Absolute(ly) No – A Reminder That When It Comes to Reorganization, Equity Comes Last

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A fundamental tenet of chapter 11 bankruptcies is the absolute priority rule. Initially a judge-created doctrine, the absolute priority rule was partially codified in section 1129(b)(2)(B)(ii) of the Bankruptcy Code. Under section 1129, plans must be “fair and equitable” in order to be confirmed. Section 1129(b)(2)(B)(ii)1 provides guidance as to what constitutes “fair and equitable.” It includes a requirement that junior classes of creditors and equity holders cannot receive property of a debtor during a reorganization, unless all senior classes either are paid in full or vote to accept the plan. This requirement is commonly referred to as the absolute priority rule.

Rarely do we see debtors propose plans that blatantly violate the absolute priority rule. Similarly, it is not often that bankruptcy courts deny approval of a disclosure statement on account of the associated plan of reorganization being patently unconfirmable. However, that is what happened in a recent chapter 11 case filed in the United States Bankruptcy Court for the Eastern District of North Carolina. The case, In re CHL, LLC,2 involved a debtor, CHL, LLC, that incorporated as a limited liability company and owned real property in the Wilmington, North Carolina area, comprising of 52 developed lots and 57 acres of undeveloped land. CHL filed a voluntary petition for relief under chapter 11 of the Bankruptcy Code on February 9, 2018. Approximately a month and a half later, it filed its disclosure statement and plan of reorganization. CHL’s plan of reorganization called for its sole member, Mr. Ernest Woodrow Davis, Jr., to retain his equity interest in CHL, without paying creditors in full on account of their prepetition claims totaling more than $19 million.3

In its order denying approval of the disclosure statement, the Bankruptcy Court for the Eastern District of North Carolina, Judge David M. Warren, noted that if a court can determine from reading a plan of reorganization that it does not comply with section 1129 of the Bankruptcy Code, “then it is incumbent upon the Court to decline approval of the disclosure statement and prevent diminution of the estate.”4 The court found that CHL’s plan of reorganization did not propose to pay creditors in full but proposed that Mr. Davis would retain his membership interest without “any infusion of capital by [him] in exchange[.]” The court called the plan not confirmable “on its face” and recommended the debtor file an amended plan, or “at a minimum” file an amended disclosure statement explaining what “new value” Mr. Davis will provide for his continued interest in CHL after confirmation.

The “new value” doctrine is a common law exception to the absolute priority rule. The basic concept behind “new value” is that equity holders may retain their interest in a debtor when they provide contribution, often in the form of capital, to the reorganization. This brings into question what is a sufficient amount of contribution that equity holders should have to provide to maintain their interests. Generally speaking, for the “new value” exception to apply, the value provided must be substantial, necessary, and reasonably equivalent to the value of the interest received in exchange. For more discussion on the “new value” exception, see prior Weil Bankruptcy Blog articles here and here.

CHL is the rare example of a court rejecting a debtor’s disclosure statement due to a proposed plan being patently unconfirmable. While this may indicate a greater willingness by the bankruptcy court to consider the patently unconfirmable argument, practitioners should be wary of placing too much stock in the holding. The facts of CHL are rather egregious, and it is likely the bankruptcy court took the opportunity to encourage debtors and their counsel to be more diligent at the disclosure statement stage, rather than signal a shift in philosophy.

** Weil Summer Associate Jason George contributed to this blog post.