Plucked From the Bargain Bin: Testing the Limits of the New Value Exception to the Absolute Priority Rule

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Contributed by Dana Hall

To most bankruptcy practitioners, it would indeed be a stretch of the imagination to conceive of a set of circumstances in which equity interest holders in a debtor that is balance sheet insolvent by more than $2.5 million would be permitted to receive new common stock in exchange for only $20,000 of new value.  In a recent decision issued by the United States Bankruptcy Court for the Western District of North Carolina, however, this is precisely what happened and, what’s more, the plan was approved over the objection of the debtor’s undersecured mortgage lender.  In In re RTJJ, Inc., the court found, among other things, that despite the reorganized debtor’s retention of nearly $1.5 million in assets (albeit fully encumbered assets) and a meager recovery to holders of general unsecured claims, a $20,000 cash infusion provided by the debtor’s former owners was necessary, substantial, and reasonably equivalent to the equity interests in the reorganized debtor that they received in exchange.

In 2011, RTJJ, a local, family-run rental property business filed for chapter 11 protection to stave off imminent foreclosure proceedings commenced by its mortgage lender, Community One Bank.  Community One’s $2.5 million claim was secured, in part, by the bulk of RTJJ’s properties, however, following a valuation hearing, the court determined Community One’s claim to be undersecured by approximately $1 million.  The plan provided for Community One to receive a cash payment of $50,000 (a recovery of approximately 5%) in satisfaction of its allowed deficiency claim and provided for the repayment of Community One’s secured claim with five percent interest per year under a 25-year amortization schedule.  The debtor’s other general unsecured creditors would receive a recovery of approximately 2% of the value of their allowed claims under the plan.  The plan also provided, among other things, for the cancellation of all outstanding stock and the issuance of new common stock to RTJJ’s former owners in exchange for their contribution of $20,000 to the debtor’s estate.  Significantly, the common stock included a restriction prohibiting the payment of any interest, dividends, or other distributions on the stock until Community One’s secured claim was fully repaid (on a 25-year amortization schedule).

Community One, preferring to foreclose on the properties, rejected the plan and objected to it on what appeared to be every conceivable basis, including, among other things, on the basis that the grant of common stock to the debtor’s former owners violated the absolute priority rule.  Section 1129(b)(2)(B) of the Bankruptcy Code provides that a chapter 11 debtor must either provide for payment of allowed general unsecured claims in full or ensure that no class junior to such claims (e.g., equity interests) receive or retain property on account of such interests.  The “new value” doctrine is a common law exception to the absolute priority rule and permits holders of junior interests to retain property in exchange for “new value” contributed by the members of that class.  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.

In RTJJ, the debtor’s former owners argued that, as a result of their contribution of $20,000 to the debtor’s estate, the grant of common stock they would be receiving in exchange fell within the new value exception.  Community One, however, countered that the amount provided was neither substantial nor necessary, that the $20,000 cash payment was grossly disproportionate to the approximately $1.5 million in encumbered assets retained by the reorganized debtor, and that the presumed value of the reorganized debtor’s equity ($20,000) had not been market tested.

With respect to the necessity of the new value, the court noted that absent the $20,000 provided by the debtor’s former owners, the debtor would be unable to pay its attorney’s fees – an administrative expense, payment of which was a condition of confirmation.   Additionally, although seemingly insubstantial when compared to the debtor’s total general unsecured debt, the court found that the $20,000 cash payment was indeed “substantial” in the particular context of a “small family business, bereft of unencumbered assets, and generally limited in its cash resources.”  When compared to the debtor’s nonexistent available cash, the $20,000 was indeed substantial and necessary because it enabled the debtor to pay its administrative expenses and confirm its plan of reorganization.

The court also determined that the $20,000 cash payment was reasonably equivalent to the equity interests provided to the debtor’s former owners in exchange.  Although Community One suggested that equivalency should be determined by comparing the debtor’s asset value to the cash provided, the court noted that the assets were, in fact, over-encumbered and that the company, therefore, had no net asset value – “RTJJ is balance sheet insolvent by more than $2.5 million . . . [and] what is being purchased with $20,000 is nothing more than the right to control a small family business that has no net asset value.”  The court also summarily rejected Community One’s market testing argument, noting that the exclusivity period had expired months before the confirmation hearing and that no party, including Community One, had filed a competing plan or offered any evidence to support the conclusion that there was any retained value in the common stock in excess of $20,000.  Interestingly, although the common stock contained a prohibition against future dividends, by purchasing RTJJ’s equity, the former owners secured the ability to continue running the company and, likely, their ability to continue receiving salaries.

The court also noted that RTJJ’s business was over-leveraged but generally well run, had experienced immensely successful postpetition operations and a substantial increase in revenue, and that the company’s demise would harm the local community because it served a “vital need” in the low income housing market.  On the other hand, the court noted that Community One’s efforts to foreclose were self-destructive because, due to a weak real estate market and the unique configuration of the rental apartments, a forced sale or chapter 7 liquidation would decrease the recoveries of secured lenders and take any distribution to general unsecured creditors off the table entirely.  The court pointed out that Community One was severely undercapitalized, operating under the supervision of the Office of the Comptroller of the Currency, and would, seemingly, go to any length to “rid itself of this nonperforming loan.”  Accordingly, the RTJJ court determined that the new value exception to the absolute priority rule was indeed applicable to the $20,000 cash contribution and confirmed the debtor’s plan.

Although the facts in RTJJ are unique, the decision is illuminating insofar as it highlights the flexible nature of the new value exception to the absolute priority rule.  That flexibility here enabled the court to save a small family business, ensure continuity of ownership and business operations, halt the short-sighted aims of a troubled lender, and preserve value for holders of general unsecured creditors.