Seventh Circuit Rules that Transfer of Equity Did Not Violate Absolute Priority Rule

203 North LaSalle
In Bank of America National Trust and Savings Association v. 203 North LaSalle Street Partnership, the Supreme Court held that a plan may not be confirmed under section 1129(b) when the existing equity holders contribute new capital and receive equity in the reorganized entity in circumstances where alternatives are not considered. Bank of Am. Nat. Trust and Sav. Ass’n v. 203 N. LaSalle St. P’ship, 526 U.S. 434 (1999). 203 North LaSalle was a single-asset real estate case involving an undersecured mortgagee. The debtor proposed a plan during the exclusivity period (which the bankruptcy court later extended for cause) under which the existing equity—and only the existing equity—would invest new money in the debtor and receive, in return, the equity in the reorganized debtor. Id. at 439–40. The bankruptcy court confirmed the plan over the mortgagee’s objection. In re 203 N. LaSalle St. Ltd. P’ship, 190 B.R. 567, 594-95 (Bankr. N.D. Ill. 1995).

The Supreme Court began its analysis by examining the Bankruptcy Act of 1898 and its requirement that any plan be “fair and equitable.” The Court observed: “The reason for such a limitation was the danger inherent in any reorganization plan proposed by a debtor, then and now, that the plan will simply turn out to be too good a deal for the debtor’s owners.” 203 N. LaSalle, 526 U.S. at 444 (emphasis added). The “fair and equitable” requirement made its way into the Bankruptcy Code in the form of section 1129(b), commonly known as “cramdown.” See 11 U.S.C. § 1129(b) (2012). Section 1129(b) contains different requirements for different types of objecting classes. In the case of an objecting class of unsecured claims, section 1129(b) requires either (a) that the claims be paid in full or (b) that no holder of a junior class of claims or interests receive or retain any property on account of such junior claims or interests. Id. § 1129(b)(2)(B). This second requirement is commonly known as the “absolute priority rule.”

Returning to 203 North LaSalle, the Court discussed the possibility of a “new value” corollary or exception to the absolute priority rule. The Court did not decide that question, however, as no formulation of the new value exception would have saved the plan in question in the case. 203 N. LaSalle, 526 U.S. at 454. By characterizing old equity’s exclusive opportunity to obtain equity in the reorganized debtor as “an item of property in its own right,” the Court reached the conclusion that:

[T]he exclusiveness of the opportunity, with its protection against the market’s scrutiny of the purchase price by means of competing bids or even competing plan proposals, renders the partners’ right a property interest extended “on account of” the old equity position and therefore subject to an unpaid senior creditor class’s objection.

Id., 526 U.S. at 455–56.

The plan’s fatal defect was its “provision for vesting equity in the reorganized business in the debtor’s partners without extending an opportunity to anyone else either to compete for that equity or to propose a competing reorganization plan.” Id. at 454.

Under 203 North LaSalle, when the debtor proposes a plan during the exclusivity period that limits the right to acquire equity in the reorganized entity to the pre-bankruptcy equity holders, the plan cannot be confirmed under section 1129(b). Id. Instead, there must be some “market test” of the value of the equity being issued, ostensibly so that the court can be satisfied that the old equity is not getting “too good a deal.” The Supreme Court expressly declined to decide whether the market test requires an opportunity to submit competing plans or, on the other hand, the right to bid for the equity under the debtor’s plan. Id. at 458.

Application of 203 North LaSalle
In the wake of 203 North LaSalle, courts have struggled to determine whether there has been sufficient market testing of the equity in a reorganized debtor. Some courts have terminated exclusivity when faced with cramdown of a new value plan. In H.G. Roebuck & Son, Inc. v. Alter Communications, Inc., for example, the district court required termination of exclusivity when the plan of reorganization provided that equity would retain 85 percent of its interest in the reorganized debtor for a set price. H.G. Roebuck & Son, Inc. v. Alter Commc’ns, Inc., No. RDB-11-0157, 2011 WL 2261483, *8 (D. Md. June 3, 2011). The district court rejected the debtor’s and the bankruptcy court’s standard of market testing, i.e. informal bid solicitation and expert testimony. Instead, the court interpreted 203 North LaSalle to require termination of exclusivity and the opportunity to allow competing plans to be filed. Id. at *8 (termination of exclusivity “ensures compliance with the principles of the LaSalle case.”). By terminating exclusivity rather than requiring competitive bidding under the debtor’s proposed plan, the H.G. Roebuck court sought to achieve greater knowledge among creditors because disclosure statements would need to be filed with each competing plan. Id; see also In re Situation Mgt. Sys., Inc., 252 B.R. 859, 866 (Bankr. D. Mass. 2000) (holding that the new value provision in a chapter 11 plan was “cause” for termination of exclusivity period, even though plan included a mechanism for an equity auction).

Other courts have denied plan confirmation until the debtor either provides for termination of exclusivity or creates, in the plan itself, an opportunity for competitive bidding for the equity in the reorganized debtor. See In re Ralph Roberts Realty, LLC, 487 B.R. 480, 484 (Bankr. E.D. Mich. 2012); In re Davis, 262 B.R. 791, 799 (Bankr. D. Ariz. 2001); In re Global Ocean Carriers Ltd., 251 B.R. 31, 49 (Bankr. D. Del. 2000) (“Here, Captain Tsakos through his control of the Debtors, as the largest shareholder and part of the group controlling over 50% of the stock in Global Ocean, has retained his exclusive right, to determine who will be the owner of Global Ocean (as well as the price that she will pay for the ownership). This control of Global Ocean is a right which he holds ‘on account of’ his current position as a controlling shareholder of Global Ocean.”)

While some debtors will create a mechanism for competitive bidding for the equity in their plans, doing so may raise issues about the fairness of the bidding process, which can easily be skewed in favor of the existing equity holders. For example, would a competing bidder have to bid to the exact plan before the court? What if the bidder perceived greater value in the company under a plan where a different set of contracts and leases were assumed? What if the plan called for retention of existing management that the bidder did not want to retain? There are countless variables that might affect a bidder’s valuation of the company. There might also be questions about the sufficiency of the time afforded to competing bidders to conduct their diligence and fashion their bids. In any case, through various arrangements, courts have struggled to apply 203 North LaSalle in the fairest and least disruptive ways. See Matter of Homestead Partners, Ltd., 197 B.R. 706, 719 (N.D. Ga. 1996) (finding that a “confirmation-point equity auction” can be equally effective and less disruptive than a termination of exclusivity in terms of confirmation of a new value plan); In re Ropt Ltd. P’ship, 152 B.R. 406, 412-13 (Bankr. D. Mass. 1993) (requiring debtor to give notice to its creditors of the equity for sale and hold an auction only if bids are received); In re Bjolmes Realty Trust, 134 B.R. 1000, 1010 (Bankr. D. Mass. 1991) (equity must be auctioned among existing equity and interested creditors); In re Smithville Crossing, LLC, No. 11-02573-8-JRL, 2012 WL 259947, at *2 (E.D. N.C. Jan. 27, 2012) (highest bidder at an equity auction acquires the debtor’s obligations under the confirmed plan and must consummate the plan). Other courts have held that 203 North LaSalle is inapplicable when exclusivity has terminated. See, e.g., In re Reid Park Props., LLC, No. 4:11-bk-15267-EWH, 2012 WL 5462919, at *8 (Bankr. D. Ariz. Nov. 7, 2012).

Is there a third way around 203 North LaSalle? Can a debtor obtain confirmation of a plan during its exclusivity period where new value is invested by a person or persons identified by—and perhaps affiliated with—the existing owners, if the new investors did not own pre-bankruptcy equity?  Recently, the Bankruptcy Court for the Southern District of Indiana answered yes. On appeal, the Seventh Circuit Court of Appeals said no.

In re Castleton Plaza, LP
The debtor in Casleton Plaza was a limited partnership that owned a shopping complex in Indianapolis, Indiana. In re Castleton Plaza, LP, No. 11-01444-BHL-11, slip op. ¶¶ 2–3 (Bankr. S.D. Ind. May 31, 2012). George Broadbent owned all of the equity in the debtor either directly or indirectly. The only secured lender, EL-SNPR, held a note for over $10 million. The proposed plan of reorganization provided for bifurcation of EL-SNPR’s claim, with payment of the secured claim at favorable terms and at a new, lower interest rate, and payment of the unsecured claim at 15 cents on the dollar. Id. ¶¶ 38, 41. The plan also proposed to distribute all the equity in the reorganized debtor to Broadbent’s wife, Mary Clare, in exchange for her new capital contribution of $75,000. Id. ¶ 44. EL-SNPR objected to confirmation of the plan on the basis that the absolute priority rule prohibited any transfer of equity to Mary Clare Broadbent when EL-SNPR’s senior claim was not being paid in full. Id. ¶ 82, 93.

The bankruptcy court confirmed the plan over EL-SNPR’s objection, ruling that the absolute priority rule did “not apply to insiders who are not prepetition owners.” Id. ¶ 95. The court reasoned that the absolute priority rule, and the Supreme Court’s holding in 203 North LaSalle, only “prohibit[] the holders of prepetition equity interests from retaining an interest in a reorganized debtor ‘on account of’ their position as prepetition owners.” Id. ¶ 92. Because Mary Clare Broadbent was not a holder of prepetition equity interests, the court allowed her to receive equity through the plan in exchange for a new capital contribution, without terminating exclusivity or mandating competitive bidding for the equity. Id. ¶ 95, 100.

Two facts appeared to influence the bankruptcy court’s ruling. First, the court noted that EL-SNPR purchased its debt at a discount from the original holder, who had begun foreclosure proceedings against the property before the bankruptcy petition was filed. Id. ¶¶ 15–16. The court characterized EL-SNPR as a secured lender seeking “more than the benefit of its bargain” because it bought “paper that entitles it to payment and security as determined by the Bankruptcy Code, not ownership of the collateral.” Id. ¶ 99.

Second, unsecured trade creditors supported the debtor’s plan despite EL-SNPR’s offer of a higher payout. Id. ¶ 58. The equity was originally offered to Mary Clare Broadbent at $75,000, with unsecured claims paid at 15 percent through the plan of reorganization. Id. ¶¶ 44, 58. When EL-SNPR offered $300,000 for the equity, the debtor rejected the proposal but increased Mary Clare Broadbent’s investment to $375,000. Id. ¶¶ 52–53. EL-SNPR then offered $600,000 for the equity as well as payment of all unsecured claims in full. Id. ¶ 54. In confirming the plan over EL-SNPR’s objection and higher offer, the court reasoned that for unsecured trade creditors “it is more valuable to receive only a 15% distribution on their claims and continue to have the Debtor and the Broadbent Company as a customer than to receive a 100% distribution and lose those relationships,” and that “EL-SNPR’s willingness to pay more than Mrs. Broadbent has no practical significance apart from the treatment of the trade creditors, who overwhelmingly support the Plan.” Id. ¶¶ 58, 99.

On appeal, the Seventh Circuit observed that Mary Clare Broadbent was a statutory insider under section 101(31) and held that “plans giving insiders preferential access to investment opportunities in the reorganized debtor should be subject to the same opportunity for competition as plans in which existing claim-holders put up the new money.” In re Castleton Plaza, LP, 707 F.3d 821, 823 (7th Cir. 2013). Thus, the Seventh Circuit assumed the validity of a new value corollary to the absolute priority rule and characterized the opportunity for George Broadbent to direct equity to his wife, as well as the benefits flowing therefrom, as the prohibited retention of property under the plan on account of his equity interest. Id. As a result, the bankruptcy court erred by confirming the plan without providing objecting creditors the benefit of competition for equity interests distributed through the plan. Id. at 824.

Since 203 North LaSalle, some bankruptcy courts have allowed equity distributions to insiders for new value over creditors’ objections. See In re Greenwood Point, LP, 445 B.R. 885, 911 (Bankr. S.D. Ind. 2011); Beal Bank, S.S.B. v. Waters Edge Ltd. P’ship, 248 B.R. 668, 680 (D. Mass. 2000); Troy Sav. Bank v. Travelers Motor Inn, Inc., 215 B.R. 485, 494 (N.D.N.Y. 1997). Interestingly, these courts took pains to emphasize that the insider was not merely acting as a “straw man” or other substitute for old equity but as a viable investor, even when the relationship indicated that some benefit would likely inure to old equity. See In re Greenwood Point, 445 B.R. at 891 (transfer to wife); Beal Bank, S.S.B., 248 B.R. at 680 (transfer to husband); Troy Sav. Bank, 215 B.R. at 494 (transfer to friend).

The Seventh Circuit’s rationale, however, signals an unwillingness to allow old equity to direct benefits back to itself through new investors, whether insiders or not, by any means. Although Castleton involved a thinly veiled attempt to circumvent the absolute priority rule by directing equity to a statutory insider, the court considered the relationship between George and Mary Clare Broadbent in aspects wholly unrelated to their marriage, including the salary George would receive as CEO of the company, owned by Mary Clare, which ran the shopping center under a management contract. The court also analogized George’s exclusive opportunity to distribute equity under the plan to the exercise of a general power of appointment, which in tax law is treated as income to the holder, and “should be treated as income for the purpose of § 1129(b)(2)(B)(ii) too.” In re Castleton Plaza, LP, 707 F.3d at 823. The Seventh Circuit’s decision indicates that even termination of exclusivity may not satisfy its standard for competition:

None of the considerations we have mentioned depends on whether Castleton proposed the plan during the exclusivity period . . . . Nor does the rationale of 203 North LaSalle depend on who proposes the plan. Competition helps prevent the funneling of value from lenders to insiders, no matter who proposes the plan or when. An impaired lender who objects to any plan that leaves insiders holding equity is entitled to the benefit of competition. If, as Castleton and the Broadbents insist, their plan offers creditors the best deal, then they will prevail in the auction. But if, as EL-SNPR believes, the bankruptcy judge has underestimated the value of Castleton’s real estate, wiped out too much of the secured claim, and set the remaining loan’s terms at below-market rates, then someone will pay more than $375,000 (perhaps a lot more) for the equity in the reorganized firm.

Id. at 824.

Such an expansion of the absolute priority rule to require competitive bidding in new value plans may, at first blush, appear to “create[] an additional requirement for plan confirmation.” In re Castleton Plaza, LP, No. 11-01444-BHL-11, slip op. ¶ 95 (Bankr. S.D. Ind. May 31, 2012). However, the absolute priority rule of 1129(b)(2) represents one—but not the only—component of a court’s determination of whether a proposed plan is “fair and equitable” under 1129(b)(1). Because section 1129(b)(2) “includes” the requirements of the absolute priority rule when unsecured creditors are not paid in full, and the rules of construction dictate that the word “includes” is not limiting, courts may employ other means of finding that a plan fails 1129(b)(1) when the absolute priority rule, by its literal terms, is not implicated. 11 U.S.C. § 102(3). Castleton forecloses the possibility that insiders may take equity under a plan of reorganization that does not provide for competitive bidding, but it may also signal that other directed equity transfers may run afoul of the broader “fair and equitable” requirement of 1129(b)(1) when courts look closely at all aspects of the relationship between old and new equity holders.

Conclusion
Castleton may be a boon to holders of unsecured claims looking to block new value plans that lack a competitive bidding process. Thus far, they are having some success using the decision to that end. See, e.g., In re GAC Storage El Monte, 489 B.R. 747 (Bankr. N.D. Ill. 2013); In re Deming Hospitality, LLC, 2013 WL 1397458 (Bankr. D. N.M. Apr. 5, 2013). Or Castleton may be a simple reminder that a chapter 11 plan must, above all else, be fair and equitable.