A “new value contribution” is a nonstatutory construct developed by courts as a counterweight to the so-called absolute priority rule in chapter 11, which precludes owners from retaining equity following confirmation if creditors object and are not paid in full.

A December 15 opinion by Bankruptcy Judge Michelle M. Harner of Baltimore gives definition to the amorphous notion of new value.

The corporate debtor began an attempted reorganization under Subchapter V of chapter 11. The debtor elected to proceed under “ordinary” chapter 11 after the Fourth Circuit held that debts of a corporate debtor in Subchapter V can be nondischargeable under Section 523(a). Cantwell-Cleary Co. v. Cleary Packaging LLC (In re Cleary Packaging LLC), 36 F.4th 509 (4th Cir. June 7, 2022). To read ABI’s report, click here.

Had the debtor remained in Subchapter V, the absolute priority rule would not have applied even if a class of creditors had voted against the plan, but in “ordinary” chapter 11, the absolute priority rule came back to life.

The corporate debtor had sought chapter 11 relief to deal with a $4.7 million state court judgment against the debtor and its owner. Now under “ordinary” chapter 11, the debtor proposed a plan where the owner would retain ownership after confirmation.

The class of unsecured creditors voted overwhelmingly in favor of the plan, but the creditor with the $4.7 million judgment was in a class of its own and voted against the plan.

To overcome the absolute priority rule and retain ownership after confirmation, the owner offered new value described by Judge Harner as:

(i) his sweat equity; (ii) the payment on his prepetition claim against the Debtor (arguably approximately $2,000 in wages and $47,000 in commissions); (iii) his $35,000 postpetition (and preconfirmation) loan to the Debtor; and (iv) $25,000 (presumably in cash) from his retirement account.

Analyzing the adequacy of the new value, Judge Harner explained that the absolute priority rule came into play under Section 1129(b), the so-called cramdown provisions in the Bankruptcy Code. It became applicable because a class voted against the plan. Section 1129(b)(1) says that “[t]he court . . . shall confirm the plan notwithstanding [a dissenting class] if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims and interests that is impaired under, and has not accepted, the plan.”

“In simple terms,” Judge Harner said that “the absolute priority rule requires that each class of impaired and unaccepting creditors be paid in full prior to any junior class of claims or interests receiving any distributions under the plan.” She said that the new value theory “emerged to address the dilemma posed to prepetition equity holders of a chapter 11 debtor.”

Judge Harner went on to say that the “general contours” of new value were “best described” by the Supreme Court in Bank of America Nat’l Trust and Savings Ass’n. v. 203 North LaSalle Street P’ship, 526 U.S. 434 (1999). There, the Court held that the provision of new value may not be offered only to existing equity holders “without consideration of alternatives.”

“Unfortunately,” Judge Harner said, “[l]ower courts have struggled to define appropriate ‘alternatives’ in the context of the new value exception.”

For definition, Judge Harner decided to follow the Ninth Circuit’s decision in Bonner Mall P’ship v. U.S. Bancorp Mort. Co. (In re Bonner Mall P’ship), 2 F.3d 899 (9th Cir. 1993), cert. granted sub nom. U.S. Bancorp Mortg. Co. v. Bonner Mall P’ship, 510 U.S. 1039 (1994), motion to vacate denied and case dismissed, 513 U.S. 18 (1994). She characterized the five-factor test in Bonner Mall as requiring new value to be:

(i) new, (ii) substantial, (iii) in money or money’s worth, (iv) necessary for a successful reorganization, and (v) reasonably equivalent to the value of the stock being retained or received.

Id., 2 F.3d at 908.

The debtor attempted to short-circuit application of the test by contending that the equity after confirmation would be worthless. Judge Harner disagreed. She said that the debtor was “a profitable business, has the ability to continue profitable operations in the future, and has particularly significant value to the [owner].”

Applying the test, Judge Harner said that sweat equity and debt forgiveness “are not considered ‘new,’ ‘substantial,’ or ‘money or money’s worth’ under the case law,” citing Northwest Bank Worthington v. Ahlers, 485 U.S. 197, 206 (1988). She said:

Courts place great emphasis on the proposed new value actually being “new” and in the nature of a fresh, outside capital infusion that will help pay creditors or otherwise aid the reorganization.

Similarly, Judge Harner said that repayment of the owner’s loan from the debtor was not “new or money or money’s worth” because “it must be repaid.”

Judge Harner did find that the contribution of $25,000 from the owner’s retirement account was new value. However, she said it was not “adequate new value,” citing In re Ambanc La Mesa Ltd. P’Ship, 115 F.3d 650, 655 (9th Cir. 1997), where the Ninth Circuit compared the offered new value to the total unsecured claims, the claims being discharged and the dividend to unsecured creditors.

Judge Harner said that the $25,000 was about 0.5% of total claims and some 1.8% of the proposed distribution to creditors. “[P]erhaps more importantly,” she said that the owner would retain all of the equity “while the Debtor pays creditors only 27% of their claims under a 60-month plan.”

Judge Harner denied confirmation of the plan, holding that “the Debtor’s plan fails the absolute priority rule of section 1129(b) of the Code.”