On May 3, 1999, the U.S. Supreme Court handed down Bank of America Nat'l Trust & Savs. Ass'n v. 203 North LaSalle Street Partnership, 119 S. Ct. 1411 (1999), 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.

Background

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 11 U.S.C. §726(a)(6). 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, Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 203 n.3 (1988).

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 Bonner 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); Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1988). And intervene it did.

Facts

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.

Majority Opinion

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).

Concurring Opinion

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."

Dissenting Opinion

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)."

Implications

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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Footnotes

¹ Mr. Singer formerly served as an attorney on staff with the National Bankruptcy Review Commission. Return to article