Another Take on the New Value Exception Keeping Insiders In After North LaSalle

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Oct 2001

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A debtor client approaches you and asks for your assistance in reorganizing its business
in chapter 11. Creditors will be paid no better than 20 cents on the dollar,
and of course, your client wants to retain control of the business and keep its stock.
Your client knows the creditors will not voluntarily accept the plan, but insists there
can be no business without current insiders.

These familiar facts run head-on into that darned absolute priority rule. Assuming
creditors won't go along, you've got to find a way around it. Enter the "new value
exception to the absolute priority rule." Is it still alive after the Supreme
Court's decision in North LaSalle?

This article will examine the new value exception (or corollary) to the absolute
priority rule and discuss plan provisions that have satisfied or should satisfy the
exception.

<h3>The Absolute Priority Rule</h3>

A bankruptcy court may confirm a plan of reorganization over the objection of a
class of creditors only if "the holder of any claim or interest that is junior to
the claims of such [objecting] class will not receive or retain under the plan on
account of such junior claim or interest any property." 11 U.S.C.
§1129(b)(2)(B)(ii); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Rushville State Bank of Rushville, Mo.,
987 F.2d 1506, 1508 (10th Cir. 1993)</a>.

This "is the core of what is known as the 'absolute priority rule.'" <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of
America National Trust and Savings Association v. 203 North LaSalle Street
Partnership, 526 U.S. 434, 442, 119 S.Ct. 1411, 1416, 143
L.Ed.2d 607 (1999)</a>. In its most general sense, "the absolute priority
rule 'provides that a dissenting class of unsecured creditors must be provided for in
full before any junior class can receive or retain any property [under a reorganization]
plan.'" <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Bank Worthington v. Ahlers, 485 U.S. 197, 202, 108
S.Ct. 963, 966, 99 L.Ed.2d 169 (1988)</a> (alteration in
original).

<h3>The New Value Corollary</h3>

The absolute priority rule began as a common-law rule that predated the current
Code. Prior to the legislative enactment of §1129(b)(2)(B)(ii), the
Bankruptcy Act only required that a reorganization plan be fair and equitable. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
LaSalle, 526 U.S. at 444, 119 S.Ct. at 1417</a>. Courts interpreted
this to mean that creditors had to be paid before stockholders could retain equity
interests. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Los Angeles Lumber Products Co., 308 U.S. 106, 60
S.Ct. 1, 84 L.Ed. 110 (1939)</a>, however, the court, in dictum,

opened the door to the possibility that, notwithstanding the common-law absolute priority
rule, stockholders could participate in a reorganization plan. Based on Case, some
courts began holding that equity-holders could retain an equity interest in a
reorganized entity if they contributed "new value." A contribution sufficient to overcome
the absolute priority rule had to be (1) in the form of money or money's worth,
(2) reasonably equivalent to the interest retained or received by the equity-holders,
and (3) necessary for the debtor's reorganization. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… LaSalle, 526 U.S. at
442, 119 S.Ct. at 1416</a>. Some courts later added the requirements that the
contribution be (4) up front and (5) substantial. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Snyder, 967
F.2d 1126, 1131 (7th Cir. 1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Haskell Dawes Inc.,
199 B.R. 867, 872 (Bankr. E.D. Pa. 1996)</a>.

In North LaSalle, the Supreme Court declined to decide whether a new value
corollary or exception to the absolute priority rule still existed after the passage of
§1129(b)(2)(B)(ii). Instead, the court, limiting its holding to the
specific facts, held that the debtor's pre-bankruptcy equity-holders could not, over
the objection of a senior class of impaired creditors, contribute new capital to
receive ownership interests in the new entity when that opportunity was given exclusively
to the old equity-holders without consideration of alternatives or market valuation.
Id. at 437, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… S.Ct. at 1414</a>. The court reasoned that the exclusive
opportunity to invest in the reorganized entity, and thereby receive equity in it,
must be considered property received "on account of" old equity interests in the
entity. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 456</a>, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… S.Ct. at 1423</a>.

The Supreme Court also clarified in North LaSalle that the "on account of" language
in §1129(b)(2)(B)(ii) means "because of" and requires only a causal
connection between the equity interest and the property to be received or retained.

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 450-51</a>, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… S.Ct. at 1420</a>. As proclaimed in its opinion:

<blockquote>
[A] causal relationship between holding the prior claim or interest and receiving
or retaining property is what activates the absolute priority rule.
</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 451</a>, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… S.Ct. at 1420</a>.

<h3>New Value After North LaSalle</h3>

Market test. North LaSalle holds that there must be some way to test the value
of a proposed contribution. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 457-58</a>, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… S.Ct. at 1423-24</a>.
Where the plan grants an exclusive right, "the best way to determine value is exposure
to a market." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 457</a>, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… S.Ct. at 1423</a>. The court, however,
refused to decide "[w]hether 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..." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 458</a>, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… S.Ct. at 1424</a>.

Under a plan proposed in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Global Ocean Carriers Ltd., 251 B.R. 31
(Bankr. D. Del. 2000)</a>, the debtor's largest shareholder retained the exclusive
right to determine who would be debtor's owner, as well as at what price, without
the benefit of a public auction or competing plan. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 51-52</a>. The court
held that this violated the absolute priority rule.

<blockquote>
To avoid this result, the debtors must subject the "exclusive opportunity" to
determine who will own Global Ocean to the marketplace test...This can be
achieved by either terminating exclusivity and allowing others to file a competing
plan or allowing others to bid for the equity (or the right to designate who
will own the equity) in the context of the debtors' plan.
</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 52</a>. The court also rejected the suggestion that talking to another unrelated
party about investing in the reorganized debtor would be sufficient to satisfy the
marketplace test. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at n. 19.

In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Situation Management Systems Inc., 252 B.R. 859 (Bankr.
Mass. 2000)</a>, the court held that a new value provision in a reorganization plan
was grounds for terminating the debtor's exclusive right to file a plan. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at
865</a>. The court further reasoned that, "where, as here, there is a party
interested in acquiring the debtor, the opportunity to offer a competing plan is a
preferable procedural mechanism to auction..." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

In In re Davis, 2001 Bankr. Lexis 501 (Bankr. D. Ariz. March
14, 2001), the plan provided for a new value alternative permitting individual
debtors to contribute certain non-estate funds, but did not permit competing plans or
other forms of competition for the new value. Id. at *18. The court rejected
the plan, reasoning in part that "it fails to use a 'market' or 'non-exclusive'
approach to the source of new value." Id. at *20. In an attempt to remedy the
situation, the court terminated the exclusivity period, allowing competing plans to be
filed. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

It appears then that post-North LaSalle, the simplest way to effectuate the
retention of equity (or other property) is to allow competing plans. Under the
post-North LaSalle cases described above, courts have terminated exclusivity in an effort
to allow "competition" to plans proposed by existing equity owners. Voluntarily
terminating exclusivity for this purpose, with an opportunity for competing plans, should
likewise be sufficient. A second way to provide "competition" would be to open up
the proposed opportunity through fair and open auction procedures. By demonstrating that
competing bids have been genuinely solicited, the concerns raised by the Supreme Court
in North LaSalle should be satisfied.

<h3>Causal Relationship</h3>

In deciding North LaSalle, the court did not inquire into any of the common-law
elements of the new value corollary.<a href="#1" name="1a">1</a> Instead, the court focused on whether a causal
relationship existed between the interest retained and the prior interest. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… LaSalle,

526 U.S. at 456, 119 S.Ct. at 1423</a>.<a href="#2" name="2a">2</a>

<blockquote>
[A] causal relationship between holding the prior claim or interest and receiving
or retaining property is what activates the absolute priority rule.
</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 451</a>, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… S.Ct. at 1420</a>.

After North LaSalle, an argument can be made that the analysis for new value
should be limited to whether or not a causal relationship exists. See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
re PWS Holding Corp., 228 F.3d 224, 238 (3d Cir. 2000)</a> (not
addressing common-law elements of new value test, instead reasoning that releases were
not "made 'on account of' KKR's junior interest as that phrase is construed in 203
North LaSalle").

<h3>Common Law New Value Test</h3>

In some jurisdictions, such as the Third Circuit, there is a large body of case
law fleshing out the elements required for sufficient new value.<a href="#3" name="3a">3</a> In these
jurisdictions, it is safe to say that the new value exception is alive and well.
See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re PWS Holding Corp. Bruno's Inc. 228 F.3d 224 (3d
Cir. 2000)</a>. In other jurisdictions, such as the Tenth Circuit, there is
little or no guidance, and it is difficult to know whether a court will even consider
a plan incorporating the concept of new value.<a href="#4" name="4a">4</a>

In any case, applying well-developed case law should shed light on whether a plan
proposing that equity-holders retain property should be confirmed. Again, the
common-law test requires that the new value be (1) in money or money's worth,
(2) necessary for the debtor's reorganization and (3) reasonably equivalent to the
interest retained or received by the equity-holders. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… LaSalle, 526 U.S. at
442, 119 S.Ct. at 1416</a>. In addition, some courts have added the
requirements that the contribution be (4) up front and (5) substantial. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
re Snyder, 967 F.2d 1126, 1131 (7th Cir. 1992)</a>. The following
discussion offers guidance with respect to each of these elements.

Up front and in the form of money or money's worth. "[C]ontributions which
satisfy the 'money's worth' requirement 'should be (1) an asset in the accounting
sense, (2) tangible, alienable and enforceable, and (3) a present
contribution that can be levied upon at the time of plan approval.'" <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
Haskell Dawes Inc., 199 B.R. 867, 873 (Bankr. E.D. Pa.
1996)</a> (quoting Kruis, Katherine, "A Framework for Application of the New
Value Exception," 21 Cal. Bankr. J. 199, 216 (1993)).
"Contributions in the form of future payments do not constitute present or
'up-front' capital contributions." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Hendrix, 131 B.R. 751,
753 (Bankr. M.D. Fla. 1991)</a> ("the contribution cannot be a future
contribution, it must be present, taking place at or before the effective date of
the plan"); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Future Energy Corp., 83 B.R. 470, 499 (Bankr.
S.D. Ohio 1988)</a> ("It is well established that a new capital investment must
be a present contribution, not a contribution promised in the future.")

Importantly, the contribution of labor, experience and expertise by an equity-holder
is not in "money's worth" and therefore not sufficient for new value purposes. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
LaSalle, 526 U.S. at 445, 199 S.Ct. at 1417-18</a>.

Necessary to the reorganization. The requirement that the contribution be necessary
to the reorganization is met if:

<blockquote>
(i) the contribution will be used to fund repairs or improvements to the
debtor's property that are necessary to its reorganization, or (ii) the
contribution is needed to enable the debtor to make payments due under the plan
of reorganization and continue operating.
</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Haskell Dawes Inc., 199 B.R. at 873</a>.

Courts have held that contributions of new value are only "necessary" if they are
to be used for the continued operations of the debtor, such as where capital is
necessary to repair or alter property owned by a debtor. Where, however, there has
been no specific need for capital other than to overcome the absolute priority rule,
contributions of capital have failed to satisfy the "necessity" prong of the new value
exception. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Sovereign Group, supra, 142 B.R. at 70</a> and cases
cited therein.

Moreover, if the new value is being contributed only for the purpose of funding
nominal payments to unsecured creditors, "necessity" is not shown. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Sovereign
Group, 142 B.R. at 708</a> (the partial payment of a pre-existing debt to an
objecting creditor, particularly in such an insignificant amount, will not facilitate
reorganization); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Mortgage Invest. Co. of El Paso, Texas, 111 B.R.
604, 619 (Bankr. W.D. Tex. 1990)</a> (where infusion of capital was to
be used for payment of a class of creditors, infusion not necessary to continued
operations of debtor).

Reasonably equivalent to the interest being retained. "The reasonable equivalence
requirement ensures that equity-holders will not get around the absolute priority rule
by offering token cash contributions." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Graphic Communications Inc., 200
B.R. 143, 150 (Bankr. E.D. Mich. 1996)</a>. If the value of the
interest being retained were more than the value of the contribution, the old
equity-holder would be receiving something "on account of" his or her junior claim.
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Haskell Dawes Inc., 199 B.R. at 877</a>.

In analyzing whether the property to be contributed is reasonably equivalent to the
property to be retained, a court should consider not only the equity interests proposed
to be retained, but also other "benefits" proposed to be retained. These might include
salaries, health benefits, releases of personal debts and potential liabilities, tax
benefits and other company perks, such as a company car. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Dawes, 199
B.R. at 879-80</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Beaver Office Products Inc., 185 B.R. 537,
544-545 (Bankr. N.D. Ohio 1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Creekside Landing Ltd.,

140 B.R. 713, 718 (Bankr. M.D. Tenn. 1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Pullman
Construction, 107 B.R. 909, 949 (Bankr. N.D. Ill. 1989)</a>.

A court must then measure the value to be received or retained against the proposed
new value contribution. Often, this will require an evaluation of the value of the
reorganized debtor. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Graphic Communications Inc., 200 B.R. at 150</a>
(holding that failure to present evidence regarding the value of the reorganized debtor
was fatal to plan).

Substantial. In determining whether a proposed contribution is substantial, courts
generally consider a combination of two or more of the following factors:

<blockquote>
[T]he size of the contribution, its relation to the amount of unsecured claims
against the estate, its relation to the plan's distribution to unsecured
creditors, its relation to the amount of pre-petition claims, its relation to
a normal market contribution, and the amount of debt to be discharged.

</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Dawes, 199 B.R. at 875</a>. In the context of a close corporation,
because "normal market contributions" do not exist, courts have generally considered
only the following two factors in determining whether a proposed contribution is
substantial: (1) the percentage of return on creditors' claims relative to the
contribution, and (2) whether the proposed payment represents the equity-holder's
best efforts. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Safety, supra, 200 B.R. at 590</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Dawes, 199 B.R. at 875-876</a>.

Courts have held that contribution-to-unpaid debt ratios within certain ranges are
not substantial. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Dawes, 199 B.R. at 876</a> (contribution of 5.1
percent of unsecured debt not substantial); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Woodbrook Associates, 19
B.R. at 876</a> (new value of 3.8 percent not substantial); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Sovereign
Group, 142 B.R. at 710</a> (new value contribution of $135,000 which
represented only 3.6 percent of unsecured debt not substantial). The contribution
percentage should be considered both in light of total unsecured claims and the plan's
proposed distribution to unsecured creditors. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Dawes, 199 B.R. at
876</a>. However, the determination of whether a contribution is "substantial" cannot
rest on a mathematical formula alone. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

In addressing whether the contribution constitutes the "best efforts" of the inside
equity-holders, it is appropriate to inquire into a contributor's financial condition.
See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 877</a>. Thus, inquiries into the insider's personal assets, revenue
streams and liquidity are all relevant to plan confirmation.

<h3>Conclusion</h3>

As a result of the market-test requirement in North LaSalle, any plan that would
provide for continuing ownership in a reorganized debtor over the objection of a class
of creditors without the benefit of competing plans or an "auction" should fail. In
many jurisdictions, well-developed case law on what is sufficient for purposes of the
new value exception offers helpful guidance on what may pass muster. These
fact-intensive inquiries provide ample ammunition for both sides of the confirmation
battle.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> According to the court, "the Code does not codify any authoritative pre-Code version of the absolute priority rule." Id.
at 448, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… S.Ct. at 1419</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> "There is no reason [for the exclusive participation by old equity] unless the very purpose of the whole transaction is, at least
in part, to do old equity a favor. And that, of course, is to say that old equity would obtain its opportunity, and the resulting
benefit, because of old equity's prior interest with the meaning of subsection (b)(2)(B)(ii)." Id. <a href="#2a">Return to article</a>

<a name="3">3</a> See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Haskell Dawes Inc, 199 B.R.867 (Bankr. E.D. Pa. 1996)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Beaver Office
Products Inc., 185 B.R. 537 (Bankr. N.D. Ohio 1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Sovereign Group 1985-27 Ltd., 142 B.R. 702
(E.D. Pa. 1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Pullman Construction, 107 B.R. 909 (Bankr. N.D. Ill. 1989)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> Before North LaSalle, the Tenth Circuit refused to decide squarely whether a new value corollary to the absolute priority rule
existed, instead holding that, even if it did, appellants failed to prove that they fulfilled its requirements. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Rushville State
Bank of Rushville, 987 F.2d 1506 (10th Cir. 1993)</a>. <a href="#4a">Return to article</a>

<hr>

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Journal Authors

Risa Lynn Wolf-Smith

Tim Gordon

Journal Date

Monday, October 1, 2001 - 12:00

Bankruptcy Rule

2001