value for the equity interests they would be retaining.  Competition, the court held, is the only way to ensure that the new investment makes senior creditors and the estate better off, as opposed to merely granting equity holders too much for their new investment at the expense of senior creditors.  Though the Supreme Court did not expressly acknowledge the existence of the “new value” exception, 203 North LaSalle has become synonymous among bankruptcy practitioners as the “new value” case.
In a brief decision authored by Chief Judge Frank Hoover Easterbrook, the United States Court of Appeals for the Seventh Circuit in In re Castleton Plaza, LP, 707 F.3d 821 (7th Cir. 2013) recently considered the question of whether a debtor’s non-equity holding insider could receive new equity in exchange for contributing new value to the debtor without submitting to a competitive process or market test.  The court answered with a resounding “no,” and, in so holding, extended the Supreme Court’s decision in 203 North LaSalle to include circumstances where a non-equity holding insider contributes new value in exchange for new equity.
Background
The facts before the Seventh Circuit were undisputed: Castleton Plaza, the debtor, was owned by George Broadbent.  George was also the CEO of Castleton Plaza’s management company, The Broadbent Company Inc., where he earned $500,000 per year.  Castleton Plaza had one secured creditor, EL-SNPR Notes Holdings, which held a $10 million secured note.  In September 2010, the note matured, and instead of paying what was owed under the note, Castleton Plaza filed for chapter 11 protection.  One year later, Castleton Plaza proposed a plan of reorganization that provided for a partial payment of the secured debt, with the balance written down and paid over 30 years with a reduced interest rate and the remaining debt treated as an unsecured claim.  Under the proposed plan, unsecured creditors would receive, over a five-year period, recoveries equalling 15% of the allowed amount of their claims.  In theory, the plan left George, the equity holder and sole owner, empty-handed.  Castleton Plaza’s proposed plan, however, would be funded by Mary Broadbent, George’s wife and the sole shareholder of The Broadbent Company Inc.  The plan provided that Mary Broadbent would, in exchange for 100% of the equity in the reorganized debtor, invest new funds in the reorganized debtor.  Initially, Mary offered $75,000 in new funding, but later increased her offer to $375,000.  Castleton Plaza’s sole secured creditor proposed a counteroffer whereby it would invest $600,000 for 100% of the equity (eight times more than Mary’s original offer and almost double Mary’s ultimate investment) and pay all other creditors in full.  Castleton Plaza rejected the counter-proposal and proceeded to seek confirmation of its plan over the objecting secured creditor.  The secured creditor requested that confirmation of Castleton Plaza’s proposed plan be conditioned on Mary’s investment being the highest bid in an open competition.  The bankruptcy court confirmed the plan over the secured creditor’s objection, holding that there was no legal requirement that Mary’s investment be subject to a competitive process because Mary did not have an equity interest in or a claim against Castleton Plaza.  The bankruptcy court stated that section 1129(b)(2)(B)(ii) applied only to circumstances where a “holder of a claim [or interest]” that is junior to the objecting impaired creditor’s claim receives interest in the reorganized debtor.  Mary was not a holder of any claim against Castleton Plaza, nor did she hold any interests in the debtor and thus, the court reasoned that the fact that she was receiving an interest in the debtor when its sole secured creditor was not paid in full, did not violate the absolute priority rule.  Mary was, however, the wife of the debtor’s sole equity holder, and it was this relationship that afflicted the Seventh Circuit when it heard the matter on direct appeal from the bankruptcy court.
The issue before the Seventh Circuit, which addressed this question of first impression, was whether competition was essential when a plan of reorganization afforded a non-equity holding insider of the debtor an option to purchase new equity in exchange for new value, over the objection of a senior creditor.
Holding
The Seventh Circuit reversed the bankruptcy court’s decision and remanded with directions to open the proposed plan of reorganization to competitive bidding.  The court found that a chapter 11 plan giving equity to a debtor’s insider, who was not a prepetition equity holder, in exchange for new funds, could be just as effective at evading the absolute priority rule as a new value plan that gave the reorganized debtor’s equity to the original investor.  An “insider” for the purposes of chapter 11 is defined in section 101(31) of the Bankruptcy Code and includes a “relative of a general partner, director, officer, or person in control of the debtor.”  Mary was an insider of Castleton Plaza because she was married to George Broadbent who controlled the debtor.  The court concluded that Castleton Plaza’s plan was merely an attempt by the controlling shareholder to circumvent the absolute priority rule.  On these facts, there was no doubt, in the court’s view, that George would receive value from Mary’s equity interest: George would continue to receive his salary from the management corporation; there would be an increase in the Broadbent’s overall wealth; and the difference between Mary’s offer and the price that could be obtained in a market-tested environment was money in the Broadbents’ pockets.  The court analogized its decision to tax law, noting that where a taxpayer directs some of his salary to go to his spouse or child, the money is still considered to be the taxpayer’s income.  The Seventh Circuit concluded that allowing an equity holder to evade the competition requirement espoused by the Supreme Court in 203 North LaSalle by having an insider infuse new value in the debtor would undermine the Supreme Court’s decision. 
Take Away
The Seventh Circuit’s decision is important for a number of reasons.  First, it confirms that the “new value” exception to the absolute priority rule is still in force.  Second, by requiring insiders of the debtor to submit their “new value” contribution to a market test, the Seventh Circuit sends a strong signal that existing controlling equity holders cannot rely on insiders to “end run” the absolute priority rule.