Contributed by Kyle J. Ortiz
Few cases have stood the test of time as well as Case v. Los Angeles Lumber Products, Justice Douglas, writing for a unanimous Supreme Court of the United States, clarified how courts were to interpret the “fair and equitable” language of section 77B of the Bankruptcy Act (a predecessor of today’s Bankruptcy Code) and in the process settled a long running dispute in the courts over whether “fair and equitable” required an “absolute priority” rule or a “relative priority” rule. With his decision in Case, Justice Douglas favored the absolute priority rule and thus thrust it on to center stage in the restructuring world. Cementing the absolute priority rule as a basic component of restructuring jurisprudence would have been significant enough, but Justice Douglas did not stop there; he also laid the framework for the primary exception to the absolute priority rule: the “new value exception.”
Prior to Case v. Los Angeles Lumber Products, courts were split in their interpretation of the equity receivership cases of the early 20th century. The most notable cases were Kansas City Terminal R. Co. v. Central Union Trust Co. and Northern Pacific Railway Co. v. Boyd. The dispute centered on whether those cases called for an absolute or a relative priority standard. Under an absolute priority regime, those with superior non-bankruptcy rights must be paid in full before those junior to them. Generally this means that senior creditors are paid ahead of junior creditors and junior creditors ahead of equity. Under a relative priority scheme, as long as stakeholders retain their relative priority to other stakeholders in a reorganization, and a majority of such stakeholders approve of the plan, the “fair and equitable” standard has been satisfied.
The United States District Court for the Southern District of California adopted the relative priority standard in approving Los Angeles Lumber’s plan of reorganization. Under Los Angeles Lumber’s plan 23% of the stock in the new corporation would go to the old stockholders, without the old stockholders contributing new (monetary) value. This plan was approved by 92% of the bonds by value with only two bondholders objecting. The district court justified its inclusion of the old stockholders in the plan because “it apparently felt that the relative priorities of the bondholder and stockholder were maintained by virtue of the preferences accorded the stock which the bondholders were to receive and the fact that the stock going to the bondholders carried 77% of the voting power of all the stock . . . issued under the plan.” The district court further justified the inclusion of old stockholders by holding that their participation added value to the business due to “their familiarity with the operation of the business and their financial standing and influence in the community.” The Ninth Circuit affirmed the district court’s ruling.
The Supreme Court, however, disagreed with the district court’s interpretation of the “fair and equitable” principal and reversed the decision even though only two bondholders had objected. Writing for the majority, Justice Douglas stated that the court is not “a ministerial register of the vote” in a restructuring and that “the fact that the vast majority of the security holders have approved the plan is not the test of whether the plan is a fair and equitable one.” Rather, Justice Douglas held that all creditors must be afforded their “full right of priority against the corporate assets” before stockholders may participate without “contribution in money [as opposed to financial standing or familiarity with the business] . . . reasonably equivalent . . . to the participation of the stockholder.”
With this decision, Justice Douglas firmly anchored the absolute priority rule’s place in restructuring jurisprudence. Following Case, it was clear that those with superior rights were entitled to their “full right of priority” before those junior to them could be paid. Nonetheless, Justice Douglas also made clear that equity holders are not foreclosed from ever taking part in a reorganized debtor, but stated that fair value must be paid for that continued interest. “It is, of course, clear that there are circumstances under which stockholders may participate in a plan of reorganization of an insolvent debtor . . . [when] old stockholders make a fresh contribution and receive in return a participation reasonably equivalent to their contribution, no objection can be made.”
The immediate consequence of Case was that unanimous consent was required to approve a plan that allowed for distribution to equity before paying all bondholders in full and that absent such unanimous consent, equity needed to make a “substantial, and necessary contribution” in new value to participate in the reorganized entity.
When Congress enacted the current Bankruptcy Code in 1978, it codified the absolute priority rule announced in Case with the enactment of section 1129(b)(2)(B)(ii) of the Bankruptcy Code. Congress did not adopt Justice Douglas’ interpretation of the Absolute Priority Rule verbatim, but softened it by requiring that the absolute priority rule be triggered by the rejection of a plan by a class of senior unsecured creditors. This was undoubtedly an improvement because it can hardly be considered “fair and equitable” for one or two holders of relatively small claims by value to hold up an otherwise consensual plan of reorganization (which is precisely what happened in Case). Ironically, under section 1129(b)(2)(B)(ii), Los Angeles Lumber’s plan of reorganization would have been confirmed because Case’s relatively small claim would have been outvoted in an otherwise accepting class.
This codification did not, however, protect the absolute priority rule or the new value exception (which despite being considered and included in earlier drafts of the 1978 Bankruptcy Code has never been fully codified) from subsequently coming under attack in the courts.
The new value exception looked to be in jeopardy after cases such as In re Coltex Loop Central Three Partners, L. P. and In re Bryson Properties, XVIII, both of which speculated that the 1978 Bankruptcy Code’s silence on the new value exception signaled Congress’s intent to move away from it. The Coltex court stated that “[t]he present, increased flexibility in confirming reorganization plans coupled with new codifications thus represents a significant change from pre-Code bankruptcy law and arguably renders the new value exception unnecessary.” Bryson went even further, stating that courts were split on whether codification of the absolute priority rule in the 1978 Bankruptcy Act without explicitly codifying the new value exception “tolled a death knell for the exception.” The Supreme Court refused to settle the debate in 203 N. LaSalle, where it held that it need not decide whether the new value exception survived the enactment of the Bankruptcy Code because, even if it did, the plan at issue did not satisfy the exception.
Meanwhile, the absolute priority rule was losing some of its sway as savvy lawyers found ways around it with developments such as the gifting doctrine. The Absolute Priority rule has regained its stature lately, however, as both the Second and the Third Circuits have rejected plans that purported to use “gifting” to distribute value to junior classes notwithstanding rejection of the plan by a senior class. As this blog has discussed, however, some questions remain following these decisions. Those issues aside, the absolute priority rule still holds its place as a central tenant of bankruptcy law that must be contended with in any plan of reorganization.
Thus, over 70 years after Justice Douglas penned his opinion in Case, the basic concept of the absolute priority rule and the new value exception are largely in tact. In fact, Case has been cited in several hundred cases (including, at the time of publishing, seven cases in 2011). This is an impressive feat when one considers that Case has survived two entirely new bankruptcy acts. Considering the decision’s longevity, it is hard not to wonder what the restructuring world would look like today if the Court had instead backed the relative priority rule and upheld the district court’s approval of Los Angeles Lumber’s plan.
Copyright © 2019 Weil, Gotshal & Manges LLP, All Rights Reserved. The contents of this website may contain attorney advertising under the laws of various states. Prior results do not guarantee a similar outcome. Weil, Gotshal & Manges LLP is headquartered in New York and has office locations in Beijing, Boston, Dallas, Frankfurt, Hong Kong, Houston, London, Miami, Munich, New York, Paris, Princeton, Shanghai, Silicon Valley, Warsaw, and Washington, D.C.