Supreme Court Clarifies New Value Exception to Absolute Priority Rule - Or Does It

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Jul/Aug 1999

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On May 3, 1999, the U.S. Supreme Court handed down <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… of America Nat'l Trust & Savs.

Ass'n v. 203 North LaSalle Street Partnership, 119 S. Ct. 1411 (1999)</a>, a decision that the

bankruptcy community had hoped would finally resolve one of the most important issues

affecting chapter 11 practice: the viability of the new value exception to the absolute priority

rule. Despite being faced squarely with the issue, the High Court managed to dodge a definitive

resolution. However, the Court's ruling does restrict the ability of a debtor to confirm a new

value plan in the context of a cramdown.

<h3>Background</h3>

At the core of American

corporate law is a fundamental ordering between owners of equity and creditors; creditors must

be paid in full in the event of a financial collapse of the business before holders of equity receive

any distribution. That ordering is also a critical component of the reorganization scheme for

companies in bankruptcy and is embedded in the "absolute priority rule."

The absolute priority rule is a statutory requirement for confirming a plan of reorganization over the objection of

creditors and requires that creditors be paid in full in such circumstances before holders of

equity "receive or retain" any property under a plan "on account" of their pre-existing

interest. See 11 U.S.C. §1129(b)(2)(i)(B)(ii) (1998). In chapter 7, this rule of absolute

priority finds expression in the priority provisions of the liquidation scheme that leave the

right to receive a distribution on account of the assets administered to equity for last, after all

debts have been satisfied. See <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C. §726(a)(6)</a>. However, the absolute priority rule is not

all that "absolute" in many chapter 11 cases because creditors often—but not always—agree to

give up value to holders of equity who otherwise would have no right to participate in the

reorganized enterprise. Creditors often object to a debtor's attempt to confirm a plan that

contemplates the infusion of additional capital by old equity in exchange for continued ownership

and control. The participation of former equity holders in the reorganized enterprise based on

additional contributions to the business is known in bankruptcy parlance as the "new value

exception" or "new value corollary" to the absolute priority rule.

The existence of an

exception or corollary to the rule of absolute priority, while a recognized principle under the

Bankruptcy Act, is not expressly codified in the Bankruptcy Code. As such, the vitality of the

new value doctrine has generated a firestorm of debate, analysis, commentary and litigation.

Courts have spent a tremendous amount of effort and ink on the threshold question of the

doctrine's survival of the enactment of the Code before engaging in an analysis of the merits of a

case. Even courts that express doubts about the exception's vitality often skirt a conclusive

ruling on the point and, instead, undertake a new value analysis in order to prove that the

exception would not apply to the facts at hand in any event. See, generally, <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… Bank

Worthington v. Ahlers, 485 U.S. 197, 203 n.3 (1988)</a>.

It can be argued that the

possibility of receiving new capital investments from holders of pre-petition equity interests

promotes the rehabilitation of financially distressed businesses and preserves the going concern

value, since former owners are often the most likely and only significant source of funding

available. This is particularly true for small and family-owned businesses. A problem with this

contention, however, is presented by §1121 of the Bankruptcy Code. Section 1121 gives the

debtor the "exclusive" right to propose a plan for 120 days; however, extensions to the

120-day period are routinely granted. Thus, the confirmation of a new value plan during the

period within which the debtor is the only party that is empowered to propose any plan further

fuels the debate over the vitality of the new value exception.

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In LaSalle, the Supreme Court thus left the door open to the innovations of debtors in dealing with the issue of exclusivity...

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The National

Bankruptcy Review Commission recognized the importance of clarifying the law on an issue that

is fundamental to the confirmation process. The Commission urged legislative action and

recommended a statutory amendment that would have expressly allowed for the continued

participation of equity owners through the infusion of substantial new value. As a quid pro quo,

the Commission's proposal also required the automatic termination of exclusivity if a debtor

attempted to confirm a non-consensual new value plan. See Report of the National Bankruptcy

Review Commission, §2.4.15 at 545 (1997). However, the recommendations of the

Commission on this point have fallen upon deaf ears in Congress: There is no amendment to the

Bankruptcy Code proposed in the legislation currently before the House or Senate that would

clarify, much less resolve, the issue.

The long-standing

division among the circuits over the issue of the continued vitality of the new value exception

set the stage for the intervention of the U.S. Supreme Court, which flirted with the issue briefly

on two prior occasions. See <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… Mall Partnership v. U.S. Bancorp Mortgage Co. (In re

Bonner Mall Partnership), 2 F.3d 899 (9th Cir. 1993), cert. granted, 510 U.S. 1039,

dismissed as moot, 513 U.S. 18 (1994)</a>; <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… Bank Worthington v. Ahlers, 485 U.S. 197 (1988)</a>. And intervene it did.

<h3>Facts</h3>

The lender in 203 North LaSalle held a non-recourse first mortgage in the debtor's principal asset—15 floors of

an office building located in downtown Chicago. The limited partnership sought relief in chapter

11 after it defaulted on the loan and the lender commenced foreclosure proceedings. The debtor

proposed a plan under which its former partners would contribute approximately $6.12

million in new capital over a five-year period in exchange for complete ownership of the

reorganized entity. Significantly, former equity owners were the only parties under the plan

who could contribute new capital and acquire an interest in the reorganized debtor.

The lender, which held

a substantial unsecured deficiency claim and would have received a 16 percent distribution in

connection with that claim, objected to the plan. The bankruptcy court confirmed the plan and

the district court affirmed. In a two-to-one decision, the Seventh Circuit Court of Appeals

affirmed and upheld the validity of the new value exception. Two of the three judges on the panel

found that the exclusive opportunity to participate in a reorganization plan was not "on account

of" the former equity interest, but rather a right to receive a return on a new capital

investment. The Supreme Court reversed in a majority opinion authored by Justice Souter.

<h3>Majority Opinion</h3>

The majority engaged in

an extensive survey of pre-Code law and analyzed comments to the legislation that preceded that

statute setting forth the absolute priority rule, in order to ferret out the genesis of an exception

predicated on new value. The Court rejected the contention that former equity owners can never

receive an interest in a reorganized business in the context of a cramdown without providing for

full payment to creditors. The majority also conceded that the legislative "history does nothing

to disparage the possibility, apparent in the statutory text, that the absolute priority rule...may

carry a new value corollary." Nevertheless, the Court concluded that it was unnecessary to

resolve the question because, "assuming a new value corollary," plans that vest equity in the

reorganized business in the hands of former owners "without extending an opportunity for

anyone else either to compete for that equity or to propose a competing reorganization plan"

violate the absolute priority rule.

It was the reservation

of an exclusive right of former equity holders to obtain the benefit of continued ownership in the

reorganized enterprise that was the focal point of the Court's opinion. Justice Souter reasoned

that an exclusive opportunity of old equity to participate in the surviving business should be

treated as an item of property. As such, the question becomes why the old equity holders "alone"

should have the exclusive right to obtain it. That opportunity, coupled with the protection

against the market's scrutiny of the purchase price by means of competing bids or competing

plan proposals, renders the right of old equity a property interest extended "on account of" its

pre-existing ownership position. The very fact that the equity's right to continued participation

was "free from competition and without the benefit of market valuation" brought the plan

within the prohibition of §1129(b)(2)(B)(ii).

<h3>Concurring Opinion</h3>

In their concurring

opinion, Justices Thomas and Scalia criticized the majority's departure from a plain meaning

approach to statutory interpretation by its resort to pre-Code practice and legislative history.

The text of the statute precludes a junior equity interest from receiving or retaining any

property "on account of" its pre-petition interest. The phrase "on account of" "obviously

denotes some causal relationship between the junior interest and the property received or

retained." The concurring justices agreed with the majority's conclusion that the ability of

pre-petition equity holders to retain or receive an exclusive opportunity for continued

participation in the ownership of the business was a property right obtained "because of" their

prior and junior interests. Accordingly, the concurrence expressly relegated the majority's

comments about the desirability of a "market test" as "dicta" that is not "binding [on]...the

lower federal courts."

<h3>Dissenting Opinion</h3>

Justice Stevens

believed that the Court should have definitively resolved the question of a new value corollary in

favor of a finding that "a holder of a junior claim or interest does not receive property 'on

account of' such a claim when its participation in the plan is based upon adequate new value." In

dissenting, Justice Stevens found the Court's objections to the plan unsupported by the text of

§1129(b)(2)(B)(ii). He argued for an interpretation of the statute that would permit a junior

claimant to receive an interest in a reorganized debtor as long as the interest received was not

obtained for a "bargain price." If the new capital being invested has an equivalent or greater

value than its present interest, it becomes clear that participation is based on the fair price

being paid and not "on account of" its former claim. The Bankruptcy Code does not impose a

requirement of a "market valuation" or an "auction" of the equity interest in order to satisfy

the standards for confirming a plan. Justice Stevens suggested that a bankruptcy court could

make a valuation determination and accept the amount of the new infusion of capital as a

sufficiently fair price or offer for the interest to be acquired by the holders of pre-petition

equity. The "exclusive opportunity" to participate in the reorganized business was not a

property right according to Justice Stevens, but was an explicit function of the Code's provision

for an exclusive period during which only the debtor may propose a plan of reorganization. "It

seems both practically and economically puzzling to assume that Congress would have expected

old equity to provide for the participation of unknown third parties, who have interests

different from (and perhaps incompatible) with the [former equity holders], in order to

comply with §1129(b)(2)(B)(ii)."

<h3>Implications</h3>

The Supreme Court in

LaSalle once again left unresolved the fundamental issue of whether the Bankruptcy Code's

provision for absolute priority includes a new value corollary or exception. The Court did not,

however, issue a per se prohibition against the participation of holders of old equity in a

reorganization on the basis of a new capital infusion. Indeed, the Court recognized the possibility

"apparent in the statutory text" and rejected the contention that Congress intended to "exclude

prior equity categorically from the class of potential owners following a cramdown." There can

be no doubt, however, that the decision eliminates the ability of former holders of junior equity

interests to retain or obtain the "exclusive" right to participate in the ownership of the

reorganized debtor. As such, it would appear that any new value plan filed during the period of

exclusivity afforded by §1121 will now be patently unconfirmable in the context of a cramdown

unless a mechanism is in place that allows for competing bids for the equity in the reorganized

venture or otherwise provides a valuation of the interest retained or acquired through a

"market test." A process must therefore be in place in such circumstances in order to permit

an assessment of the adequacy of the proposed contribution by the former equity owners.

Although the Court

opined that the existence of competing plans and the establishment of an auction or bidding

process for the equity interests could satisfy the absolute priority rule, it also indicated that its

holding "does not suggest an exhaustive list of the requirements of a proposed new value plan."

In LaSalle, the Supreme Court thus left the door open to the innovations of debtors in dealing

with the issue of exclusivity (such as through a waiver of the period of exclusivity) or in

constructing advantageous procedures within their plans sufficient to subject future

participation to an appropriate market test.

It is without question

more difficult now for business debtors to cram down a new value plan and preserve the right to

continued control, particularly for closely held companies where the guarantee of control is a

paramount consideration. But it is not impossible. More decisions will certainly follow.

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<h3>Footnotes</h3>

<a name="1">1</a> Mr. Singer formerly served as an attorney on staff with the National Bankruptcy Review Commission. <a href="#1a">Return to article</a>

Journal Authors

George H. Singer

Journal Date

Thursday, July 1, 1999 - 12:00