Much attention in the commercial bankruptcy world has been devoted recently to judicial pronouncements concerning whether the practice of senior creditor class "gifting" to junior classes under a chapter 11 plan violates the Bankruptcy Code's "absolute priority rule." Comparatively little scrutiny, by contrast, has been directed toward significant developments in ongoing controversies in the courts regarding the absolute priority rule outside the realm of senior class gifting - namely, in connection with the "new value" exception to the rule and whether the rule was written out of the Bankruptcy Code in individual debtor chapter 11 cases by the addition of section 1115 as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"). This article examines these concepts as well as some recent court rulings addressing them.
Cram-Down and the "Fair and Equitable" Requirement
If a class of creditors or shareholders votes to reject a
chapter 11 plan, it can be confirmed only if the plan satisfies the
"cram-down" requirements of section 1129(b) of the
Bankruptcy Code. Among these requirements is the mandate that a
plan be "fair and equitable" with respect to dissenting
classes of creditors and shareholders.
Section 1129(b)(2)(B) of the Bankruptcy Code provides that a plan
is "fair and equitable" with respect to a dissenting
impaired class of unsecured claims if the creditors in the class
receive or retain property of a value equal to the allowed amount
of their claims or, failing that, in cases not involving an
individual debtor, if no creditor of lesser priority, or no equity
holder, receives or retains any distribution under the plan
"on account of" its junior claim or interest. This
requirement is sometimes referred to as the "absolute priority
rule."
History of the Absolute Priority Rule
The U.S. Supreme Court first formally articulated the absolute priority rule, originally referred to as the "fixed principle," in Northern Pacific Railway Co. v. Boyd, 228 U.S. 482 (1913), which involved an equity receivership of a railroad. In Boyd, the old stockholders and bondholders agreed to a plan of reorganization in 1896 pursuant to which the company was to be sold to a new company in which the old stockholders had rights. Boyd asserted an unsecured claim against the predecessor company that resulted in a judgment in 1896 and was revived in 1906. However, because the old railroad's assets had been sold to the new company 10 years earlier, there were no longer any assets on which to levy an execution. Boyd accordingly sued to hold the new company responsible for the old company's debt to him. The Supreme Court ruled that the stockholders' receipt of property was invalid:
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Thus was established the "fixed principle"- a concept
that later came to be known as the "absolute priority
rule." According to this precept, stockholders could not
receive any distribution in a reorganization case unless creditor
claims were first paid in full. The Supreme Court continued to
apply this principle in equity receivership cases throughout the
early 1900s, emphasizing that it should be strictly applied.
In 1934, Congress amended the former Bankruptcy Act to introduce
the words "fair and equitable" to bankruptcy
nomenclature. Section 77B(f) of the Act provided that a plan of
reorganization could be confirmed only if the bankruptcy judge was
satisfied that the plan was "fair and equitable and does not
discriminate unfairly in favor of any class of creditors or
stockholders and is feasible." The provenance of this
restriction was none other than the "fixed principle." As
later expressed by the Supreme Court in Bank of America Nat.
Trust and Sav. Ass'n v. 203 North LaSalle, 526 U.S. 434
(1999), reversing Matter of 203 North LaSalle Street
Partnership, 126 F.3d 955 (7th Cir. 1997), "[t]he 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."
The "fair and equitable" requirement endured as part of
chapter X of the former Bankruptcy Act when Congress passed the
Chandler Act in 1938. As applied, the absolute priority rule
prohibited any distribution to the holders of junior interests if
senior creditors were not paid in full. This was so even if senior
creditors agreed to the arrangement.
Congress partially codified the absolute priority rule into section
1129(b)(2) of the Bankruptcy Code in 1978. Prior to the enactment
of the Bankruptcy Code, the absolute priority rule prevented junior
classes from receiving consideration at the expense of a senior
creditor even if the majority of senior creditors agreed. Now, the
rule applies only if the senior class does not vote to accept the
plan. Thus, the rule would be an obstacle to confirmation only if a
class of senior creditors is "impaired" by, for example,
receiving less than full payment, the senior class votes to reject
a chapter 11 plan, and the plan provides for some distribution to
junior creditors or interest holders.
The New Value Exception
In 1939, the Supreme Court made explicit the connection between
old equity cases and bankruptcy practice by holding in Case v.
Los Angeles Lumber Prods. Co., 308 U.S. 106 (1939), that under
section 77B(f) of the former Bankruptcy Act, the requirement of a
"fair and equitable" plan of reorganization meant
application of the absolute priority rule. In Case, the
debtor's existing shareholders sought to retain an ownership
interest in the company, even though senior creditors were not to
be paid in full. The shareholders argued that retention of their
interests was important to the company's future success, given
their familiarity with business operations and the advantages of
continuity in management. The Supreme Court ruled that continued
shareholder participation in the ownership of an insolvent company
may be acceptable under certain circumstances. From this
pronouncement evolved the controversial "new value"
corollary or exception to the absolute priority rule.
Under the new value exception, a junior stakeholder (e.g.,
a shareholder) may retain its equity interest under a chapter 11
plan over the objection of a senior impaired creditor class,
provided the shareholder contributes new capital to the
restructured enterprise. According to some courts, that capital
must be new, substantial, necessary for the success of the plan,
reasonably equivalent to the value retained, and in the form of
money or money's worth.
In In re Bonner Mall Partnership, 2 F.3d 899 (9th Cir.
1993), motion to vacate denied, case dismissed sub nom. U.S.
Bancorp Mortg. Co. v. Bonner Mall Partnership, 513 U.S. 18
(1994), the Ninth Circuit held that "if a proposed plan
satisfies all of these [five] requirements, i.e. the new value
exception, it will not violate section 1129(b)(2)(B)(ii) of the
Code and the absolute priority rule." Such a plan, the court
wrote, "will not give old equity property 'on account
of' prior interests, but instead will allow the former owners
to participate in the reorganized debtor on account of a
substantial, necessary, and fair new value contribution."
Other courts have concluded that the new value exception did not
survive the enactment of the Bankruptcy Code in 1978 because, among
other things, the concept is not explicitly referred to in section
1129(b)(2) or elsewhere in the statute.
Since the enactment of the Bankruptcy Code, the U.S. Supreme Court
has only obliquely addressed the viability of the new value
exception. In its decision in Norwest Bank Worthington v.
Ahlers, 485 U.S. 197 (1988), the court held that, even if the
new value exception to the absolute priority rule survived the
enactment of the Bankruptcy Code in 1978, new value could not be
satisfied by promised contributions of labor. The court was
similarly reluctant to tackle the issue head on in the other two
cases to date in which it had an opportunity to do so. In 1994, the
court declined to vacate the Ninth Circuit's Bonner
Mall opinion, and in 1999, it similarly declined to overrule
the Seventh Circuit's interpretation of the corollary in
Matter of 203 North LaSalle Street Partnership. Instead,
the court held that one or two of the five elements of the new
value corollary could not be satisfied when old equity retains the
exclusive right to contribute the new value. The court expressly
declined to define what "on account of" requires, except
to hold that it cannot be satisfied when old equity has the
exclusive right to propose a plan.
The Absolute Priority Rule in Individual Chapter 11 Cases
"High-asset" individual debtors, such as business
owners or owners of rental property or other significant business
and personal assets, whose financial problems are too extensive to
qualify for treatment under the wage-earner provisions in chapter
13, commonly seek protection under chapter 11 of the Bankruptcy
Code. Such debtors are a prominent feature of commercial insolvency
practice in California and certain other western states. Recent
statistics indicate that the volume of individual chapter 11 cases
has risen significantly since the October 17, 2005, effective date
of BAPCPA.
BAPCPA amended section 1129(b)(2)(B)(ii) with respect to individual
chapter 11 debtors. It now provides (with added language
italicized) as follows:
(ii) the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property, except that in a case in which the debtor is an individual, the debtor may retain property included in the estate under section 1115, subject to the requirements of subsection (a)(14) of this section.
The added language allows individual chapter 11 debtors to
retain "property included in the estate under section
1115," even if a dissenting class of unsecured creditors could
otherwise argue that retention of such property violates the
absolute priority rule.
Section 1115 was also added in 2005 by BAPCPA. It provides in
relevant part as follows:
Thus, the bankruptcy estate in an individual chapter 11 case is
more expansive than the estate in a case involving a nonindividual
debtor because section 1115 specifies that the estate in an
individual chapter 11 case "includes" all property
covered by section 541 as well as certain property expressly
excluded from nonindividual debtor cases under section 541(a)(6) -
i.e., an individual debtor's postpetition earnings
from services. However, because, among other things, the term
"includes" is "not limiting" pursuant to
section 102(3) of the Bankruptcy Code, a dispute has arisen as to
whether the carve-out added by BAPCPA to section 1129(b)(2)(B)(ii)
for property retained by individual debtors might extend to
property other than postpetition earnings - in effect, abrogating
the absolute priority rule in individual chapter 11 cases.
If "included in the estate under section 1115" in section
1129(b)(2)(B)(ii) means only property that is added by section
1115, it has a very narrow meaning, referring only to postpetition
earnings and not to property originally specified in section 541.
Conversely, if "included in the estate under section
1115" means that section 1115 entirely supplants section 541,
assuming that property of the estate in an individual chapter 11
case is defined only by section 1115, it has a very broad meaning,
essentially exempting individuals from the absolute priority rule
as to unsecured creditors.
Some courts, representing the minority view as of this writing,
have construed section 1115 broadly. These courts interpret the
phrase "in addition to the property specified in section
541" to mean that section 1115 absorbs and then supersedes
section 541 for individual chapter 11 cases. From this construction
is derived the approach that, in individual chapter 11 cases,
section 1129(b)(2)(B)(ii)'s exception from the reach of the
absolute priority rule extends to all property of the estate,
including, for example, prepetition ownership interests in
nonexempt property and an individual debtor's ownership
interests in a business. According to some courts, this approach
comports with the underlying purpose of most of the changes
effected by BAPCPA in adapting various provisions of chapter 13 -
which has no absolute priority rule - to fit in the chapter 11
context.
Other courts, representing a growing majority, subscribe to a
narrow construction of section 1115 and confine the exemption from
absolute priority to postpetition earnings. At least five
bankruptcy courts have taken this position in reported or
electronically available opinions thus far in 2011.
Some Recent Cases on Absolute Priority and the New Value Exception
2011 has already seen a wealth of court rulings addressing the
new value exception and section 1115. In In re Red Mountain
Machinery Co., 2011 WL 1428266 (Bankr. D. Ariz. Apr. 14,
2011), the court confirmed a chapter 11 plan proposing to give
equity in the reorganized company to the debtor's principals
(and sole shareholders) notwithstanding less than full payment of a
lender's unsecured deficiency claim. The court found that new
value to be contributed by old equity for new equity interests in
the reorganized entity in the amount of up to $1.2 million was
"necessary for a successful reorganization" because the
Bankruptcy Code unequivocally requires that administrative expenses
be paid in full, in cash, on the effective date of the plan, and
the debtor's cash position, without such a contribution from
old equity, was insufficient to permit such payment. It also
concluded that the new value the old equity would contribute under
the chapter 11 plan was "reasonably equivalent" to the
value of the equity interest they would receive, where exclusivity
had expired, such that there was no option value to old equity in
having the right to propose a plan, and the amount of the
contribution was greatly in excess of the value of the equity
interests based on either a pro forma balance sheet of the
reorganized debtor or capitalization of the reorganized
debtor's projected income.
In In re Multiut Corp., 2011 WL 1486035 (Bankr. N.D. Ill.
Apr. 19, 2011), the bankruptcy court denied confirmation of a
chapter 11 plan proposing that the debtor's existing
shareholder would retain 100 percent of his equity interest in
exchange for a cash contribution of $100,000 under the "new
value" exception. According to the court, although the money
"to be contributed to the Plan is new, necessary for the
success of the Plan, and in the form of money or money's
worth," and "[w]ithout that contribution, there likely
would not be enough funds with which to pay administrative
claimants in full on the Effective Date of the Plan," the plan
proponent failed to demonstrate that "the $100,000
contribution is reasonably equivalent to [the shareholder's]
one hundred percent ownership interest."
In In re Greenwood Point, LP, 445 B.R. 885 (Bankr. S.D.
Ind. 2011), the court held that a chapter 11 plan proposing to
distribute new equity to the wife of the debtor's principal,
rather than the principal himself, in exchange for a $100,000
contribution, did not violate the absolute priority rule.
Furthermore, the court held, even assuming that the absolute
priority rule was implicated by equity provisions in the plan, the
$100,000 contribution, when no lender was willing to provide such
financing upon comparable terms, was sufficient to permit
confirmation of the plan, despite nonpayment in full of senior
creditor claims, under the new value exception.
The bankruptcy court adopted the narrow view of the impact of
section 1115 in In re Draiman, 2011 WL 1486128 (Bankr.
N.D. Ill. Apr. 19, 2011). In that case, an individual debtor's
chapter 11 plan provided for less than full payment of senior
creditor claims but proposed that the debtor would retain certain
nonexempt assets, including office equipment, furnishings,
supplies, and certain management agreements of his management and
consulting firm as well as personal household items and an
automobile. The court ruled that, although the debtor was entitled
to postpetition income from the management company under section
1115, his attempt to keep nonexempt assets of the bankruptcy estate
that are not specifically addressed by section 1115 violated the
absolute priority rule. However, the debtor also argued that his
contribution of $100,000 for the retained assets was sufficient for
the new value exception to apply. The court agreed, concluding that
the contribution, which was to be made by a business associate, was
"new"; "necessary" to the plan because it would
serve as the initial funding for a liquidation and litigation trust
to be created by the plan; "reasonably equivalent to the
value" of the retained assets (which were valued at no more
than $30,000); and, being in cash, in "money or money's
worth."
In In re Kamell, 2011 WL 1760282 (Bankr. C.D. Cal. May 4,
2011), the court similarly adopted the narrow view of BAPCPA and
section 1115's impact on the absolute priority rule in
individual chapter 11 cases. According to the court, "there is
no good reason to conclude that Congress intended to abrogate this
long-standing and important centerpiece of Chapter 11 jurisprudence
based on the ambiguous language of the BAPCPA amendments." The
court found the narrow view more persuasive than the "broad
view," which reads into the language of sections
1129(b)(2)(B)(ii) and 1115 an intent to abrogate the absolute
priority rule entirely, as in chapter 13. The court accordingly
ruled that the debtor's plan could not be confirmed because it
proposed to allow the debtor to retain substantial prepetition
property without paying dissenting unsecured creditors in full.
Other decisions thus far in 2011 adopting the narrow view have
included In re Maharaj, 2011 WL 1753795 (Bankr. E.D. Va.
May 9, 2011); In re Walsh, 447 B.R. 445 (Bankr. D. Mass.
2011); and In re Stephens, 445 B.R. 816 (Bankr. S.D. Tex.
2011).
Outlook
The appellate courts have yet to address the impact of section
1115 on the absolute priority rule, and only a handful of courts
(and none at the circuit level or above) have examined the new
value exception in any published opinion in five years or more.
That may soon change, especially with respect to section 1115. The
number of individual chapter 11 filings has risen considerably in
the last two years, and the continued existence (or not) of the
absolute priority rule will determine whether plans are confirmable
in many of those cases. The issue is an important one that needs
resolution in many individual chapter 11 cases. Disputes regarding
these issues are likely to percolate upward through the appellate
processes in the not too distant future. Perhaps the circuit courts
of appeal and even the U.S. Supreme Court will soon have an
opportunity to rule on both the impact of section 1115 and the
viability of the new value exception.
Interestingly, in Ala. Dep't of Econ. & Comm. Affairs
v. Ball Healthcare-Dallas, LLC (In re Lett), 632 F.3d 1216
(5th Cir. 2011), the Fifth Circuit Court of Appeals was presented
with an opportunity earlier this year to weigh in on the absolute
priority rule in individual debtor chapter 11 cases as well as the
new value exception. However, section 1115 did not apply in that
case because the chapter 11 filing preceded the October 17, 2005,
effective date of the provision, and the court expressly declined
"further discussion of this exception to the absolute priority
rule, as it is not at issue in this case." On remand, however,
the district court ruled in In re Lett, 2011 WL 2413484
(S.D. Ala. June 13, 2011), that the debtor's plan violated the
absolute priority rule because certain property would revest in the
debtor upon confirmation without paying senior creditor classes in
full and that the plan failed to satisfy the new value exception
because the debtor contributed no new value to the estate.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.