Daily Development for Tuesday, May 11, 1999

 

By: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
prandolph@cctr.umkc.edu

 

The substance of today's DD is reported by G. Ray Warner, the bankruptcy expert

on our faculty here at UMKC, and a nationally known bankruptcy commentator. Any errors, resulting from attempts to make the piece more user friendly to non bankruptcy types, are mine.

 

BANKRUPTCY; REORGANIZATION; CONFIRMATION; "NEW VALUE:" Supreme Court discusses, but dodges, the issue of whether there is a "new value" exception to the rule prohibiting old owners from acquiring an equity interest in a reorganized debtor where some unpaid creditors dissent.

 

Bank of America National Trust and Savings Association v. 203 North LaSalle Street Partnership, #97-1418, 1999 WL 25763 (May 3, 1999).

 

Under 11 U.S.C. 1129(b)(2)(B)(ii) of the Bankruptcy Code, a plan cannot be crammed down on a dissenting senior class unless either the senior class is paid in full or no junior class will "receive or retain under the plan on account of such junior claim . . . any property."

 

In the 203 North LaSalle case, as in many single asset real estate cases, the parties holding equity interests in the debtor prior to bankruptcy were attempting to retain their equity interest in the reorganized debtor even though the secured lender's unsecured deficiency claim was not being paid in full. They proposed to contribute $6.125 million (present value of $4.12 million) in new capital in exchange for that equity interest. The plan proposed that only the holders of the old equity would be entitled to acquire the new equity.

 

The old equity owners had a very clear motive in what they were about. They were looking at a $20 million tax liability if they could not retain ownership. Presumably their argument to the bankruptcy court was not that this reorganization gave them a huge financial benefit, but rather that one purpose of bankruptcy is to continue the enterprise and that the creditor (the bank's unsecured claim) would be protected because they had the expertise to manage the enterprise, now that all those difficult litte financial problems had been dealt with. The special problem here was that the "old equity group" had a had

to address with the requirements of 1129(b) set forth above, in light of the fact that there was a dissenting creditor. Not everyone believed that it was in the best interests of the creditors for the old equity owners to be given back the keys to the ranch while leaving creditors unsatisfied.

 

Note that third parties who were strangers to the transaction, with less expertise in the enterprise, might have been able to acquire the enterprise from the trustee following the reorganization, even if certain classes of creditors were not paid. But there probably was no significant value to attract new investors, who did not reap a huge tax windfall by acquiring the entity.

 

Justice Souter, writing for a majority of six Justices, decided the case on the narrow grounds that the exclusive nature of the old equity holders' opportunity to acquire the new equity meant both that the right was "property" and that it was given "on account of" the pre-bankruptcy equity interests. Justices Scalia and Thomas joined the majority in this view. Justice Stevens dissented. Both the majority and Justice Stevens agreed that a Chapter 11 debtor's 1121 exclusive period in which to propose a plan was not "property" under 1129(b)(2)(B)(ii).

 

Beyond those narrow holdings, it is difficult to say what the case means. While denying that it was deciding the "new value" question, the majority opinion contains lengthy musings about the three alternative interpretations of the 1129(b)(2)(B)(ii) "on account of" language. The debtor had argued that the statutory provision is triggered only where the property is given "in exchange for" the old equity interest. This would mean that where there is "new value" injected into the entity, there is not an "exchange" and the bankruptcy law does not prohibit a plan providing for such an arrangement. But the majority rejects this interpretation. Instead, the majority reads the statutory language to mean "because of" and states that a causal relationship between holding the old interest and receiving property is what activates the 1129(b)(2)(B)(ii) rule. Where the "old equity" has a sole right to contribute new equity and control the reorganized entity, then it may be getting property "because of" the earlier relationship to the enterprise. The remaining issue is the degree of causation required to trigger the prohibition contained in the bankruptcy statute. Although the majority declines to resolve that issue, it appears to reject the absolutist view that any degree of causation is sufficient. Such a view would erect a per se bar on equity participation by the old equity. Instead, the opinion suggests that the "on account of" language be read to reconcile the two recognized goals of Chapter 11 -- (1) preserving going concerns, and (2) maximizing the property available to satisfy creditors. The way to reconcile those goals is to insure that the old equity is paying a higher price for the equity than anyone else would pay.

 

The majority rejects the view that the Bankruptcy Court's valuation process accomplishes that goal. Noting that the Code disfavors decisions untested by competitive choice when some form of market valuation may be available, the majority states that "plans providing junior interest holders with exclusive opportunities free from competition and without benefit of market valuation fall within the prohibition of 1129(b)(2)(B)(ii)." Under this view, the problem with the 203 North LaSalle plan is that the exclusive nature of the option provides the old equity with "protection against the market's scrutiny of the purchase price by means of competing bids or even competing plan proposals." That is what turns the interest into one extended "on account of "the old equity position under 1129(b)(2)(B)(ii). The majority declines to decide whether the "market test" would require an opportunity to offer competing plans or would be satisfied by a right to bid for the same interest.

 

Reporter's Comment 1:

The decision seems to raise more questions than it resolves and it leaves the Bankruptcy Courts free to approve a wide array of creative "new value" type plans. (Lawyers who want to see the future in five minutes or less should read Section IV and footnote 26 of the majority opinion.)

 

Reporter's Comment 2:

While the Court appears to reject the old fashioned "new value" corollary, the dicta seems to create a rule that focuses on insuring that the old equity pay a market rate (as determined by market forces) for its equity stake in the reorganized entity. Since many single asset new value plans are driven by tax considerations, the value of the equity interest to anyone who was not a former equity holder is likely to be de minimis. If so, then the Court's "market testing" requirement may allow the old equity to confirm a new value plan for a smaller contribution than would have been required by a Bankruptcy Judge under the old "substantial, necessary, and fair" test.

 

Reporter's Comment 3:

It turns out that the Supreme Court's bankruptcy opinion

on the "new value" corollary to the "absolute priority" rule was not worth the wait. Although this is the third time the Court has accepted a case involving the "new value" issue, it once again avoided deciding whether such a corollary exists

 

 

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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