A debtor that owned a shopping center proposed a plan of reorganization that gave the spouse of the debtor’s owner 100% of the equity of the reorganized debtor in return for a cash investment, but without any competitive bidding. The bankruptcy court had no objection to this result, but the 7th Circuit disagreed.
As the 7th Circuit noted, under Section 1129(b)(2)(B)(ii) of the Bankruptcy Code (also known as the absolute priority rule) in order for a plan to be confirmed over the objection of creditors, the holder of a junior claim or interest is not permitted to receive any property under the plan “on account of such junior claim or interest.” To get around this requirement, a debtor’s equity holders have sometimes proposed to contribute “new value,” and then argued that they are obtaining equity in the debtor based on the new value rather than on account of their junior equity interests.
However, in Bank of America Nat’l Trust & Savings Assoc. v. 203 North LaSalle Street Partnership, 526 U.S. 434, 119 S. Ct. 1411, 143 L. Ed. 2d 607 (1999) the Supreme Court held that other potential investors must be allowed to bid when a plan proposes to allow existing equity holders to acquire equity in the reorganized debtor for new value.
In this case there was secured debt of ~$10 million. Under the proposed plan, $300,000 would be paid immediately, the balance would be written down to ~$8.2 million as a secured claim, with the remaining deficiency treated as an unsecured claim. The post-confirmation secured loan was extended to 30 years, with “little to be paid until 2021;” the interest rate was cut from 8.37% to 6.25%; and the loan did not include protective features of the original loan, such as a lock box for rents and various approval rights.
An insider of the debtor’s owner (his wife) was given the right to purchase all of the equity in the reorganized debtor in exchange for cash. Initially the wife was to acquire 100% of the new debtor equity for $75,000. The mortgage lender contended that this undervalued the debtor’s assets, and made an offer of $600,000 together with payment of 100¢ on the dollar to other creditors (in contrast to the debtor’s proposal to pay 15% on unsecured claims over 5 years). The debtor rejected the offer, although the proposed investment by the wife was increased to $375,000. The lender asked the bankruptcy court to condition acceptance of the plan on the wife making the highest bid in an open auction, but the court held that competition was not necessary and confirmed the plan.
Technically the wife was not subject to the absolute priority rule since she did not hold a claim or interest junior to the bank’s claim, and thus clearly was not receiving anything on account of a junior claims. However, the 7th Circuit concluded that insiders pose the same danger of diverting assets as the original equity holders, and consequently should be subject to the same requirement for competition. (It also noted that the debtor’s equity holder would receive value from the continuation of a salary as CEO of the company together with an increase in the family’s wealth.)
The court drew an analogy to tax law examples: (1) The exercise of a general power of appointment is treated as income to the holder; and (2) exercise of a discretionary power under a trust to direct assets to either the principal or his wife would result in income to the principal even if paid to his wife. Similarly, in this case using the owner’s authority to propose a plan that directs a valuable opportunity to his wife means that the absolute priority rule should apply even though it is his wife that is doing the investment.
The bottom line for the 7th Circuit was:
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 [the debtor and the principal and his wife] insist, their plan offers creditors the best deal, then they will prevail in the auction. But if, as [the lender] believes, the bankruptcy judge has underestimated the value of [the debtor’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.
There is always an argument that Section 1129(b)(2)(B)(ii) is triggered when existing equity holders offer new value without allowing others an opportunity to bid because they would not have the opportunity to acquire the new equity “but for” their control of the existing equity. However, an investment by an insider who does not hold a junior interest does not give rise to that argument.
Based on the court’s characterization of the facts, the clear inadequacy of the proposed investment seems to drive the result in this case. This raises the question of how much further courts might be willing to go if they are faced with egregious facts.
Vicki R. Harding, Esq.