The Second Circuit Rejects the Viability of the New Value Exception to the Absolute Priority Rule Is an Auction for the Equity Necessary and Do the Unsecured Creditors Win

The Second Circuit Rejects the Viability of the New Value Exception to the Absolute Priority Rule Is an Auction for the Equity Necessary and Do the Unsecured Creditors Win

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In February 19, 1998, the Second Circuit Court of Appeals expressly rejected the viability of the so-called new value exception to the absolute priority rule under the Bankruptcy Code, in direct opposition to both the Ninth and Seventh Circuits.1 In re Coltex Loop Central 3 Partners, LP, 138 F.3d 39 (2nd Cir. 1998) (Coltex). Given the express split in the circuits, the Supreme Court granted certiori in Coltex on June 4, 1998.

While the Second Circuit decision (as well as an earlier, albeit less heralded, decision by the Fourth Circuit Court of Appeals)2 undoubtedly will be heralded as a victory for secured creditors—at least until the Supreme Court resolves the dispute—one cannot help but wonder if unsecured creditors are tactically disadvantaged by a rejection of the new value exception to the absolute priority rule. In many reorganization cases, and particularly so in single asset real estate cases, a chapter 11 generally tends to be a "battle of the Titans"—i.e., the secured creditor (usually with a massive unsecured deficiency claim) fighting the equity holders who wish to retain equity and effectively cramdown the secured lender (usually to avoid unfavorable tax consequences that would result from a foreclosure or for other reasons). As one might expect, the trade debt in many of these cases tends to be of considerably less magnitude than the unsecured deficiency of the lender.

Assuming a debtor can obtain an accepting impaired class in order to get to a contested cramdown confirmation, the Bankruptcy Code specifically requires that no junior class or interest may receive or retain any property or value on account of that junior claim or interest unless senior claims or interests either consent to it or are paid in full. See Bankruptcy Code §1129(b)(2)(C). According to both Bryson and Coltex, unless unsecured creditors (as a class) consent to allowing equity interests to receive or retain their interests in the debtor (presumably even if they pay for the retention of those interests), there are essentially three choices available to the debtor:

1. Pay the unsecured creditors in full (presumably including an interest factor). This is rarely a realistic alternative for a debtor;

2. Give up equity in the debtor and reorganized debtor to the unpaid, unsecured creditors. While this is an interesting concept (and is frequently done in larger cases), in the single asset case it is never a palatable alternative for a debtor who is only going through this exercise to retain its interests; or

3. Sell the equity in the reorganized debtor to a third party.

This creates a very interesting scenario whereby Coltex and Bryson would prevent existing equity from "buying" the equity in the reorganized debtor through a new value plan, but would in no way prevent a third party from coming in and "buying" the equity.

The Coltex decision is interesting with respect to an almost offhanded comment made at the very conclusion of the opinion. Specifically, the Second Circuit in the very last paragraph stated as follows:

In conclusion, we hold that any plan providing for old equity to contribute new capital to fund a chapter 11 reorganization plan, is limited by the various requirements for confirmation set forth in 11 U.S.C. §1129(b)(2)(B)(ii). Each such plan must be examined to make sure that old equity does not retain or receive property of the debtor "on account of" its prior subordinate position. Where no other party seeks to file a plan or where the market for the property is adequately tested, old equity may be able to demonstrate that it can meet the requirements of 11 U.S.C. §1129 and that, in essence, it receives nothing on account of its prior position. This is not such a case. This was an insider’s plan for the benefit of insiders. It was of little benefit to any creditor, and the major creditor was stymied in its legitimate attempts to obtain the value of its claims. The plan was not fair and equitable.

Coltex, 138 F.3d at 46 (emphasis supplied).

This is a very interesting statement by the Second Circuit. Is the Second Circuit suggesting that any time there is a new value plan being proposed, some sort of "open auction" should be instituted for the equity in the reorganized debtor? In Coltex, the debtor was jealously defending its exclusive right to file a plan. The Second Circuit thought it was significant that perhaps the debtor’s plan would have been confirmable as "fair and equitable" had the debtor shown to the court that, in fact, no other party was interested in filing a plan or the "market for the property" was adequately tested.3 Was the Second Circuit suggesting that had this debtor consented to termination of exclusivity to allow any and all parties to file plans, or perhaps conducted an "auction" for the equity, that it might have ruled differently in the case? The comment in the conclusion of the Second Circuit’s opinion in Coltex creates an interesting scenario, and it has been endorsed in other decisions. See In re Bjolmes Realty Trust, 134 B.R. 1000 (Bankr. D. Mass. 1991); In re Ropt Limited Partnership, 152 B.R. 406 (Bankr. D. Mass. 1993). See, also, Miscioscia, Bankruptcy Code and the New Value Doctrine: An Examination Into History, Allusions and the Need for Competitive Bidding, 79 Va. L. Rev. No. 4172 (June 1993).

If an auction is indeed necessary, it seems that the ultimate winner must certainly be the unsecured creditors who presumably will reap some benefit from the additional equity being put in. Accordingly, it would seem that unsecured creditors in the Second Circuit (and at least until the Supreme Court renders the definitive ruling, which is expected early in 1999) should embrace the dicta contained in Coltex and demand an auction. Of course, this can be a dangerous strategy, because any time debtors terminate or otherwise modify exclusivity (which most debtors are loathe to do), they not only potentially give up control of the process but also open the way for a liquidation plan to be filed by a secured creditor. From the unsecured creditor’s perspective, one wonders if it really makes a difference. If the debtor is unable to obtain cramdown because of the non-availability of the new value exception, then it is likely the secured creditor will ultimately obtain stay relief or otherwise be able to realize on its collateral. If that were to occur, the unsecured creditors are left with nothing. Accordingly, taking the chance that a liquidation plan would be put into effect by the same secured creditor leaves the unsecured creditor no worse off, and indeed the unsecured creditors probably have more leverage in dealing with the secured creditor in obtaining some payout in order to obtain their vote.

Query: Do the unsecured creditors really benefit from the rationale of the Fourth and Second Circuits? Probably not. Classification issues aside, the availability of a new value plan gives the debtor incentive to either make peace with the unsecured trade creditors or, at a minimum, make enough of a new value contribution to hopefully increase the recovery to unsecured creditors. Certainly if the new value exception is not available, the secured creditor will have essentially a veto power over confirmation, and the unsecured creditors have no leverage and less likelihood of any significant recovery because the secured creditor undoubtedly wishes to obtain the collateral through a foreclosure or other means.


Footnotes

1See In re Bonner Mall Partnership, 2 F.3d 899 (9th Cir. 1993); In re 203 North LaSalle Street Partnership, 126 F.3d 955 (7th Cir. 1997). Return to Text

2See In re Bryson Properties, XVIII, 961 F.2d 496 (4th Cir. 1992) (Bryson). Return to Text

3Of course, the "marketing of the property" dicta really makes no sense. The debtor could never show that there was no "market for the property" because presumably the secured creditor whose ox is being gored would certainly suggest that there is a ready market for the property—the secured lender would take the property in a foreclosure. Return to Text

Journal Date: 
Monday, June 1, 1998