The Evolution of New Value Plans

Background

The Supreme Court first hinted at the new value corollary in Case v. Los Angeles Lumber, 308 U.S. 106 (1939), stating the requirements to allow a stockholder to participate in a debtor's plan of reorganization, but such statements were only dicta. See LaSalle, 526 U.S. at 446. The application of the new value corollary was put into question by the Supreme Court in Bank of America v. 203 N. LaSalle St. P'ship. In LaSalle, the Seventh Circuit Court of Appeals had upheld the confirmation of a plan of reorganization where a debtor's equity owners were provided with the exclusive opportunity to purchase the reorganized debtor's new equity. Id. at 440'41. This type of plan is often referred to as a new value plan. The Supreme Court, however, disagreed with the Seventh Circuit, finding that such a plan violated the absolute priority rule, and the new value corollary did not apply. Id. at 456.

However, the LaSalle Court, in dictum, suggested that new value plans were possible: “Whether a market test would require an opportunity to offer competing plans or would be satisfied by a right to bid for the same interest sought by old equity is a question we do not decide here.” Id. at 458. From this, many practitioners believed that the new value corollary would apply either when the exclusivity period expires, and creditors have the opportunity to file competing plans, or when the new equity is put up for bid.

The Castleton Plaza Decision

The Seventh Circuit's recent decision in Castleton Plaza may change this belief. In Castleton Plaza, the debtor submitted a plan of reorganization whereby the individual old equity holder would transfer all of the new equity in the reorganized debtor to the holder's wife. This transfer was proposed to be done without marketing ' the old equity owner set a value for the new equity and his wife would pay this value. Such a transfer, the debtor argued, avoided the application of the absolute priority rule because old equity was not receiving or retaining any property ' rather, old equity's wife was receiving property (i.e., the new equity).

Over the lender's objection, the Bankruptcy Court for the Southern District of Indiana agreed with old equity's argument: “The Court concludes that the absolute priority rule does not apply to insiders who are prepetition owners.” In re Castleton Plaza, LP, No. 11-01444-BHL-11, Dkt. 285, ' 95 (Bankr. S.D. Ind. May 31, 2012). The debtor's plan was confirmed. With the approval of both the bankruptcy court and the Seventh Circuit, the lender appealed this decision directly to the Seventh Circuit, asserting that the absolute priority rule was violated when new equity is transferred to an insider without marketing. In re Castleton Plaza, LP, No. 12-2639, Appellant's Brief [Dkt. No. 12], p. 3 (7th Cir. 2012).

At oral argument on Dec. 6, 2012, Chief Judge Easterbrook observed that if the decision below was allowed to stand, the absolute priority rule may be in jeopardy: “It would certainly leave [the absolute priority rule] as meaning essentially nothing. All the old equity holder has to do is make sure that all the interest goes to a close relative and, bingo, absolute priority vanishes.” In addition, Chief Judge Easterbrook noted that, by following the reasoning in LaSalle, a determination of the proper owner of a reorganized debtor is “tested by competition.”

On Feb. 14, 2013, the Seventh Circuit issued its opinion: Castleton Plaza's plan violated the absolute priority rule. In a seven-page opinion, debtors were prohibited from passing equity ownership to an insider absent competition. “A plan of reorganization that includes a new investment must allow other potential investors to bid. ' Competition is essential whenever a plan of reorganization leaves an objecting creditor unpaid yet distributes an equity interest to an insider.” In re Castleton Plaza, L.P., 707 F.3d 821, 821'22 (7th Cir. 2013). Following this opinion, the case was remanded back to the bankruptcy court for further ruling, where it remains pending.

Castleton Plaza and the New Value Corollary

On the surface, the Castleton Plaza decision does not explicitly deal with the new value corollary. The old equity is not providing new value to purchase the new equity ' a third party is. However, a closer reading of the Seventh Circuit's opinion suggests a further limitation on the application of the corollary.

The following statement in the Castleton Plaza opinion essentially describes the new value argument advanced by the debtor: “Equity investors sometimes contend that the value they receive from the debtor in bankruptcy is on account of new (post-bankruptcy) investments rather than their old ones.” Id. at 821. Then the next two sentences appear to limit the effectiveness of the new value corollary: “The Supreme Court held in [LaSalle] that competition is the way to tell whether a new investment makes the senior creditors (and the estate as a whole) better off. A plan of reorganization that includes a new investment must allow other potential investors to bid.” Id.

Accordingly, if new value is to be pumped into a reorganized debtor, the plan must allow competition for the new equity that is being purchased. “The process protects creditors against plans that would give competing claimants too much for their new investments and thus dilute the creditors' interests.” Id. (emphasis added). From this, future new value plans may be expected typically to allow other parties the opportunity to bid for the ownership of the reorganized debtor.

The Castleton Plaza decision seems to take one more step to limit the potential effects of the new value corollary. In LaSalle, the Supreme Court noted that its opinion did not determine whether competitive bidding or the possibility of alternative plans would necessarily make a new value arrangement viable. LaSalle, 526 U.S. at 458. Castleton Plaza seemed to squarely state that the possibility of a competing plan in that case didn't make a difference. “None of the considerations we have mentioned depends on whether Castleton proposed the plan during the exclusivity period.” Castleton Plaza, 707 F.3d at 824.' In fact, the exclusivity period had expired, and the lender was afforded the opportunity to propose a competing plan. The lender did not file a competing plan.

The Seventh Circuit's opinion seems to suggest that this does not matter ' what does matter is that there is competition and marketing for the new equity. This would mean that the expiration of the exclusivity period may still not permit a new value plan to be confirmed absent competition. Since Castleton Plaza, courts have flatly rejected new value plans that do not allow for marketing of the new equity. See In re GAC Storage Lansing, LLC, No. 11-40944, 2013 Bankr. LEXIS 729 (Bankr. N.D. Ill. Feb. 27, 2013); In re Deming Hospitality, LLC, No. 11-12-13377, Dkt. No. 102 (Bankr. D.N.M. April 5, 2013).

Future Implications

The three separate standards for the application of the new value corollary, as described in Los Angeles Lumber, may be viewed after Castleton Plaza as having been reduced to one requirement: open competition for the new equity. Los Angeles Lumber suggested three requirements for application of the new value corollary: 1) a contribution of new money; 2) that is reasonably equivalent to the new equity; and 3) is necessary for a successful reorganization. If old equity holders bid and win the new equity in an open competition, they would clearly be providing new value. Also, open competition for the new equity should tend to result in a market price or reasonably equivalent value for those interests. The third element, necessity of contribution by old equity, becomes inapplicable. Competition should allow the best price to be recovered for the sale of the new equity. This will result in potentially greater payouts to creditors and/or increased chances of a successful reorganization.

Conclusion

Especially for closely held or family-owned businesses, the Castleton Plaza decision could often constrict the possibility of a “standalone” Chapter 11 reorganization. New value plans had previously been used to discharge or modify obligations in a Chapter 11 case while enabling owners to maintain control of the business after emergence from bankruptcy. Following the requirements of Los Angeles Lumber, several debtors had confirmed new value plans without any provision for new equity to be exposed to competitive bidding.' After the Seventh Circuit's decision in Castleton Plaza, this type of plan may no longer be confirmable. Requiring that new equity be exposed to the market means that there is a risk as to whether old equity holders can become the new equity owners.

'Since there can be no guarantee that a closely held business will remain under the control of its pre-bankruptcy owners, Chapter 11 may now be a less attractive alternative. Certainly, the Seventh Circuit's opinion in Castleton Plaza should provide guidance whenever a debtor seeks to confirm a new value plan that is not acceptable to creditors.

Alan K. Mills is a partner in the Indianapolis, IN, office of Barnes & Thornburg LLP. He was the lead counsel for the appellant/secured creditor in the Castleton Plaza case. David M. Powlen is a partner in the firm's Wilmington, DE, office and Jonathan D. Sundheimer is an associate in the Indianapolis office. They also acted as counsel for the appellant/secured creditor in the case. This Barnes & Thornburg LLP publication should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer on any specific legal questions you may have concerning your situation.

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Although many circuit courts of appeal have recognized the existence of a new value exception to the absolute priority rule, the Supreme Court has yet to issue a ruling that expressly adopts this exception, which is also known as the “new value corollary.” These circumstances have led many to question whether the new value corollary would survive Supreme Court review. A recent decision by the Seventh Circuit Court of Appeals, In re Castleton Plaza, LP, 707 F.3d 821 (7th Cir. 2013) has put into question the application of the corollary in future Chapter 11 cases.

New Value Corollary

The new value corollary provides that an equity owner of a debtor may purchase the new equity of the reorganized debtor if: 1) the equity owner contributes new capital in money or money's worth; 2) the new capital is reasonably equivalent to the property's value; and 3) the new capital is necessary for a successful reorganization. Bank of America v. 203 N. LaSalle St. P'ship, 526 U.S. 434, 442 (1999). The new value corollary is a common law exception to the absolute priority rule, 11 U.S.C. ' 1129(b)(2)(B)(ii). The absolute priority rule prohibits junior creditors, such as equity holders, from receiving or retaining any property on account of their junior claims unless all senior creditors, such as unsecured creditors, are paid in full. The new value corollary was developed in case law to allow old equity owners to infuse needed new capital into a reorganized debtor and, in exchange, receive the new equity in the reorganized debtor. In theory, old equity was not receiving or retaining any property on account of its junior claims ' rather, old equity was receiving the new equity on account of this cash infusion.

Background

The Supreme Court first hinted at the new value corollary in Case v. Los Angeles Lumber , 308 U.S. 106 (1939), stating the requirements to allow a stockholder to participate in a debtor's plan of reorganization, but such statements were only dicta. See LaSalle, 526 U.S. at 446. The application of the new value corollary was put into question by the Supreme Court in Bank of America v. 203 N. LaSalle St. P'ship. In LaSalle, the Seventh Circuit Court of Appeals had upheld the confirmation of a plan of reorganization where a debtor's equity owners were provided with the exclusive opportunity to purchase the reorganized debtor's new equity. Id. at 440'41. This type of plan is often referred to as a new value plan. The Supreme Court, however, disagreed with the Seventh Circuit, finding that such a plan violated the absolute priority rule, and the new value corollary did not apply. Id. at 456.

However, the LaSalle Court, in dictum, suggested that new value plans were possible: “Whether a market test would require an opportunity to offer competing plans or would be satisfied by a right to bid for the same interest sought by old equity is a question we do not decide here.” Id. at 458. From this, many practitioners believed that the new value corollary would apply either when the exclusivity period expires, and creditors have the opportunity to file competing plans, or when the new equity is put up for bid.

The Castleton Plaza Decision

The Seventh Circuit's recent decision in Castleton Plaza may change this belief. In Castleton Plaza, the debtor submitted a plan of reorganization whereby the individual old equity holder would transfer all of the new equity in the reorganized debtor to the holder's wife. This transfer was proposed to be done without marketing ' the old equity owner set a value for the new equity and his wife would pay this value. Such a transfer, the debtor argued, avoided the application of the absolute priority rule because old equity was not receiving or retaining any property ' rather, old equity's wife was receiving property (i.e., the new equity).

Over the lender's objection, the Bankruptcy Court for the Southern District of Indiana agreed with old equity's argument: “The Court concludes that the absolute priority rule does not apply to insiders who are prepetition owners.” In re Castleton Plaza, LP, No. 11-01444-BHL-11, Dkt. 285, ' 95 (Bankr. S.D. Ind. May 31, 2012). The debtor's plan was confirmed. With the approval of both the bankruptcy court and the Seventh Circuit, the lender appealed this decision directly to the Seventh Circuit, asserting that the absolute priority rule was violated when new equity is transferred to an insider without marketing. In re Castleton Plaza, LP, No. 12-2639, Appellant's Brief [Dkt. No. 12], p. 3 (7th Cir. 2012).

At oral argument on Dec. 6, 2012, Chief Judge Easterbrook observed that if the decision below was allowed to stand, the absolute priority rule may be in jeopardy: “It would certainly leave [the absolute priority rule] as meaning essentially nothing. All the old equity holder has to do is make sure that all the interest goes to a close relative and, bingo, absolute priority vanishes.” In addition, Chief Judge Easterbrook noted that, by following the reasoning in LaSalle, a determination of the proper owner of a reorganized debtor is “tested by competition.”

On Feb. 14, 2013, the Seventh Circuit issued its opinion: Castleton Plaza's plan violated the absolute priority rule. In a seven-page opinion, debtors were prohibited from passing equity ownership to an insider absent competition. “A plan of reorganization that includes a new investment must allow other potential investors to bid. ' Competition is essential whenever a plan of reorganization leaves an objecting creditor unpaid yet distributes an equity interest to an insider.” In re Castleton Plaza, L.P., 707 F.3d 821, 821'22 (7th Cir. 2013). Following this opinion, the case was remanded back to the bankruptcy court for further ruling, where it remains pending.

Castleton Plaza and the New Value Corollary

On the surface, the Castleton Plaza decision does not explicitly deal with the new value corollary. The old equity is not providing new value to purchase the new equity ' a third party is. However, a closer reading of the Seventh Circuit's opinion suggests a further limitation on the application of the corollary.

The following statement in the Castleton Plaza opinion essentially describes the new value argument advanced by the debtor: “Equity investors sometimes contend that the value they receive from the debtor in bankruptcy is on account of new (post-bankruptcy) investments rather than their old ones.” Id. at 821. Then the next two sentences appear to limit the effectiveness of the new value corollary: “The Supreme Court held in [LaSalle] that competition is the way to tell whether a new investment makes the senior creditors (and the estate as a whole) better off. A plan of reorganization that includes a new investment must allow other potential investors to bid.” Id.

Accordingly, if new value is to be pumped into a reorganized debtor, the plan must allow competition for the new equity that is being purchased. “The process protects creditors against plans that would give competing claimants too much for their new investments and thus dilute the creditors' interests.” Id. (emphasis added). From this, future new value plans may be expected typically to allow other parties the opportunity to bid for the ownership of the reorganized debtor.

The Castleton Plaza decision seems to take one more step to limit the potential effects of the new value corollary. In LaSalle, the Supreme Court noted that its opinion did not determine whether competitive bidding or the possibility of alternative plans would necessarily make a new value arrangement viable. LaSalle, 526 U.S. at 458. Castleton Plaza seemed to squarely state that the possibility of a competing plan in that case didn't make a difference. “None of the considerations we have mentioned depends on whether Castleton proposed the plan during the exclusivity period.” Castleton Plaza, 707 F.3d at 824.' In fact, the exclusivity period had expired, and the lender was afforded the opportunity to propose a competing plan. The lender did not file a competing plan.

The Seventh Circuit's opinion seems to suggest that this does not matter ' what does matter is that there is competition and marketing for the new equity. This would mean that the expiration of the exclusivity period may still not permit a new value plan to be confirmed absent competition. Since Castleton Plaza, courts have flatly rejected new value plans that do not allow for marketing of the new equity. See In re GAC Storage Lansing, LLC, No. 11-40944, 2013 Bankr. LEXIS 729 (Bankr. N.D. Ill. Feb. 27, 2013); In re Deming Hospitality, LLC, No. 11-12-13377, Dkt. No. 102 (Bankr. D.N.M. April 5, 2013).

Future Implications

The three separate standards for the application of the new value corollary, as described in Los Angeles Lumber, may be viewed after Castleton Plaza as having been reduced to one requirement: open competition for the new equity. Los Angeles Lumber suggested three requirements for application of the new value corollary: 1) a contribution of new money; 2) that is reasonably equivalent to the new equity; and 3) is necessary for a successful reorganization. If old equity holders bid and win the new equity in an open competition, they would clearly be providing new value. Also, open competition for the new equity should tend to result in a market price or reasonably equivalent value for those interests. The third element, necessity of contribution by old equity, becomes inapplicable. Competition should allow the best price to be recovered for the sale of the new equity. This will result in potentially greater payouts to creditors and/or increased chances of a successful reorganization.

Conclusion

Especially for closely held or family-owned businesses, the Castleton Plaza decision could often constrict the possibility of a “standalone” Chapter 11 reorganization. New value plans had previously been used to discharge or modify obligations in a Chapter 11 case while enabling owners to maintain control of the business after emergence from bankruptcy. Following the requirements of Los Angeles Lumber, several debtors had confirmed new value plans without any provision for new equity to be exposed to competitive bidding.' After the Seventh Circuit's decision in Castleton Plaza, this type of plan may no longer be confirmable. Requiring that new equity be exposed to the market means that there is a risk as to whether old equity holders can become the new equity owners.

'Since there can be no guarantee that a closely held business will remain under the control of its pre-bankruptcy owners, Chapter 11 may now be a less attractive alternative. Certainly, the Seventh Circuit's opinion in Castleton Plaza should provide guidance whenever a debtor seeks to confirm a new value plan that is not acceptable to creditors.

Alan K. Mills is a partner in the Indianapolis, IN, office of Barnes & Thornburg LLP. He was the lead counsel for the appellant/secured creditor in the Castleton Plaza case. David M. Powlen is a partner in the firm's Wilmington, DE, office and Jonathan D. Sundheimer is an associate in the Indianapolis office. They also acted as counsel for the appellant/secured creditor in the case. This Barnes & Thornburg LLP publication should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer on any specific legal questions you may have concerning your situation.

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